How and How Far to Liberalize a Developing Economy with Informal Sector and Factor Market Distortions

Whether a liberalizing developing economy should implement the entire WTO-prescribed package and to what extent this is expedient, are the two burning questions, especially because available empirical evidence suggests that the developing countries have been facing substantial adjustment costs in their endeavor in implementing trade and investment reform. The present paper makes a humble effort to provide answers to the above questions in terms of a three-sector general equilibrium model with informal sectors. Welfare implications of three liberalization policies: inflow of foreign capital, tariff reduction and labour market reform, have been first analyzed in a full-employment framework. Later, the paper has been extended into a Harris-Todaro framework with an urban informal sector and capital market distortion. We have shown that welfare consequences of a tariff reform and/or a policy of deregulating the labour market crucially depend on the presence and magnitude of foreign capital in the economy. We have argued that unless a proper choice among different prescribed policies compatible to the internal institutional, technological and trade related characteristics, is made, drastic implementation of reform measures may produce counterproductive result on welfare of the relevant country