Mass versus Exclusive Goods, and Formal-Sector Employment

We explore how the underemployment problem of less-developed economies is related
to income inequality. Our crucial assumption is that consumers have non-homothetic preferences over differentiated products of formal-sector goods and thus that inequality affects
the composition of aggregate demand via the price-setting behavior of formal-sector firms.
We find that (i) high inequality divides the formal sector into mass producers (which charge
low prices that are within the reach of the poor) and exclusive producers (which charge
high prices and sell only to the rich); (ii) high inequality generates an equilibrium where
many workers are crowded into the informal economy; and (iii) an increase in subsistence
productivity raises the wages of unskilled workers and boosts employment due to the higher
purchasing power of poorer households.