Segmented Labor Markets and Structural Transformation

Abstract

Most urban growth this century will occur in developing economies. Whether this urbanization translates into sustained economic development depends on how quickly workers gain access to productive formal employment. I develop a dynamic spatial general equilibrium model with three types of labor markets: rural, urban informal, and urban formal. Migrants enter an informal queue, and formalization depends on informal labor congestion and the economy’s capacity to move informal workers into formal employment. I quantify the model for Ethiopia using novel geospatial and microdata. Formalization speed emerges as a key determinant of long-run structural transformation, growth, and welfare. At current capacity, workers wait about 26 years for a formal job and informality persists. Reducing formalization frictions to match rates observed in successfully transforming economies cuts the wait to about 17 years. This raises the urban formal employment share by 26 percentage points and real GDP by 13.1 percent by 2065. Formalization speed shapes the effectiveness of economic policies and national resilience to climate shocks and conflict. Cities become engines of structural transformation not when workers arrive, but when labor markets absorb them into productive employment.