Labor market regulation is a controversial area of public policy in both developed and developing countries.
Mainstream economic analysis traditionally portrays legal interventions providing for minimum wages, unemployment insurance and (often only a modicum of) employment protection as ‘luxuries’ developing countries cannot afford. After decades of de-regulatory advice, international financial institutions have recently come to a less extreme position. But any such concessions to labor regulation are based on concerns for social stability or for short-term support to aggregate demand, while regulation continues to be viewed as harmful to economic efficiency in the long run. In this paper we take a deeper look at the impact of labor institutions on economic development in two ways. First, we propose a macroeconomic model of a balance-of-payments constrained “small” developing country open to trade and foreign capital. This helps us clarify the importance of a dynamic view of economic efficiency, as opposed to the static view embedded in mainstream policy advice. Secondly, we discuss the political economy of labor regulation. We argue that labor institutions promote economic development through positive effects on aggregate demand, labor productivity and technology.