# **1 Introduction**

This paper seeks to understand the impact of market-oriented structural reforms on steady state unemployment, wage dispersion and the distribution of employment across sectors in a small open economy with a persistently large informal sector. To this end, I formulate and estimate an equilibrium search and matching model of a labor market with search frictions and idiosyncratic productivity shocks.

The central idea behind modeling the labor market with a search model (instead of a neoclassical one) is that, given the existence of heterogeneity, frictions or imperfect information, search is a costly activity for both firms and workers who must spend resources before job creation and job destruction occurs. In these types of models equilibrium unemployment in the steady state emerges naturally as a result of the transitions in and out of unemployment, since some existing jobs break up before new matches are made. None of these properties characterize Walrasian labor markets.

The model is particularly relevant for developing economies, in particular Latin American (LA) economies, where wage inequality, high unemployment, job instability and large informal sectors are longstanding concerns, particularly in the last two decades (Inter-American Development Bank, 2004)<sup>1</sup> .

After the 1990s, many LA countries followed a sequence of market-oriented structural reforms, including changes in labor market legislation, social security programs, and changes in the degree of trade and financial openness. The extent to which these countries’ labor market, trade and social security reforms contribute to deteriorating labor market conditions is still a debatable question in the literature. Some other factors including aggregate and idiosyncratic market shocks, demographic changes affecting the size of the labor force, or skill biased-technological change may also play an important role<sup>2</sup> .

The model is simulated for the Colombian economy, a country that in the 1990s and 2000s implemented substantial market-oriented reforms whose main goal was to deregulate labor and markets.

There are some previous empirical studies focusing on the effects of Colombian structural reforms on labor markets: Cardenas and Gutierrez (1996); Cardenas, Kugler and Bernal (1998); Kugler (1999); Eslava, Haltiwanger, Kugler and Kugler (2010); Camacho, Conover and Hoyos (2013). Most of these studies employ reduced form estimation and none of them build a search model as an analytical framework to understand incentives behind flows between the formal and informal sectors. I provide a new lens to study the impact of the reforms by building and estimating

> 1 The informal sector is particularly large in Latin American economies (from 30 to 70 percent of GDP) according to some studies (Maloney, 2004). Other studies (Schneider, 2005) suggest also that the size of the informal sector in other economies is not negligible. They estimate that, for the period 1999-2000, the average size of the informal economy (as percent of GDP) is 41.2 percent in African countries, 26.3 percent in Asian countries, 37.9 percent in transitional economies and 16.7 percent in OECD countries.

> 2For a survey of the impact of labor market regulations in Latin America see Heckman and Pages (2004), on the impact of trade liberalization and job turnover, see Haltiwanger et al (2004). For a survey of the impact of trade on wage inequality and informality in Latin America and other developing economies see Attanazio, Goldberg and Pavcnik (2004).

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