Dix-Carneiro and Kovak Trade Reform and Regional Dynamics Other potential explanations are less plausible. First, following the logic of our model in Section 4.1, capital could be slowly reallocating from firms in the formal sector to firms in the informal sector. This mechanism is unlikely, as firms in the informal sector are much less capital intensive than firms in the formal sector (LaPorta and Schleifer 2008, Fajnzylber et al. 2011). Second, displaced formal sector workers who move into informal employment may have more favorable unobserved characteristics than average informal workers, even after controlling for education and other demographics we use when calculating regional wage premia. This mechanism would predict that overall wage effects mirror those for the formal sector, since compositional changes net out when combining informal and formal employment. We show that this is not the case by examining liberalization’s effects on overall wages for formal and informal workers together.

Table 12 shows the effects of regional tariff changes on overall wages for all workers irrespective of formal status. In 2000, we find that wages for all workers fell more in regions facing larger tariff declines. The coefficients are positive and significant in many specifications, consistent with the formal sector results in Table 1. However, in contrast to the formal sector, there is little evidence of growing wage effects by 2010. These effects are imprecisely estimated and vary substantially across specifications. More generally, the findings for all workers in Table 12 make it clear that liberalization had very different effects on the formal and informal sectors. These important differences would be missed if one only examined overall wage effects without regard to formality.

# **8 Conclusion**

In this paper, we have examined regional labor market dynamics following the Brazilian trade liberalization of the early 1990s. Using matched employer-employee data as our primary data source, we find large effects of trade liberalization on regional formal labor market outcomes such as earnings and employment. Contrary to conventional wisdom, which assumes equalizing labor adjustment, the regional effects of liberalization grow for more than a decade before leveling off. This pattern is not driven by post-liberalization economic shocks and is robust to a wide variety of alternative specifications. Rather, we argue that it is driven by mutually reinforcing, imperfect, and slow adjustment of labor and complementary factors, driving dynamics in local labor demand. We present a specific-factors model allowing for imperfect and slow factor adjustment, which yields a theoretically consistent measure of liberalization’s effects on local labor demand and rationalizes the labor market dynamics we observe. Dix-Carneiro (2014) shows that adjustment frictions across industries in both labor and capital can lead to quantitatively similar effects to those we observe While there is little direct evidence on the relative quality of goods produced by formal and informal firms, it is well known that informal firms are significantly smaller than formal firms (LaPorta and Schleifer 2014, Meghir et al. forthcoming, Ulyssea 2014), and Kugler and Verhoogen (2011) show that larger firms produce higher quality goods than small firms, on average. Moreover, LaPorta and Schleifer (2008) show that informal firms use lower quality inputs and speculate that they produce lower quality outputs as a result.

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