n?u=RePEc:irn:wpaper:16-09&r=ara

University of Neuchatel

Institute of Economic Research

IRENE, Work**in**g paper 16-09

**Informality**, **Public** **Employment** **and**

**Employment** **Protection** **in** Develop**in**g **Countries**

François Langot*

Shaimaa Yass**in****

* University of Le Mans (GAINS-TEPP & IRA), Paris School of Economics,

CEPREMAP **and** IZA. Email: flangot@univ-lemans.fr.

** University of Neuchâtel (IRENE), University of Paris 1 Pantheon-

Sorbonne (CES **and** Paris School of Economics) **and** University of Le Mans

(GAINS-TEPP). Email: shaimaa.yass**in**@un**in**e.ch

**Informality**, **Public** **Employment** **and** **Employment** **Protection** **in**

Develop**in**g **Countries** ∗

François Langot † Shaimaa Yass**in** ‡

November 2016

Abstract

This paper proposes an equilibrium match**in**g labor market model for develop**in**g countries

where the **in**teraction between public, formal **and** **in**formal sectors is considered. Theoretical

analysis shows that labor markets’ liberalization reforms can be evicted by shifts **in** public employment.

S**in**ce the public sector accounts for a substantial share of employment **in** develop**in**g

countries, this approach is crucial to underst**and** their labor market outcomes. Wage offers to

public sector employees **in**crease the outside option value of workers dur**in**g their barga**in****in**g

processes **in** the formal **and** **in**formal sectors. It becomes more profitable for workers to search

on-the-job to access more attractive **and** stable jobs. The public sector acts as an additional tax

imposed on private firms. Us**in**g workers flows data from Egypt, we show that labor markets’

liberalization plays aga**in**st **in**formal employment by **in**creas**in**g formal jobs’ profitability, but is

evicted by the **in**crease of public sector wages observed at the same time.

JEL Classification: E24; E26; J60; J64; O17

Keywords: Job search, **Informality**, **Public** Sector, Egypt, Unemployment, Wages, Policy

Interventions.

∗ We thank R. Assaad, O. Charlot, N. Jacquemet, D. Margolis, F. Postel-V**in**ay **and** H. Turon for their

helpful comments. We also appreciate feedback from the research sem**in**ar participants at the University of

Paris 1 Pantheon-Sorbonne (CES), Paris School of Economics **and** the University of Le Mans (GAINS-TEPP).

† University of Le Mans (GAINS-TEPP & IRA), Paris School of Economics, Cepremap **and** IZA. Email:

flangot@univ-lemans.fr.

‡ University of Neuchâtel (IRENE), University of Paris 1 Pantheon-Sorbonne (CES **and** Paris School

of Economics) **and** University of Le Mans (GAINS-TEPP). Email: shaimaa.yass**in**@un**in**e.ch or

yass**in**.shaimaa@gmail.com

1

1 Introduction

Policy prescriptions for develop**in**g countries struggl**in**g to raise their **in**come levels are often

contradictory. Although provid**in**g more employment should alleviate poverty, there is no

clear consensus regard**in**g the best policies for exp**and****in**g employment opportunities **in** these

economies. Labor market regulations are necessary to protect the rights of workers **and** to

improve their work**in**g conditions. Yet, they might discourage firms from hir**in**g workers **and**

would thus have un**in**tended consequences of harm**in**g the people they are designed to protect.

**Public** sector employment policies **and** conditions can also contradict these regulations

where workers would will**in**gly queue for the more attractive **and** more stable public sector

jobs. Fiscal realities, however, make it impossible for these government jobs to absorb all

those queu**in**g job seekers. Moreover, **in** develop**in**g countries, massive non-compliance is the

norm **and** labor market regulations could simply encourage the expansion of a non-regulated

**in**formal market, where wages are lower, employment is more flexible **and** work**in**g conditions

are worse. The aim of this paper is to provide a new theoretical model of the labor market

where the **in**teractions between public, formal **and** **in**formal sectors can be analyzed as an

equilibrium outcome. It also provides empirical support to these theoretical implications by

us**in**g data on Egypt, which provide an **in**terest**in**g natural experiment where policies directed

towards the private **and** public employment sectors have changed at the same time.

S**in**ce the flow approach to labor markets has become the basic toolbox to modern labor

macroeconomics, this paper proposes an equilibrium match**in**g model à la Diamond-

Mortensen-Pissarides (DMP). We extend the textbook model **in** order to take **in**to account

the **in**teraction between the public, the formal private **and** the **in**formal 1 private employment

sectors, as well as the job-to-job mobilities. A worker’s employment/non-employment choices

are therefore based on the comparisons between his/her expected job values **in** the current

or all the prospective jobs i.e **in** any of the three employment sectors. There have been recent

attempts to **in**clude with**in** the DMP model an **in**formal sector (such as Albrecht et al.

(2009), Meghir et al. (2015), Bosch **and** Esteban-Pretel (2012), Charlot et al. (2013, 2014)

**and** Charlot et al. (2015)) or a public sector **and** an unsegmented private sector (such as

Burdett (2012) , Postel-V**in**ay et al. (2016)). In this paper, we aim to add both an **in**formal

**and** a public sector to the Mortensen **and** Pissarides (1994) model, with job-to-job transitions.

These extensions are crucial to underst**and** the economic mechanisms result**in**g **in** the

1 The **in**formal sector **in** this paper is def**in**ed as the wage employment that is not taxed or controlled by

any form of government. The lack of a contract **and** social **in**surance identify **in**formal wage workers **in** our

dataset.

2

labor market outcomes of develop**in**g countries, which are characterized by large proportions

of their employment be**in**g **in** the **in**formal **and** the public sectors.

How can these **in**teractions between sectors be illum**in**at**in**g? First, the workers’ occupational

choices between sectors imply that their outside options depend on opportunities **in**

all sectors: when they barga**in** their wages **in** a particular sector, they **in**tegrate their potential

opportunities **in** other sectors. Hence, if the formal sector becomes more profitable, the

threat po**in**t of the employees **in** each sector goes up, lead**in**g to wage pressures **in** the **in**formal

sector. If the latter does not observe changes **in** its profitability, workers move to the formal

sector, which will be the most able to support these high wages. The **in**teraction between the

private (formal **and** **in**formal) sector **and** the public sector is also **in**terest**in**g. Indeed, if the

public sector provides high wages, it is profitable for the employees to search on-the-job, **in**

order to move to these types of jobs. Hence, the public sector can act as an additional tax

imposed on the private firms: they pay an open**in**g cost **in** order to hire workers, but dur**in**g

the duration of the contract, some of these workers will choose to move to a more stable

better paid opportunity, **in** the public sector. The model built **in** this paper also takes **in**to

consideration the fiscal realities faced by the public sector. It’s true that the public sector can

**in**crease its wages but given its budgetary constra**in**t, it is likely to decrease the rate at which

it hires employees. This could be done by ration**in**g public sector vacancies for **in**stance.

In this paper, we use available data on labor market flows **in** Egypt, from the Egypt Labor

Market Panel Survey (ELMPS) rounds **in** 1998, 2006 **and** 2012, between the different employment

sectors **and** unemployment as an application to our model. Egypt is a Middle East

**and** North Africa (MENA) country with a substantial unregulated **in**formal private sector,

that counts up to 40% of wage work, **and** a sizable public sector employer. Egypt has long

been ranked as a country with very rigid labor laws 2 . Accord**in**g to different labor regulations

**in**dices it was ranked among the most rigid MENA region countries, which are themselves

the most restrictive develop**in**g countries, after the Lat**in** American region (see (Veganzones-

Varoudakis **and** Pissarides, 2007) **and** (Campos **and** Nugent, 2012)). The importance of a

more flexible labor market was therefore recognized by the Egyptian Government **in** 2003,

2 Accord**in**g to WorldBank (2014), this has stemmed from the time when virtually all **in**dustrial employment

was public sector **and** heavily unionized. In 1990, the private sector accounted at most for 23 percent of Egypt’s

manufactur**in**g sector output, **and** 25 percent of its employees. Very bureaucratic rules were established. Fear

of social costs of privatization may have kept these rules rigid, especially the costs of pay**in**g off fired workers.

The crisis of the beg**in**n**in**g of the n**in**eties, compelled the government to look to the International Monetary

Fund (IMF), World Bank **and** the Paris Club for support, where Egypt was required to undergo a structural

adjustment package as a counterpart to receiv**in**g a st**and**-by credit. The result was an **in**crease **in** economic

activity, **and** strong growth **in** private-sector manufactur**in**g. By 2003, the share of the Egyptian total **in**dustrial

value added reached 70 percent **and** employment **in**creased substantially to 60 percent.

3

as they **in**troduced the new labor law (No.12). The law came to action **in** 2004 aim**in**g at

**in**creas**in**g the flexibility of the hir**in**g **and** fir**in**g processes **in** Egypt.

It directly addresses

the right of the employer to term**in**ate an employee’s contract **and** the conditions **in** which it

performs under. With such a reform, should an employer need to go out of bus**in**ess, he gets

the right to lay off all workers. In case of economic necessity, an employer has the right to lay

off workers or modify contracts given that he provides a certa**in** notice period(see WorldBank

(2014) for more details).

Theoretically, the liberalization of the labor market, modeled through the **in**troduction of

reduced fir**in**g taxes **in** a conventional one-sector Mortensen **and** Pissarides (1994) job search

model, leads to the **in**crease of both job creation **and** job destruction.

Empirical f**in**d**in**gs

**in** Langot **and** Yass**in** (2015) suggest however that the 2004 Egyptian labor market reform

**in**creased significantly the separation rates **and** had no significant impact on the job f**in**d**in**g

rates 3 . We use the proposed 3-sector job search model to offer an explanation to this empirical

paradox. Even though the policy is directed to the formal private sector, it surely affects the

**in**teraction **and** the flow of workers between the different employment sectors, which is what

the conventional aggregate Mortensen **and** Pissarides (1994) model fails to expla**in**.

Our ma**in** f**in**d**in**gs suggest that **in**troduc**in**g flexible employment protection rules, modeled

as reduced fir**in**g taxes, favors a more proportionate **in**crease **in** the job separations of the

private formal sector than the **in**crease **in** job creations of the same employment sector. These

effects can themselves be evicted by changes **in** the wage policy of the public sector. We also

show that the liberalization of the labor market **in**creases job separations **in** the **in**formal sector

**and** decreases workers f**in**d**in**g **in** **in**formal jobs. Hence, **in**troduc**in**g flexibility **in**to develop**in**g

countries’ labor markets is important to scale down the difference between formal **and** **in**formal

jobs. Such a reform causes a shift of employment from **in**formal jobs, which are very flexible

by def**in**ition given that they are not controlled by any **in**stitutional regulations, to formal

work. However, if at the same time, the wages offered by the public sector are **in**creased,

this creates a crowd**in**g out effect: the new surpluses created by the labor market reform are

more than compensated by the new costs of worker mobility **in**duced by the **in**crease **in** the

attractiveness of the public sector. We show that this result is robust, even if the **in**troduction

of reduced fir**in**g taxes decreases the proportion of on-the job search towards the public sector

of both workers **in** the formal **and** **in**formal sectors. This paper therefore supports the view

that s**in**ce reduc**in**g fir**in**g taxes **in** Egypt has been accompanied simultaneously by an **in**crease

3 These rates represent the overall labor market flows. There is no dist**in**ction made between the three

employment sectors to calculate the separation **and** job f**in**d**in**g rates **in** Langot **and** Yass**in** (2015).

4

**in** the real wages of public sector workers 4 , formal **and** **in**formal workers are encouraged to

search more on-the-job to move to the public sector: this tends to cancel out the positive

effect on the private formal sector’s job creation, **and** may even reduce it. The net effect of

the reform would therefore be an **in**crease **in** the unemployment rates s**in**ce job separations **in**

all cases are enhanced, but job f**in**d**in**gs rema**in** unchanged or even dampened.

In this paper, we choose to focus on explor**in**g the effects of fir**in**g taxes **and** public sector

wage policies on job creation, job destruction, on-the-job search **and** employment. It is worth

not**in**g however that the model developed **in** this paper can be used to explore the effect of

changes of many other parameters such as subsidies, cost of ma**in**ta**in****in**g jobs **and** productivity

shocks on labor market outcomes. For the purpose of this paper, we limit the analysis to

fir**in**g taxes **and** public sector wage policies. The model can therefore provide ma**in** guidel**in**es

to how develop**in**g countries need to design their future employment policies, whether public

or private, **in** order to obta**in** the most efficient labor market outcomes.

The rest of the paper is divided as follows. In section 2, we extend a theoretical job search

equilibrium model a la Mortensen **and** Pissarides (1994) show**in**g the **in**teraction between the

three typical wage employment sectors **in** a develop**in**g nation, namely (public, formal **and**

**in**formal), **and** the non-employment state. We calibrate the model **in** section 3 **and** provide

simulations for the impact of structural reforms that can take place **in** such economies, such

as the 2004 Labor law **in** Egypt **and** the change **in** the wage **and** hir**in**g policies of the public

sector. Section 4 shows support**in**g evidence from available data on labor market flows **in**

Egypt, between the employment sectors **and** unemployment, before **and** after the 2004 reform.

We then conclude **in** section 5.

2 A Model with Formal, Informal **and** **Public** Sectors

2.1 Sett**in**g the Model

Match**in**g.

Job **and** worker match**in**g **in** the private sector is viewed as a production process.

The function m i (v i , u) represents the match**in**g rate **in** sector i = F, I associated with every

possible vacancy **in** that sector **and** unemployment pair. Based on evidence from Petrongolo

**and** Pissarides (2001), constant returns is considered a convenient assumption, such that for

4 The **in**crease of the public sector wages is more proportionate than than the **in**crease **in** the wages of

private sector workers. Said (2015) shows that over the period 1998-2006, i.e. from a po**in**t **in** time before the

reform to a po**in**t **in** time after, there has been a 40% **in**crease **in** the median real monthly wages of government

employees, a 26% **in**crease **in** the median real monthly wages of public firm’ employees **and** only a 9% **in**crease

**in** the median real wage of the private sector.

5

i = F, I, we have m i (v i , u) = m i (1, u v i

) ≡ q i (θ i ), where θ i = v i

u

, is the labor market tightness

**in** sector i i.e.

the ratio of vacancies **in** that specific sector to the overall unemployment.

These are endogenous variables **and** are determ**in**ed by the model. In either the formal or the

**in**formal private sector, a vacant job is taken by a worker at the rate q i (θ i ). The rate at which

workers f**in**d jobs is θ i q i (θ i ). Given that the match**in**g functions are assumed to be concave,

homogeneous **and** l**in**ear, q i (θ i ) decreases **in** θ i , while θ i q i (θ i ) **in**creases **in** θ i .

Job heterogeneity.

The output of a job **in** sector i is the product of two components p i , a

common productivity of all jobs **in** a particular skill group **in** sector i, **and** x, the idiosyncratic

component tak**in**g values on the unit **in**terval **and** arriv**in**g from time to time at the Poisson

rate λ i . Given an arrival of an idiosyncratic shock, x is distributed accord**in**g to the c.d.f.

F (x). The sequence of shocks is **in**dependently **and** identically distributed (i.i.d.). In a specific

sector, an exist**in**g match is destroyed if the idiosyncratic productivity shock falls below an

endogenous reservation threshold R i specific to each sector. The average rate of transition

from employment **in** sector i to unemployment is therefore λ i F (R i ), which **in**creases with

the reservation threshold. S**in**ce certa**in** workers take the private sector (whether formal or

**in**formal) as an **in**termediary till they get their appo**in**tment **in** the public sector (Yass**in**,

2015), we allow for these types of transitions among a productivity level (x) below a certa**in**

qualification threshold (Q i ). Offers from the public sector arrive at an exogenous poisson

rate λ iG , with i = F, I depend**in**g on where the worker receiv**in**g the offer is hired. In simple

words, when it’s a good/high productivity job, there is no **in**terest to search for another **and**

when it’s a bad/low productivity job, it’s only an **in**termediate step till the public sector’s

appo**in**tment arrives. In each of the private sectors, formal (F ) **and** **in**formal (I), there are

therefore 3 values: (i) the **in**itial value (0) of the match as it starts, when x is at its highest

i.e. x = 1 , (ii) the no-search value (NS) when Q i < x ≤ 1, **and** (iii) the on-the-job search

value (S), when R i ≤ x ≤ Q i .

Match destroyed On-the-job search (S) No search (NS)

x =

0 R i Q i 1

**Public** employment.

The public sector is added as an exogenous player. Wages, as well as

the employment strategy are determ**in**ed by the policy maker **and** should not be determ**in**ed

by the Nash barga**in****in**g rule. The exogenous wages **and** number of **in**dividuals hired **in** the

public sector are however constra**in**ed by a government budget D. Workers with**in** the public

6

sector are neither hit by productivity reallocation shocks nor get laid off.

workers retire at an exogenous rate δ.

In all sectors,

Hir**in**g **and** fir**in**g costs. The flow cost of recruit**in**g **in** each sector is c i p i . Applications **in**

each sector beg**in** arriv**in**g at a hazard rate q i (θ i ). Only **in** the formal sector, the firm is required

to pay a set-up cost p F C. This **in**cludes the cost of hir**in**g **in** terms of legal formalities, tra**in****in**g

**and** other forms of match specific **in**vestments. The **in**formal sector be**in**g not controlled by

any form of government is assumed not to **in**cur any of these costs. If x falls below some

reservation level R i (p i ), job destruction takes place. Only formal firms **in** that case pay a

fir**in**g cost p F T . This is an implicit fir**in**g tax imposed by employment protection regulations.

2.2 Private Firms’ Behavior

2.2.1 Formal Firms

The **in**itial value of an occupied job **in** the formal sector is given by the equation :

∫ 1

(r + δ)JF 0 (1) = p F − wF 0 [

+ τ + λ F max{J

NS

F (z), JF S (z)} − JF 0 (1) ] dF (z)

R F

+ λ F F F (R F )[V F − p F T − JF 0 (1)] (1)

r **and** τ represent respectively the risk free **in**terest rate **and** a payroll tax. V F is the value

of a vacancy **in** the formal private sector. S**in**ce the idiosyncratic component of a new job is

x = 1, **and** due to the existence of job creation costs p F C **and** policy parameters, p F H **and**

p F T , we def**in**e JF 0 (1) as the expected profit of a new match to the employer, given an **in**itial

formal sector wage w 0 F .

A cont**in**u**in**g match has a specific productivity x. However, as expla**in**ed **in** the previous

section, we def**in**e two **in**tervals: (i) no search **and** (ii) on-the-job search. If it’s a good (high

productivity) job i.e x > Q F , the workers will not be look**in**g for a job **in** the public sector i.e.

no on-the-job search (NS), **and** the capital value of the job to the employer JF

NS (x) therefore

solves the follow**in**g asset pric**in**g equation for each p F ,

(r + δ)J NS

F (x) = p F x − w NS

F (x) + τ + λ F

∫ 1

[

max{J

NS

F

R F

(z), JF S (z)} − JF

NS (x) ] dF (z)

+ λ F F F (R F )[V F − p F T − J NS

F (x)] (2)

given the wage wF

NS (x) **and** where the match can end if a new match specific shock z is less

7

than some reservation threshold R F .

If it’s a bad (low-productivity) job x ≤ Q F , the workers are look**in**g for better options

**in** the public sector (on-the-job search S). This decreases the capital value of the job to the

employer. In the asset pric**in**g equation, an outside option be**in**g the transition of the worker

from the formal sector to the public sector is added. This becomes an additional possibility

to why the match can end **in** the future. Given the wage wF S (x), the asset pric**in**g equation

for each p F is:

(r + δ)J S F (x) = p F x − w S F (x) + τ + λ F

∫ 1

[

max{J

NS

F

R F

(z), J S F (z)} − J S F (x) ] dF F (z)

+ λ F F F (R F )[V F − p F T − J S F (x)] + λ F G (V F − J S F ) (3)

Given the def**in**itions of the policy parameters described **in** the sett**in**g of the model, the

present value of an unfilled vacancy for a formal firm, V F , is:

rV F = −p F c F + q F (θ F )(J 0 F (1) − p F (C − H) − V F ) (4)

Free entry requires that new vacancies are created until the capital value of hold**in**g one is

driven to zero i.e. V F = 0. The free entry condition for formal jobs can therefore be formalized

us**in**g the equation:

p F c

q F (θ F ) + p F (C − H) = J 0 F (1) (5)

The free entry condition therefore equates the cost of recruit**in**g **and** hir**in**g a worker to the

expected discounted future profit stream.

2.2.2 Informal Firms

The logic beh**in**d the behavior of the **in**formal firms is similar to that of the formal firms

except that any form of government regulation or policy parameter is be**in**g excluded.

It

follows that, **in** the **in**formal sector, there will neither be fir**in**g costs nor sett**in**g up costs.

The **in**itial job value with an idiosyncratic productivity x = 1 **in** that case would be exactly

equal to the capital value of a job **in** a cont**in**u**in**g match over the no search **in**terval i.e. if

Q I < x ≤ 1, we formally have J 0 I

whether workers are on the job-search or not.

(1) = J

NS

I

(1). Q I is the skill threshold that determ**in**es

In the case of a high-productivity job i.e. x > Q I , the only way the match can end is

8

if a new match with a specific shock z arrives, **and** this shock is lower than the reservation

threshold R I . With a wage wI

NS (x), the expected profit of the job to the employer is:

(r + δ)J NS

I (x) = p I x − w NS

I (x) + λ I

∫ 1

[

max{J

NS

I

R I

(z), JI S (z)} − JI

NS (x) ] dF I (z)

+ λ I F I (R I )[V I − J NS

I (x)] (6)

When it’s a bad low-productivity job, i.e. x ≤ Q I , on-the-job search towards the public sector

becomes an outside option **and** threatens the match to end. The capital value to an employer

J S I

(x) is therefore the solution of the asset-pric**in**g equation:

∫ 1

(r + δ)JI S (x) = p I x − wI S (x) + max{JI

NS (z), JI S (z)} − JI S (x)dF I (z)

R I

+ λ I F I (R I )(V I − J S I (x)) + λ IG (V I − J S I (x)) (7)

In the **in**formal sector there are no policy parameters, the value of a vacant job is therefore:

rV I = −p I c + q I (θ I )J NS

I (1) (8)

The free entry condition for **in**formal firms therefore equates the cost of recruit**in**g **and** the

anticipated profit of the match to the employer:

2.3 Workers’ Behavior

p I c

q I (θ I ) = J NS

I (1) (9)

An employed worker can be either employed **in** the formal or the **in**formal sector i = F, I

respectively. Accord**in**g to the level of productivity x, the worker decides whether to search

on-the-job for better options **in** the public sector or not. The **in**itial job value of a worker,

Wi 0 (1), **in** sector i = F, I is when the idiosyncratic component is at its highest value i.e.

x = 1. This is expressed by the equation:

∫ 1

(r + δ)Wi 0 (1) = wi 0 [

(1) + λ i max{W

NS

i (z), Wi S (z)} − W 0 ]

i dFi (z) + λ i F (R i )(U − Wi 0 (1)) (10)

R i

For a cont**in**u**in**g match, as the specific productivity x is below the on-the-job search threshold

of the sector, Q i , the worker will be search**in**g for better options **in** the public sector with an

exogenous poisson rate of arrival of public sector offers λ iG . The rate at which the public

9

sector hires workers is therefore specific to the sector i where the worker is employed as he/she

receives the offer. The worker’s value Wi S (x) **in** that case solves the follow**in**g asset pric**in**g

equation:

(r + δ)W S

i (x) = w S i (x) + λ i

∫ 1

[

max{W

NS

i

R i

(z), W S

i (z)} − W S

i (x) ] dF i (z)

+ λ i F i (R i )(U − W S

i (x)) + λ iG (W G − W S

i (x)) (11)

If the specific productivity x exceeds the threshold Q i , the only outside option for the worker

becomes unemployment. No on-the-job search takes place **in** that case. The worker’s value

over the no search **in**terval is expressed by:

∫ 1

(r + δ)Wi NS (x) = wi NS

[

(x) + λ i max{W

NS

i (z), Wi S (z)} − W NS ]

i dFi (z)

R i

+ λ i F i (R i )(U − W NS

i (x)) (12)

Be**in**g unemployed **in** this economy, the **in**dividual receives an imputed **in**come b > 0. In

the future, the unemployed can get hired by one of the three sectors, private formal, private

**in**formal or public. The follow**in**g bellman equation therefore solves for the value of be**in**g

unemployed, U:

(r + δ)U = b + θ F q F (W 0 F (1) − U) + θ I q I (W 0 I (1) − U) + λ UG (W G − U) (13)

By arriv**in**g to the public sector, the workers **in** our model are content with their jobs. In

the model, the government employees are assumed not to be search**in**g for jobs **in** the private

sector 5 . Moreover, transitions from employment to unemployment are very rare among public

sector workers **and** are therefore set to zero. Given that the public sector wage policy (offer**in**g

a wage w g ) is assumed to be determ**in**ed accord**in**g to the government’s exogenous budget,

the value of an employed worker **in** the public sector is W G , where

(r + δ)W G = w g (14)

5 Evidence from the Egypt Labor Market Panel Survey for **in**stance, **in** Assaad et al. (2016), has shown that

transitions from the public sector to other sectors **in**clud**in**g the private sector (whether formal or **in**formal)

**and** non-wage work are very few, sometimes nil.

10

2.4 The Separation Rule

In the formal sector, given a match product shock z, a firm decides to destroy a job,

whether with**in** the on-the-job search or the no search **in**terval, if **and** only if the value of

hold**in**g it as a vacancy exceeds its value as a cont**in**u**in**g job plus the fir**in**g costs p F T . In

other words, V j F > J j F (z) + p F T , where j = NS, S. Similarly, a worker **in** the private sector

prefers to stay unemployed if **and** only if U > W j F

(z). S**in**ce, under the wage rule, **and** as

we will show below, J j F (z) **and** W j F

(z) are **in**creas**in**g, separation occurs when a new value of

the shock arrives **and** falls below a reservation threshold R F . This reservation productivity

R F

is def**in**ed as max{R eF , R wF }, where W j F (R wF ) = U **and** J j F (R eF ) = V F − p F T . The

separation rule **in** our case, a bilateral barga**in**, should be jo**in**tly optimal **in** the sense that it

maximizes the total wealth. The necessary **and** sufficient condition for this jo**in**t optimization

is therefore R F = R eF = R wF imply**in**g that J(R F ) + W (R F ) = V F − p F T + U.

Similarly, the same reason**in**g applies to come up with the reservation threshold **and** the

necessary **and** sufficient condition for the jo**in**t optimization **in** the **in**formal sector. The only

difference is that no fir**in**g costs should be paid by the employer as jobs are destroyed. It

therefore follows that R I is def**in**ed as max{R eI , R wI }, where W j I (R wI) = U **and** J j I (R eI) =

V I , with j = S, NS. The necessary **and** sufficient condition for the jo**in**t optimization would

be R I = R eI = R wI lead**in**g to J(R I ) + W (R I ) = V I + U.

2.5 On-the-job Search

After deriv**in**g the value of the surplus **in** every sector, as shown **in** appendix A, it becomes

possible to determ**in**e the threshold at which workers would decide to search on-the-job or

not. In the formal sector, the productivity threshold Q F is def**in**ed when the surplus obta**in**ed

from a job with on-the-job search is equal to the surplus obta**in**ed from one with no search,

such that SF

NS(Q

F ) = SF S(Q F ). By do**in**g so, one obta**in**s

λ F G S S F (Q F ) = λ F G [p F T + (W G − U)] (15)

which allows us to derive a unique value for Q F , only if λ F G > 0. If λ F G = 0, the threshold

Q F

can not be def**in**ed. Us**in**g equations 15 **and** 46, the expression for Q F , the on-the-job

threshold **in** the formal sector, when λ F G > 0 is :

(

Q F = R F + (r + δ + λ F + λ F G ) T + W )

G − U

p F

(16)

11

Similarly **in** the **in**formal sector, the productivity threshold Q I is def**in**ed when the surplus

obta**in**ed from an **in**formal job with on-the-job search is equal to the surplus obta**in**ed from

one with no search, such that SI

NS (Q I ) = SI S(Q I). By do**in**g so, one obta**in**s

λ IG S S I (Q I ) = λ IG (W G − U) (17)

As **in** the formal sector, the Q I

threshold is only def**in**ed if λ IG > 0 **and** is consequently

expressed as follows:

Q I = R I + (r + δ + λ I + λ IG ) W G − U

p I

(18)

2.6 Nash Barga**in****in**g **and** Wage Determ**in**ation

The wages are barga**in**ed, with β be**in**g the worker’s barga**in****in**g power **and** 1 − β the

employer’s, **and** V i = 0 (i = F, I) is set accord**in**g to the free-entry condition. By us**in**g the

def**in**itions **and** expressions of surpluses derived **in** appendix A, we are able to build up the

first order conditions of the st**and**ard wage optimization problem for each sector i = F, I,

dur**in**g the absence **and** presence of on-the-job search. For the **in**itial wage of a job **in** the

formal sector, we obta**in**

β(J 0 F (1) − V F − p F (C − H)) = 1 − β(W 0 F (1) − U) (19)

For a cont**in**u**in**g job **in** the formal sector, we derive the follow**in**g equations:

β(J S F (x) − V F − p F T ) = 1 − β(W S F (x) − U) for x ≤ Q F (20)

β(J NS

F (x) − V F − p F T ) = 1 − β(W NS

F (x) − U) for x > Q F (21)

Recall**in**g that the **in**itial wage **in** the **in**formal sector is the same as the wage of a no-search

job when x = 1, i.e. w 0 I

(1) = wNS

I

(1), the first order condition for an **in**formal job is

β(J NS

I (x) − V I ) = 1 − β(W NS

I (x) − U) for x > Q I (22)

β(J S I (x) − V I ) = 1 − β(W S I (x) − U) for x ≤ Q I (23)

Us**in**g the free entry conditions for the formal **and** **in**formal sectors

JF 0 (1) **and**

p

Ic

q I (θ I )

p F c

q F (θ F ) + p F (C − H) =

= JI NS (1) respectively, we can re-write (WF 0 β

(1) − U) =

1−β

p F c

q F (θ F )

**and**

12

(WI NS (1) − U) = β p I c

1−β q I (θ I ) . This implies6 :

(r + δ)U =

r + δ

r + δ + λ UG

(b +

βc

1 − β (θ F p F + θ I p I )) +

λ UG

r + δ + λ UG

w G (24)

Introduc**in**g these results **in** the wage equations, we obta**in** the expressions for the **in**itial wages

**and** wages **in** cont**in**u**in**g jobs **in** both the formal **and** **in**formal sectors.

Formal Sector.

The **in**itial wage expression **in** the formal sector therefore becomes:

[

wF 0 (1) = β

p F + τ − (r + δ + λ F )p F (C − H) − λ F p F T +

[

]

r + δ

λ UG

+ (1 − β)

b +

w G

r + δ + λ UG r + δ + λ UG

]

r + δ

c(θ F p F + θ I p I )

r + δ + λ UG

For the wages of jobs occupied by workers who are look**in**g out for outside options **in** the

public sector, i.e. x ≤ Q F

(25)

[

wF S (x) = β p F x + τ − (r + δ + λ F G )p F T + r + δ + λ ]

F G

c(θ F p F + θ I p I )

r + δ + λ UG

[ r + δ + λF G

+ (1 − β)

b + λ ]

UG − λ F G

w G

r + δ + λ UG r + δ + λ UG

(26)

For a cont**in**u**in**g match, when workers are not search**in**g on the job, x > Q F , we have:

[

wF NS (x) = β

p F x + τ − (r + δ)p F T +

[

r + δ

+ (1 − β)

b +

r + δ + λ UG

]

r + δ

c(θ F p F + θ I p I )

r + δ + λ UG

]

λ UG

w G

r + δ + λ UG

(27)

As **in** the conventional Mortensen **and** Pissarides (1994) model, the wages of the formal sector

depend on the policy parameters. By **in**troduc**in**g the **in**formal sector **in** the model, these wages

not only depend on the labor market tightness **in** the formal segment of the market, but also

on the labor market tightness **in** the **in**formal sector. As the tightness θ i **in**creases **in** any of

the sectors, the net share of match product obta**in**ed by the employer **in**creases. Add**in**g the

public sector **in**creases the barga**in**ed share of the worker. This is valid at the start of the job

s**in**ce now the outside option is not only be**in**g unemployed **and** receiv**in**g an imputed **in**come

b. It is now possible for an unemployed worker to get hired by the public sector **and** this

therefore adds to his/her net share of the barga**in**ed wage. Moreover, the on-the-job search

6 The expression of W G − U is obta**in**ed us**in**g the public sector worker’s value function (r + δ)W G = w g,

allow**in**g us to obta**in** W G − U = w G−b− βc

1−β (θ F p F +θ I p I )

r+δ+λ UG

.

13

possibility acts as a liability to the employer. It therefore strengthens the worker’s h**and** **in**

the wage barga**in**.

Informal Sector. Similarly **in** the **in**formal sector, the wages depend on the labor market

tightness **in** both segments of the private sector, θ I **and** θ F . S**in**ce the **in**formal sector

represents any form of employment that is not regulated by the government, the wages **in**

this sector do not depend by any means on policy parameters. The outside option of gett**in**g

hired by the public sector, however, strengthens the worker’s barga**in** **and** acts as a tax or

liability to the employer. The **in**formal wage **in** a cont**in**u**in**g match **in** the **in**formal sector,

when workers are search**in**g on-the-job, i.e. x ≤ Q I , becomes:

[

wI NS (x) = β p I x +

] [

r + δ

c(θ F p F + θ I p I ) + (1 − β)

r + δ + λ UG

r + δ

r + δ + λ UG

b +

]

λ UG

w G

r + δ + λ UG

(28)

When, there is no on-the-job search, x > Q I , the wage equation is def**in**ed as:

[

wI S (x) = β p I x + r + δ + λ ] [

iG

r + δ + λiG

c(θ F p F + θ I p I ) + (1 − β)

b + λ ]

UG − λ iG

w G

r + δ + λ UG r + δ + λ UG r + δ + λ UG

(29)

2.7 Equilibrium

Def**in**ition 1 The labor market equilibrium is def**in**ed by the labor market tightness **in** each

segment of the private sector, θ F **and** θ I , the reservation productivity threshold for each sector,

R F **and** R I , **and** the on-the-job search threshold **in** each sector, Q F **and** Q I :

p F c F

q F (θ F )

p I c I

q I (θ I )

= (1 − β)[ p F (1 − R F ) − λ F G p F T − λ F G (W G − U)

r + δ + λ F

− p F (C − H + T )] (30)

= (1 − β)[ p I(1 − R I ) − λ IG (W G − U)

r + δ + λ I

] (31)

p F R F = (r + δ)U − τ − λ F

∫ 1

R F

S F (z)dF F (z) − (r + δ + λ F G )p F T − λ F G (W G − U) (32)

p I R I =

∫ 1

(r + δ)U − λ I S I (z)dF I (z) − λ IG (W G − U)

R I

(33)

p F Q F = p F R F + (r + δ + λ F + λ F G )(p F T + W G − U) (34)

p I Q I = p I R I + (r + δ + λ I + λ IG )(W G − U) (35)

with (r+δ)U =

r+δ

r+δ+λ UG

(b+ βc

1−β (θ F p F +θ I p I ))+

See appendix A for the derivation of the expected surpluses.

λ UG

r+δ+λ UG

w G **and** W G −U = w G−b− βc

1−β (θ F p F +θ I p I )

r+δ+λ UG

.

Us**in**g the wage equations (25)-(29), we plug them **in**to the asset value equations, the job

14

creation, job destruction **and** on-the-job search conditions, **in** order to derive the overall

market equilibrium.

The job destruction conditions (Equations (32) **and** (33)) suggest that at the worst possible

surplus, whether for the formal or **in**formal sector, the reservation productivity does not only

depend on the possible ga**in**s from the match **in** the sector itself. It depends as well on

the potential ga**in**s one could have from pass**in**g on eventually to a job **in** the public sector

after be**in**g for a while **in** the formal or the **in**formal sector. A worker might prefer hav**in**g

a low salary **in** the private sector i.e. a low reservation productivity R i , whether formal or

**in**formal i = F, I, know**in**g that eventually he/she can access the public sector via this job.

The Equations (34 **and** (35) show that the gaps between the two thresholds R i **and** Q i for

i = F, I, are **in**creas**in**g functions of the surplus (W G − U) that a worker will obta**in** if he/she

f**in**ds a job **in** the public sector.

Steady-state Stocks. Us**in**g def**in**ition 1 we can deduce the steady-sate labor market

stocks. The entire Population of the economy, P op, is sub-divided **in**to four sub-populations:

the unemployed u, the public sector employees n G , the formal private sector wage workers

n F **and** the **in**formal private sector wage workers n I :

1 = n F + n I + n G + u (P op) (36)

S**in**ce the model is assumed to be **in** steady-state, for each sub-population, **in**flows are equal

to outflows. This can be formalized by the follow**in**g equations 7

δn G = λ UG u + λ F G n F + λ IG n I (NG) (37)

f F u = λ F F F (R F )n F + λ F G n F (NF ) (38)

f I u = λ I F I (R I )n I + λ IG n I (NI) (39)

Given the above relationships, the number of workers hired **in** the public sector is given by

the equation:

n G =

λ UG

δ + λ UG

+ λ F G − λ UG

δ + λ UG

f F

λ F F F (R F ) + λ F G

u + λ IG − λ UG

δ + λ UG

f I

λ I F I (R I ) + λ IG

u

7 f F **and** f I are the job f**in**d**in**g rates **in** the formal **and** the **in**formal sectors respectively. Formally, f F =

θ F q F (θ F ) **and** f I = θ Iq I(θ I).

15

F**in**ally the steady-state unemployment rate is obta**in**ed:

u =

⎡

δ(λ I F I (R I ) + λ IG )(λ F F F (R F ) + λ F G )

⎤

(40)

⎣ (λ IF I (R I ) + λ IG )(λ F G + δ)f F + (λ F F F (R F ) + λ F G )(λ IG + δ)f I

+(λ I F I (R I ) + λ IG )(λ F F F (R F ) + λ F G )(λ UG + δ)

⎦

Policy. It’s important to note at this po**in**t that due to fiscal realities, even though the

hir**in**g **and** wage policies **in** the public sector are determ**in**ed by the policy maker, they are

limited **and** constra**in**ed by the government’s budget. This is def**in**ed as D such that

D = n G (λ UG , λ F G , λ IG ) × w G (41)

3 A Numerical Analysis of the Model

One of the ma**in** aims of this paper is to expla**in** how the labor market equilibrium, particularly

job creations **and** job destructions, **in** develop**in**g countries react as flexible employment

protection is **in**troduced **in** their markets, **in** a context where the share of public wage employment

is substantially large to evict the impact of such labor market reforms. We use

the case study of the Egyptian labor market as an application to demonstrate these effects.

The **in**troduction of the 2004 Labor Law 8 is modeled by a reduction of the fir**in**g taxes T ,

whereas the observed **in**crease **in** the median real wages of the public sector employees (see

Said (2015)) is modeled by an **in**crease **in** w G **and** is compensated by a decl**in**e **in** the public

sector hir**in**g over the same period **in** order to take **in**to account the budget constra**in**t of the

government 9 . We then show that our model is sufficient to expla**in** the puzzle of the Egyptian

labor market: build**in**g up on the empirical results of Langot **and** Yass**in** (2015), section 4

shows that as the fir**in**g taxes were reduced, only separations **in**creased significantly, while job

creations rema**in**ed unchanged.

We present computed solutions to the model that provide some numerical feel for its

policy implications. Parsimonious functional forms are assumed. We set some basel**in**e parameters

at reasonable values, as per previous literature as shown **in** table 1. Other basel**in**e

8 The Egypt labor law came to action **in** 2004 aim**in**g at **in**creas**in**g the flexibility of the hir**in**g **and** fir**in**g

processes **in** Egypt. The law provides comprehensive guidel**in**es for recruitment, hir**in**g, compensation **and**

term**in**ation of employees. It directly addresses the right of the employer to term**in**ate an employee’s contract

**and** the conditions **in** which it performs under.

9 Assaad (2014) show how the public sector hir**in**g has been decl**in****in**g over the past decade **in** Egypt given

the fiscal constra**in**ts faced by the government **and** hence the **in**ability of the government jobs to absorb the

queu**in**g masses of job seekers.

16

parameters are structurally estimated, us**in**g transitions data moments (table 2) obta**in**ed

from the ELMPS datasets 10 , **and** by apply**in**g a simulated method of moments to match unemployment

spell durations, the oversized share of the public sector **and** **in**cidences typically

experienced by the Egyptian workers **in** the different sectors. 11

3.1 Calibrations

Follow**in**g Mortensen **and** Pissarides (2001), the match**in**g function of sector i = F, I is

log-l**in**ear. Formally, q i (θ i ) = χ i θ −η i

i

where χ i denote the scale parameter of the match**in**g

function **and** η i is the constant elasticity of each sector’s match**in**g function with respect to

unemployment. The distribution of the idiosyncratic shock to match productivity is uniform

over the **in**terval [γ i , 1]. We therefore have F i (x) = x−γ i

1−γ i

. The basel**in**e parameter used for

the policy cases under study are presented **in** Table 1. 12

This table also justifies the choice

of the value of the exogenous basel**in**e parameters. This could be chosen follow**in**g previous

search equilibrium literature, **in**spired by the data or modified to fit results that match the

economy **in** question. The analysis considers only the case of an efficient equilibrium solution

to the model, where β = η. Without any **in**formation on observed productivity **and** associated

wages, we choose to normalize the productivity {p F , p I } = {1, 0.9} **and** the outside option

values {w g , b} = {0.8, 0.7}. This calibration satisfies the **in**tuitive rank**in**g p F > p I > w g > b.

We then use the labor market transitions data moments before the reform (table 2) as well

as the the budget constra**in**t which the government faces (as per the model described **in** section

2) **and** their equilibrium counterparts generated by the theoretical model to estimate the basel**in**e

parameters. More precisely, we estimate the basel**in**e parameters that m**in**imize a function

of the difference between a chosen set of transitions moments from the data ψ **and** data simulated

with these values of structural parameters **and** the steady state solution of the model

ψ(˜Θ). With Θ = {λ F , λ I , λ F G , λ IG , λ UG , χ F , χ I } **and** x SS = {θ SS

F

, θSS I

, R SS

F

, RSS I

, Q SS

F

, QSS I

},

10 The ELMPS 1998, 2006 **and** 2012 are the first, second **and** third rounds of a periodic longitud**in**al survey

that tracks the labor market **and** demographic characteristics of households **and** **in**dividuals **in** Egypt, **in**terviewed

**in** 1998. The households selected **in** the contemporaneous panel data are national-representative **and**

r**and**omly selected. Longitud**in**al annual retrospective panels are extracted to be able to compute the transition

rates of male workers, ages 15-49, between the different employment **and**/or non-employment sectors, over the

period 1999-2011. The recall **and** design bias, which these retrospective panels suffer from (Assaad et al.,

2016), is corrected by us**in**g the markovian structure of these transitions by apply**in**g a simulated method of

moments, as proposed by Langot **and** Yass**in** (2015).

11 Section 4 provides empirical evidence on the labor market transition probabilities **in** the Egyptian labor

market over the period 1999-2011 (i.e before **and** after the reform). Yass**in** (2015) also provides detailed

descriptive statistics **in** the labor market transition probabilities, sectors’ shares **and** unemployment rates

obta**in**ed from the Egypt Labor Market Panel Survey, fielded **in** 2012. Some of these descriptive statistics

provide guidel**in**es **in** our numerical analysis to choose the basel**in**e parameters.

12 Because these policy tools are not relevant for the Egyptian case, we set H = τ = 0.

17

Parameters Benchmark Reason for sett**in**g this value

Worker Barga**in****in**g power β 0.5 To obta**in** an efficient equilibrium solution

Interest rate r 0.09 Average **in**terest rate **in** Egypt over the studied period of time

Cost of ma**in**ta**in****in**g a vacant formal job c F 0.3 Mortensen **and** Pissarides (2001)

Cost of ma**in**ta**in****in**g a vacant **in**formal job c I 0.3 Mortensen **and** Pissarides (2001)

Cost of Sett**in**g up a job **in** the formal sector C 0.3 Mortensen **and** Pissarides (2001)

Government’s budget D 0.23 Average share of public sector × public sector wage

Duration Elasticity (Formal Sector) η F 0.5 Petrongolo **and** Pissarides (2001)

Duration Elasticity (Informal Sector) η I 0.5 Petrongolo **and** Pissarides (2001)

Fir**in**g Tax T 1.6 2 years of the average wage

Lower productivity shock support (Formal) γ F 0 assumed nil

Lower productivity shock support (Informal) γ I 0 assumed nil

Exit rate from participation δ 0.033 30 years as average duration of a worker **in** the job market

Table 1: Exogenous Basel**in**e parameters

we obta**in** ˆΘ = argm**in** Θ ||g(x SS , ˜Θ)||, where

g(x SS , Θ) =

⎧⎡

⎪⎨

⎢

⎣

⎪⎩

JF R F

JF R I

JSR F

JSR I

JT J F

JT J I

JF R G

D

⎤ ⎡

−

⎥ ⎢

⎦ ⎣

⎤

θF

SS ˜χ F (θF SS)

θI

SS ˜χ I (θI SS

)

˜λ F F F (RF SS)

˜λ I F I (RI SS )

˜λ F G F F (Q SS

F )

˜λ IG F I (Q SS

I

)

˜λ UG ⎥

n G (˜λ UG , ˜λ F G , ˜λ

⎦

IG ) × w G

⎫

⎪⎬

⎪⎭

≡

[ )]

ψ − ψ

(˜Θ (42)

**and** such that x SS is the steady state solution of the model’s job creation, destruction **and**

on-the-job search conditions given by the equations 30, 31, 32, 33, 34 **and** 35 respectively.

The results are reported **in** table 2.

Type of Average rate Parameters (Θ) Estimated

Transition (ψ) over 1999-2003 values

JF R F 0.0105 Reallocation Shock (Formal) ̂λ F 0.0216

JF R I 0.0597 Reallocation Shock (Informal) ̂λ I 0.0464

JSR F 0.0110 Transition from Formal to **Public** ̂λ F G 0.0124

JSR I 0.0360 Transition from Informal to **Public** ̂λ IG 0.0126

JT J F 0.0127 Transition from unemployment to **Public** ̂λ UG 0.0150

JT J I 0.0110 Match**in**g Efficiency (Formal) ̂χ F 0.0695

JF R G 0.0163 Match**in**g Efficiency (Informal) ̂χ I 0.1671

1. JF R i refers to the empirical job f**in**d**in**g rate, JSR i refers to the empirical job separation rate, where i = F, I, G, **and** JT J j

refers to the rate of transition from sector j, where j = F, I, to the public sector (G).

2. The table reports the average corrected annual transition rates over the period 1999-2003, i.e. before the reform came to action.

These are calculated by the authors us**in**g a retrospective longitud**in**al panel obta**in**ed from the ELMPS 1998,2006 **and** 2012.

3. We consider non-employment state (i.e. both unemployment **and** **in**activity) to obta**in** these data moments.

Table 2: Data Moments obta**in**ed from ELMPS datasets

18

3.2 The quantitative impacts of the reforms

3.2.1 The impact of the liberalization of the labor market

The Egypt Labor Law, implemented **in** 2004, **in**troduced lower levels of employment protection

**in** the Egyptian Labor market. This is modeled as a reduction **in** the fir**in**g tax T . In

Figure 1, we show the impact of decreas**in**g the fir**in**g taxes on the steady-state labor market

outcomes. The blue solid l**in**es represent the reference economy obta**in**ed with T = 1.6.

We note that both separations **in** the formal **and** **in**formal sectors **in**crease, s**in**ce both

R F **and** R I (the reservation productivity levels) shift upwards after the reform. The **in**crease

**in** separations is proportional **in** magnitude to the decrease **in** the fir**in**g taxes, i.e the larger

the reduction **in** Taxes, the larger the **in**crease **in** job destruction. For the job creations, the

story is different. As suggested by the conventional Mortensen **and** Pissarides (1994) model,

the decrease **in** the fir**in**g tax leads to an **in**crease **in** the job creations of the formal sector.

This is the direct effect, correspond**in**g to the shift of the job creation curve **in** the plane

(labor market tightness, reservation productivity) which always dom**in**ates the reduction of

the employment duration implied by the **in**crease **in** the separation (the shift of the job

destruction curve **in** the plane (labor market tightness, reservation productivity)). Extend**in**g

the model to **in**clude the **in**formal sector, shows that such a reform decreases the job creations

**in** the **in**formal sector: the new opportunities **in** the formal sector push up the real wages **in**

all sectors, **and** hence reduces the hir**in**g **in** the sector where this **in**crease of labor costs

is not over-compensated by a reduction of tax (the fir**in**g taxes **in** the formal sector). The

reform, therefore scales down the difference between the formal **and** **in**formal sector by shift**in**g

employment **and** favor**in**g the formal sector. Moreover, our simulations show that decreas**in**g

fir**in**g taxes reduces substantially the on-the-job search of private formal workers towards the

public sector jobs. It is shown that if the decrease **in** T is huge, the share of workers on-the-job

search **in** the formal sector, described by the difference between Q F **and** R F , might be very

small. This is ma**in**ly driven by the comb**in**ed effect of the small decrease **in** the on-the-job

search threshold Q F along with a substantial **in**crease **in** the reservation productivity R F

for a given dT . In the **in**formal sector, on-the job search towards the public sector almost

rema**in**s unchanged or slightly decreases, follow**in**g a relatively small **in**crease **in** the reservation

productivity R I **and** almost no change **in** the on-the-job search threshold Q I . Figure 1 also

shows that follow**in**g the reduction **in** fir**in**g taxes, overall steady-state unemployment shifts

upwards.

19

0.03

θ F

0.129

θ I

0.025

0.128

0.127

0.02

0 0.2 0.4 0.6 0.8 1 1.2 1.4 1.6

T

0.8

0.126

0 0.2 0.4 0.6 0.8 1 1.2 1.4 1.6

T

R I

0.78

R F

0 0.2 0.4 0.6 0.8 1 1.2 1.4 1.6

0.6

0.778

0.4

0 0.2 0.4 0.6 0.8 1 1.2 1.4 1.6

T

0.84

0.776

0.856

T

Q I

Q F

0 0.2 0.4 0.6 0.8 1 1.2 1.4 1.6

0.82

0.8555

0.8

0 0.2 0.4 0.6 0.8 1 1.2 1.4 1.6

T

0.855

bench

reform

T

(a) Steady State Outcomes (Before **and** After Reform)

0.272

U

0.12

Pop F

0.271

0.118

0.27

0.269

0.268

0.116

0.114

0.267

0.112

0.266

0 0.2 0.4 0.6 0.8 1 1.2 1.4 1.6

T

0.331

0.33

0.329

0.328

0.327

Pop I

0.326

0 0.2 0.4 0.6 0.8 1 1.2 1.4 1.6

T

0.11

0 0.2 0.4 0.6 0.8 1 1.2 1.4 1.6

T

Pop G

0.2882

0.2881

0.288

0.2879

0.2878

0 0.2 0.4 0.6 0.8 1 1.2 1.4 1.6

bench

T

reform

(b) Labor market stocks (Before **and** After Reform)

Figure 1: Impact of reduc**in**g fir**in**g Taxes, keep**in**g all other basel**in**e parameters constant

20

3.2.2 The crowd**in**g-out impact of the wage policy **in** the public sector

Evidence from Said (2015) has shown, however, that dur**in**g the period 1998-2006, i.e.

dur**in**g the time period where the reform came **in**to action, there has been a relatively higher

**in**crease **in** the median real wages of public sector employees. Said (2015) shows that there

has been a 40% **in**crease **in** the median real monthly wages of government employees **and** a

26% **in**crease **in** the median real monthly wages of public firms’ employees, as opposed to only

a 9% **in**crease **in** the median real wage of the private sector.

New hir**in**g policy of the Government. The government is constra**in**ed by a budget (D)

that does not change after the decision to **in**crease the wages of the public sector employees. In

order to calibrate the necessary changes **in** its hir**in**g policy allow**in**g to keep its expenditures

constant after the wage **in**crease, we assume that (i) this constra**in**t is satisfied ex ante **and**

(ii) all the contact rates from government are changed **in** the same proportions λ ′ iG = κλ iG,

for i = F, I, U. Thus, we deduce that:

n ′ G =

with u ′ =

(

λ UG λF G − λ UG JF R F

+

δ + κλ UG δ + κλ UG

δ + κλ UG

δ(JSR I + κλ IG )(JSR F + κλ F G )

⎡

JSR F + κλ F G

+ λ IG − λ UG

)

JF R I

κu ′

JSR I + κλ IG

⎣ (JSR I + κλ IG )(κλ F G + δ)JF R F + (JSR F + κλ F G )(κλ IG + δ)JF R I

+(JSR I + κλ IG )(JSR F + κλ F G )(κλ UG + δ)

⎤

⎦

Given these constra**in**ts **and** the ex-ante **in**formation of {JF R F , JF R I , JSR F , JSR I }, the

parameter κ is estimated us**in**g D = n ′ (κ)w

G ′ . Hence, this estimated value for κ is obta**in**ed

us**in**g the labor market flows before the liberalization **and** before the **in**crease of the wage of

the public sector employees: its value depends only on the choice of w G . The results **and** the

evolution of λ iG , for i = F, I, U, as the public sector wage **in**creases, are reported graphically

**in** figure 2.

Implications for the labor market. In figures 3, we show how the steady-state labor

market outcomes vary **in** response to only a variation **in** the public sector wages. The blue

l**in**es therefore represent the reference economy obta**in**ed us**in**g the basel**in**e parameters. In

order to better expla**in** the mechanisms at work, we first remove the fir**in**g tax T = 0, reflect**in**g

a case where the market has been totally liberalized by the reform. Interest**in**gly, the **in**crease

**in** public sector wages shows opposite effects to the decrease **in** fir**in**g costs on the reservation

productivity levels of both sectors R F **and** R I : they both decrease.

21

0.0155

λ UG

0.015

0.0145

0.014

0.0135

0.013

0.0125

0.8 0.81 0.82 0.83 0.84 0.85 0.86 0.87 0.88 0.89 0.9

w g

0.0125

λ FG

0.012

0.0115

0.011

0.0105

0.8 0.81 0.82 0.83 0.84 0.85 0.86 0.87 0.88 0.89 0.9

w g

0.0135

λ IG

0.013

0.0125

0.012

0.0115

0.011

0.0105

0.8 0.81 0.82 0.83 0.84 0.85 0.86 0.87 0.88 0.89 0.9

w g

bench

reform

Figure 2: Evolution of λ iG , i = F, I, U as w G **in**creases

As has been expla**in**ed **in** the theoretical model, when the public sector jobs become more

attractive, the reservation productivities R F **and** R I are pushed downwards. Consequently,

**in**creas**in**g the public sector’s wages while keep**in**g all other parameters constant, separations

are dampened **in** both sectors. It is **in**terest**in**g for workers to stay temporarily **in** these

private sector jobs know**in**g that eventually there are potentials to move to the public sector.

It is worth not**in**g that it might be possible however, that even if the public sector wages

**in**crease, **in** case the hir**in**g rate encounters a substantial relative decrease, **in** other words

λ iG is very elastic, there exists less potential to move to public sector jobs. In that case

the reservation productivities might on the contrary **in**crease or rema**in** unchanged. Figure 4

shows an example to this possible phenomenon. This shows the response of the steady-state

labor market outcomes to only a variation **in** the public sector wages at a higher level of fir**in**g

tax T = 1.6 i.e. a more rigid formal employment sector.

Figures 3 **and** 4 also show that job creations **in** both private formal **and** **in**formal sectors

are discouraged. Indeed, follow**in**g the rise of w G , it becomes more attractive for all workers

to search for better options **and** potential jobs **in** the **Public** sector: the expected employment

duration is reduced, lead**in**g to a lower **in**centive for private firms to post vacancies. This

decrease is non-l**in**ear depend**in**g on the way job f**in**d**in**g rate **in** the public sector decreases.

Generally, by rais**in**g its attractiveness, the public sector reduces the expected employment

duration of each job, **and** hence the expected surplus. This implies that θ F **and** θ I decrease.

22

θ F

θ I

0.028

0.13

0.027

0.125

0.026

0.12

0.025

0.8 0.82 0.84 0.86 0.88 0.9

w g

0.115

0.8 0.82 0.84 0.86 0.88 0.9

w g

R F

0.8 0.82 0.84 0.86 0.88 0.9

0.743

0.742

0.741

0.74

0.8 0.82 0.84 0.86 0.88 0.9

w g

0.78

0.778

0.776

R I

w g

Q F

0.8 0.82 0.84 0.86 0.88 0.9

1

0.9

0.8

0.8 0.82 0.84 0.86 0.88 0.9

w g

1

0.95

0.9

0.85

bench

reform

Q I

w g

(a) Steady State Outcomes (Before **and** After Reform)

0.278

U

0.13

Pop F

0.276

0.128

0.274

0.272

0.27

0.126

0.124

0.122

0.12

0.268

0.118

0.266

0.8 0.82 0.84 0.86 0.88 0.9

w g

0.116

0.8 0.82 0.84 0.86 0.88 0.9

w g

0.35

Pop I

0.29

Pop G

0.345

0.28

0.34

0.335

0.27

0.33

0.26

0.325

0.8 0.82 0.84 0.86 0.88 0.9

w g

0.25

0.8 0.82 0.84 0.86 0.88 0.9

bench

w g

reform

(b) Labor market stocks (Before **and** After Reform)

Figure 3: Impact of an **in**crease **in** public sector wages, after the market has been totally

liberalized (T = 0), keep**in**g all other basel**in**e parameters constant

23

0.023

θ F

0.135

θ I

0.022

0.13

0.125

0.021

0.8 0.82 0.84 0.86 0.88 0.9

w g

0.12

0.8 0.82 0.84 0.86 0.88 0.9

w g

R F

0.8 0.82 0.84 0.86 0.88 0.9

0.514

0.512

0.51

0.8 0.82 0.84 0.86 0.88 0.9

w g

0.777

0.7765

0.776

0.7755

R I

w g

Q F

0.8 0.82 0.84 0.86 0.88 0.9

1

0.9

0.8

0.8 0.82 0.84 0.86 0.88 0.9

w g

1

0.95

0.9

0.85

bench

reform

Q I

w g

(a) Steady State Outcomes (Before **and** After Reform)

0.278

U

0.13

Pop F

0.276

0.128

0.274

0.126

0.272

0.124

0.27

0.122

0.268

0.12

0.266

0.8 0.82 0.84 0.86 0.88 0.9

w g

0.118

0.8 0.82 0.84 0.86 0.88 0.9

w g

0.35

Pop I

0.29

Pop G

0.345

0.28

0.34

0.335

0.27

0.33

0.26

0.325

0.8 0.82 0.84 0.86 0.88 0.9

w g

0.25

0.8 0.82 0.84 0.86 0.88 0.9

bench

w g

reform

(b) Labor market stocks (Before **and** After Reform)

Figure 4: Impact of an **in**crease **in** public sector wages, **in** a market with rigid regulations

(T = 1.6), keep**in**g all other basel**in**e parameters constant

24

On-the-job search **in** both sectors also **in**creases, given that workers can now ga**in** more with

higher wages **in** the public sector.

3.2.3 The impact of a simultaneous change **in** T **and** w g

Figures 5 **and** 6 show results us**in**g a three-dimensional display of the impact of simultaneous

variations of fir**in**g taxes **and** public sector wages on steady-state outcomes. The ma**in**

results of these simulations can be summarized as follows: if the government liberalizes the

formal labor market **and**, at the same time, raises the wages of the public sector employees, it

reduces a tax on one h**and** **and** **in**creases another, on the other h**and**. Hence, noth**in**g changes

**in** the economy, except the job separation rate of the formal jobs, which is directly impacted

by the decrease **in** T .

For the match surplus the net effect of these opposite policies is ambiguous: by reduc**in**g

the fir**in**g taxes, the surplus **and** consequently the **in**centive to hire rise, but at the same

time the **in**creased attractiveness of the public sector reduces the time horizon of a new job,

**and** thus the **in**centive to create it. Figure 5 shows that the positive effects on job creations

result**in**g from the liberalization of the labor market, are dampened by an **in**crease **in** the

public sector wage. Indeed, the on-the-job search towards the public sector is encouraged **in**

both sectors the formal **and** **in**formal, thanks to the rise **in** w G . This is obvious **in** figure 5,

show**in**g the large **in**creases **in** Q F **and** Q I . Overall for the formal sector’s separations, i.e.

R F (Figure 5), there has been a substantial **in**crease follow**in**g the simultaneous decrease **in**

the fir**in**g tax **and** the **in**crease **in** public sector wage. This is however ma**in**ly driven by the

**in**troduction of flexible regulations. The **in**crease **in** the public sector wage, accompanied by

a decrease **in** the public sector hir**in**g had almost no effect, possibly a very slight decrease, on

the reservation productivity **in** the formal sector.

Overall, separations **in** the **in**formal sector almost rema**in** unchanged or slightly **in**crease.

Job creations **in** the **in**formal sector are reduced, given the comb**in**ed effect of both the liberalization

reform **and** the **in**crease **in** the public sector wage. Nevertheless the decrease is only

substantial, because the two policies (the reduction of the fir**in**g tax, **and** the **in**crease of the

wages of the public sector employee) act **in** opposite directions.

These theoretical mechanisms possibly provide an explanation to the empirical results

obta**in**ed on the aggregate level **in** (Langot **and** Yass**in**, 2015) show**in**g that although the Egypt

labor law came **in**to action **in** 2004, overall job f**in**d**in**gs rema**in** unchanged afterwards (Figure

7). In all cases, steady-state unemployment **in**creases after the change **in** both parameters.

25

Comb**in**ed Effect on R F

Comb**in**ed Effect on θ F

Comb**in**ed Effect on Q F

0.94

0.92

0.96

0.94

0.75

0.029

0.028

0.92

0.9

0.7

0.027

0.9

0.65

0.026

Q F

0.88

0.88

R F

0.6

θ F

0.025

0.024

0.86

0.55

0.023

0.022

0.84

0.82

0.86

0.5

1.6

1.4

1.2

1

0.8

0.6

0.84

0.86

0.88

0.9

0.021

1.6

1.4

1.2

1

0.8

0.6

0.84

0.86

0.88

0.9

0.8

1.6

1.4

1.2

1

0.8

0.6

0.86

0.88

0.9

0.84

0.82

T

0.4

0.2

0.82

w g

T

0.4

0.2

0.82

w g

T

0.4

0.2

0.82

0.84

0

0.8

0

0.8

0

0.8

w g

Comb**in**ed Effect on R I

Comb**in**ed Effect on θ I

Comb**in**ed Effect on Q I

1

0.779

0.7785

0.95

0.778

0.7775

0.128

0.127

0.126

Q I

R I

0.777

0.125

0.9

0.124

0.7765

θ I

0.123

0.776

0.7755

1.6

1.4

0.9

0.122

0.121

0.12

0.119

1.6

0.9

0.89

0.88

0.87

0.85

1.6

1.4

1.2

1

0.8

0.6

0.4

0.2

T

0

0.8

0.82

0.84

0.86

w g

0.88

1.4

1.2

1

0.8

0.6

0.4

0.2

T

0

0.86

0.85

0.84

0.83

0.82

w

0.81

g

0.8

1.2

1

0.8

0.6

0.4

0.2

T

0

0.8

0.82

0.84

w g

0.86

0.88

0.9

Figure 5: Impact of chang**in**g T **and** w G on Steady-state outcomes

26

Comb**in**ed Effect on unemp. rate

Comb**in**ed Effect on the size of formal sector

0.29

0.285

0.14

0.28

0.13

u

0.275

Pop F

0.12

0.27

0.265

2

1.5

1

T

0.5

0

0.8

0.82

0.84

w g

0.86

0.88

0.9

0.11

2

1.5

1

T

0.5

0

0.8

0.82

0.84

w g

0.86

0.88

0.9

Comb**in**ed Effect on the size of Informal sector

Comb**in**ed Effect on the size of **Public** sector

0.355

0.35

0.28

0.345

Pop I

0.34

0.335

0.33

2

1.5

1

0.5

0.82

0.84

0.86

0.88

0.9

Pop G

0.26

0.24

2

1.5

1

0.5

0.82

0.84

0.86

0.88

0.9

T

0

0.8

w g

T

0

0.8

w g

Figure 6: Impact of chang**in**g T **and** w G on Steady-state outcomes

0.014

0.013

without reform

with reform

0.3

0.28

0.26

without reform

with reform

0.012

0.24

0.011

0.22

0.2

0.01

0.18

0.009

0.16

0.14

0.008

1998 2000 2002 2004 2006 2008 2010 2012

0.12

1998 2000 2002 2004 2006 2008 2010 2012

(a) Separation rate

(b) Job f**in**d**in**g rate

Figure 7: Job F**in**d**in**g **and** Separation Rates with **and** without the new labor market reform

**in** 2004, courtesy of Langot **and** Yass**in** (2015)

27

4 Empirical Evidence from Egypt

In this section, we use the Egypt Labor Market Panel Survey, fielded **in** 2012 to extract

a longitud**in**al retrospective panel for the period 1998-2011. This allows us to construct the

time series for the labor market flows before **and** after the reform. The data also allows us

to categorize employed workers by sector of employment namely, public, formal **and** **in**formal

wage work 13 . Given these flows, we use the econometric methodology described **in** Langot **and**

Yass**in** (2015) to purge the time series of each type of transition from the the macroeconomic

trend. The reform is then detected as a structural break **in** the series. This estimation allows

us to construct the counterfactual time series if the reform has not been implemented **in** 2004.

To be able to estimate the impact of the reform on each type of flow, it would be necessary

to use a regression such as x t − x ⋆ t = α(y t − yt ⋆ ) + β + ɛ t , for x = s F , s I , f F , f I , λ F G , λ IG

**and** where x t **and** x ⋆ t represent the current values **and** the natural rates of the labor market

flows (whether job f**in**d**in**g f i , separation s i or transitions towards the public sector λ iG , for

i = F, I). y t is the log of the observed output **and** yt ⋆ is the log of the potential output.

The left-h**and** side term represents the flow gap, whereas y t − yt

⋆ captures the output gap

(the difference between the observed **and** potential real GDP, which captures the cyclical

component of the output). Likewise, the difference between the observed **and** natural rate of

job f**in**d**in**g **and** the job separation represent the cyclical rate of worker flows. We approximate

y t − yt

⋆ by the first difference of the observed output ∆y t **and** we assume that the natural

rates of the different labor market transitions are constant over time, i.e. x ⋆ t = x ⋆ , ∀t. This

leads us to use the follow**in**g regression:

x t = α∆y t + b + I a γ + ɛ t for x = s F , s I , f F , f I , λ F G , λ IG (43)

with b = β + x ⋆ **and** where the **in**stability of the natural rate of labor market transition

implied by the reform is captured by γ, given that I a **in**dicates the year of the reform.

The estimations reported **in** table 3 show the results of runn**in**g the regressions of equation

(43), which allow us to test for the impact of the policy change **in** 2004 on the natural rate

of worker flows. The figures 8, 9 **and** 10 display the time series of the labor market flows **and**

13 It has been shown **in** Assaad et al. (2016) **and** Langot **and** Yass**in** (2015) that the retrospective panel

extracted from the ELMPS 2012 suffer from a recall **and** design bias. Moreover, Assaad et al. (2016) **and** Yass**in**

(2016) show that the characteristics of the sample are not kept r**and**om as we go back **in** time. Follow**in**g the

correction methodology based on match**in**g population moments, from other rounds **in** 2006 **and** 1998, (Langot

**and** Yass**in**, 2015) **and** creat**in**g differentiated weights (Yass**in**, 2016), we are able to reconstruct corrected flows

between the employment sectors as well as unemployment. See Yass**in** (2015) for the raw labor market flows

obta**in**ed form the ELMPS12 dataset. The regressions **in** this section use the corrected flows.

28

s F s F s I s I f F f F f I f I λ F G λ F G λ IG λ IG

α 0.116 -0.250 0.065 0.022 0.628 0.307 -0.363 0.143 -0.064 -0.082 -0.025 -0.041

b 0.016 ∗∗∗ 0.010 ∗∗ 0.024 ∗∗∗ 0.014 ∗∗∗ 0.044 ∗∗∗ 0.052 ∗∗∗ 0.010 ∗∗∗ 0.010 ∗∗∗ 0.010 ∗∗∗ 0.011 ∗∗∗ 0.009 ∗∗∗ 0.009 ∗∗∗

γ 0.009 ∗ 0.002 -0.011 -0.000174 -0.002 0.001

Table 3: OLS regression results show**in**g the impact of Egypt 2004 New Labor Law on Labor

market flows

their counterfactual counterparts.

0.04

without reform

Job separation rate − Formal Sector

0.022

without reform

Job separation rate − Informal Sector

0.035

with reform

0.02

with reform

0.03

0.018

0.025

0.016

0.02

0.014

0.015

0.01

0.012

0.005

0.01

0

1998 2000 2002 2004 2006 2008 2010 2012

0.008

1998 2000 2002 2004 2006 2008 2010 2012

(a) Formal Sector

(b) Informal Sector

Figure 8: Impact of Egypt 2004 New Labor Law on Separations of the Formal **and** Informal

Sector

0.12

without reform

Job f**in**d**in**g rate − Formal Sector

0.16

without reform

Job f**in**d**in**g rate − Informal Sector

with reform

0.15

with reform

0.1

0.14

0.08

0.13

0.12

0.06

0.11

0.1

0.04

0.09

0.02

0.08

0.07

0

1998 2000 2002 2004 2006 2008 2010 2012

0.06

1998 2000 2002 2004 2006 2008 2010 2012

(a) Formal Sector

(b) Informal Sector

Figure 9: Impact of Egypt 2004 New Labor Law on Job F**in**d**in**gs of the Formal **and** Informal

Sector

The results of these regressions us**in**g the ELMPS 2012 show that only the separations **in**

the formal sector **in**creased significantly after the reform. The impact on all other flows are

**in**significant 14 . These results are however **in** accordance with the theoretical model. Indeed,

the direction of change **in** the natural rates of these flows is coherent with the theoretical

model presented **in** the previous section. Separations **in** both sectors **in**creased show**in**g that

the effect of the reduced fir**in**g taxes has dom**in**ated **in** that case. F**in**d**in**gs **in** both sectors

14 This can be due to the fact that we’re over exploit**in**g the data by detail**in**g the transitions between the

different employment sectors, given the structure of the dataset **and** the samples’ sizes discussed **in** Yass**in**

(2015) **and** Assaad et al. (2016).

29

0.018

without reform

On−the−Job Search − Formal to **Public**

0.014

without reform

On−the−Job Search − Informal to **Public**

0.016

with reform

0.013

with reform

0.014

0.012

0.012

0.011

0.01

0.01

0.008

0.009

0.006

0.008

0.004

0.007

0.002

1998 2000 2002 2004 2006 2008 2010 2012

0.006

1998 2000 2002 2004 2006 2008 2010 2012

(a) Formal to **Public**

(b) Informal to **Public**

Figure 10: Impact of Egypt 2004 New Labor Law on the On-the-Job Search towards the

**Public** Sector

rema**in** constant or slightly retreated. For the **in**formal sector, this is due to both the decrease

**in** the fir**in**g taxes as well as the **in**crease **in** the public sector wages. For the formal sector,

it shows that the job creations were still taxed by the **in**crease **in** the public sector wage

even though the hir**in**g has decl**in**ed. Workers consider**in**g on-the-job search are now more

than before. Interest**in**gly however, this was not followed by more people really mov**in**g to

the public sector. On the contrary, actual transitions occurr**in**g to the public sector from the

formal sector decreased. This comes however from the two contradict**in**g forces act**in**g **in** two

different directions: where decreas**in**g fir**in**g taxes discouraged transitions to the public sector

while **in**creas**in**g public sector wage encouraged them. S**in**ce the fir**in**g taxes do not have any

effect on the on-the-job search towards the public sector **in** the **in**formal jobs, these **in**creased

follow**in**g the rise **in** the public sector wage.

5 Conclusion

The segmented nature of labor markets **in** develop**in**g countries **in** general, **and** **in** the

MENA region **in** particular, plays an important role **in** their lack of dynamism. High levels

of public sector employment are also used as part of the authoritarian barga**in**, where public

employment has always been exchanged for political acquiescence under authoritarian regimes

(Assaad, 2014). With an aim to portray the nature of labor markets **in** develop**in**g countries,

we extend the Mortensen-Pissarides model to add to the conventional private formal sector,

both a public **and** an **in**formal wage employment sectors. The public sector is added as an

exogenous player where wage **and** employment policies are decided exogenously by the policy

maker. These are however constra**in**ed by the government’s budget. The model shows the

different **in**teractions between the sectors, **and** particularly endogenizes job creations, job

30

destructions as well as on-the job search towards public employment, **in** both the formal **and**

the **in**formal sectors.

One example of a reform attempt**in**g but struggl**in**g to encourage dynamism **in** the MENA

labor markets is observed **in** the case of Egypt. In Egypt, a new labor law (Law 12 of 2003)

was enacted with the goal of **in**creas**in**g the dynamism of the private sector by mak**in**g hir**in**g

**and** fir**in**g workers easier. Nevertheless, **in** the data, only separations **in**creased significantly

while job f**in**d**in**gs hardly change. Our model is able to expla**in** this partial failure of the

reform, by modell**in**g the particular nature of a labor market of a develop**in**g country such as

Egypt, due to the existence of **in**formal sectors **and** tak**in**g **in**to account the strategies of the

public employer. Firstly, we show that a liberalization of the private formal sector, lead**in**g

to an **in**crease **in** the formal job creations accompanied by a decrease **in** the **in**formal job creations,

would result **in** an ambiguous impact on the aggregate job creations depend**in**g on the

magnitude of each variation. Secondly, we show that the **in**crease **in** the public sector wages

tends to nullify the positive effects on the private formal sector’s job creations **in**duced by the

liberalization of the formal sector. It might even reduce it, even if this has been accompanied

by less hir**in**g **in** the public sector, due to fiscal realities. Hence, our model expla**in**s the

empirical paradox of the Egyptian case: after the liberalization of the labor market, only job

separations **in**crease **and** job f**in**d**in**gs rema**in** unchanged. The 2004 reform achieves its mission

**in** liberaliz**in**g the market by favor**in**g the formal sector aga**in**st the **in**formal, boost**in**g both

its job creations **and** separations. But, these positive effects, **and** particularly the **in**crease **in**

job creations, have been nullified **and** even dampened by rais**in**g the levels of the public sector

wages at the same time. The **in**crease **in** the public sector wages acts as an extra taxation to

the job creations **in** the private (formal **and** **in**formal) sector.

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33

A

Deriv**in**g the Market’s Surplus

A.1 Formal Sector

The **in**itial surplus **in** the formal sector is def**in**ed as S 0 F = J 0 F −V F −p F (C−H)+W 0 F (1)−U,

while the cont**in**u**in**g job surplus is S F (x) = max{JF

NS(x)

+ p F T − V F + WF NS(x)

− U, J F S(x) +

p F T − V F + WF S (x) − U}.

At the time of the hir**in**g, when the idiosyncratic component is at its highest value x = 1,

the **in**itial match surplus **in** the formal sector is therefore :

(r + δ + λ F )S 0 F (1) = p F + τ + λ F

∫ 1

S F (z)dF F (z) − (r + δ)(U + V F )

R F

− (r + δ + λ F )p F (C − H) − λ F p F T (44)

For a cont**in**u**in**g match, **and** **in** case on-the-job search takes place i.e. if x ≤ Q F , the

surplus of the job, SF S (x) solves the follow**in**g equation:

(r + δ + λ F + λ F G )S S F (x) = p F x + τ + λ F

∫ 1

S F (z)dF F (z) + (r + δ + λ F G )p F T

R F

− (r + δ)(V F + U) + λ F G (W G − U) (45)

If x > Q F , the workers do not search on-th-job for better options **in** the public sector.

The only outside option **in** this case is the destruction of the job **and** the worker becom**in**g

unemployed. The surplus, SF

NS (x), **in** this case solves the follow**in**g equation:

(r + δ + λ F )S NS

F (x) = p F x + τ + λ F

∫ 1

R F

S F (z)dF F (z) − (r + δ)(V F − p F T + U)

S**in**ce the separation rule has to maximize the total wealth **in** a bilateral agreement, we

know that J(R F ) + W (R F ) = V F − p F T + U , where j = S, NS. It follows that S j F (R F ) = 0.

This allows us to derive SF S (x) as

S S F (x) =

p F (x − R F )

r + δ + λ F + λ F G

(46)

**and** S NS

F (x) as S NS

F (x) = p F (x − R F ) − λ F G p F T − λ F G (W G − U)

r + δ + λ F

(47)

Us**in**g all the above we can therefore conclude that the total surplus of the formal sector

34

is:

∫ 1

R F

S F (z)dF F (z) =

=

+

∫ QF

∫ 1

SF S (z)dF F (z) + (z)dF F (z)

R F

{

p F

−(Q F − R F )(1 − F F (Q F )) +

r + δ + λ F + λ F G

SF

NS

Q F

{

p F

(Q F − R F )(1 − F F (Q F )) +

r + δ + λ F

∫ 1

∫ QF

R F

}

[1 − F F (x)]dx

Q F

}

[1 − F F (x)]dx

− λ F Gp F T − λ F G (W G − U)

r + δ + λ F

(1 − F F (Q F )) (48)

A.2 Informal Sector

The expressions for the surplus **in** the **in**formal sector are derived **in** a similar way to

that adopted for the formal sector. However, due to the absence of policy paramters **in** the

**in**formal sector, the **in**itial surplus is the same as the surplus of a cont**in**u**in**g match, when

there is no on-the-job search **and** when the productivity is at its highest level, x = 1, i.e.

S 0 I

(1) = SNS

I

(1). When there is no on-the-job search, i.e. x > Q I , the value of the surplus,

SI

NS (x), is given by the equation:

(r + δ + λ I )S NS

I (x) = p I x + λ I

∫ 1

R I

S I (z)dF I (z) − (r + δ)(V I + U) (49)

whereas for x ≤ Q I , when workers are search**in**g on-the-job for positions **in** the public sector,

we have

(r + δ + λ I + λ I G)S S I (x) = p I x + λ I

∫ 1

S I (z)dF I (z) − (r + δ)(V I + U)

R I

+ λ IG (W G − U) (50)

S**in**ce SI S(R I) = 0, subtract**in**g SI S(R I) from SI S (x) allows us to obta**in**:

S S I (x) =

**and** subtract**in**g SI S(R I) from SI

NS (x) gives:

p I (x − R I )

r + δ + λ I + λ IG

(51)

S NS

I (x) = p I(x − R I ) − λ IG (W G − U)

r + δ + λ I

(52)

Us**in**g all the above we can therefore conclude that the total surplus **in** the **in**formal sector

35

is derived as follows:

∫ 1

R I

S I (z)dF I (z) =

=

+

∫ QI

∫ 1

SI S (z)dF I (z) + (z)dF I (z)

R I

{

p I

−(Q I − R I )(1 − F I (Q I )) +

r + δ + λ I + λ IG

SI

NS

Q I

{

p I

(Q I − R I )(1 − F I (Q I )) +

r + δ + λ I

∫ 1

∫ QI

R I

}

[1 − F I (x)]dx

Q I

}

[1 − F I (x)]dx

− λ IG(1 − F I (Q 1 ))

r + δ + λ I

(W G − U) (53)

36