The Labor-Market Effects of International Trade and Production Sharing

1. 16 The Labor-Market Effects of International Trade and Production Sharing

2. Chapter Outline • Why Does Trade Take Place? • Trade between Individuals and the Principle of Comparative Advantage • The Incentives for Trade across Different Countries • Effects of Trade on the Demand for Labor • Product Demand Shifts • Shifts in the Supply of Alternative Factors of Production • The Net Effect on Labor Demand • Will Wages Converge across Countries? • Policy Issues • Subsidizing Human-Capital Investments • Income Support Programs • Subsidized Employment • How Narrowly Should We Target Compensation? • Summary

3. Globalization/trade has made it increasingly unclear what “American” output is, and this is due to the geographic dispersion of the various steps in the production process – “production sharing.” • We now experience increased movements of components, services, and final goods across international borders. • American workers now face increased competition from a huge number of lower-paid foreigners. • Production sharing means work is being outsourced (or “offshored”) to other (low-wage) countries. • American workers – or at least a large segment of them – are being made worse off by a more integrated world economy.

4. 16.1 Why Does Trade Take Place? • Recall that the function of a market is to facilitate mutually beneficial transactions, which will be socially beneficial (Pareto improving) if some gain and no one loses. • Transactions across international borders take place between countries and these transactions are also beneficial to all countries involved. • Overall, most economists would agree that trade is mutually beneficial, more so, in the diffusion of technology.

5. 16.1 Why Does Trade Take Place? Trade between Individuals and the Principle of Comparative Advantage • Make-or-buy decisions are made by weighing the opportunity costs of doing tasks ourselves against the costs of buying the goods or services from others. • Fostering specialization andtrade • Performing all activities (household or other) by ourselves without specialization will lead to inferior outcomes and prevent us from utilizing our time in others ways, which may be either more productive or more pleasant.

6. 16.1 Why Does Trade Take Place? • The first step in the make-or-buy decision is for each party to perform an internal comparison: individuals must consider their own opportunity costs of producing the good or service in question. • Economists agree that comparative advantage is the basis of trade between two or more individuals/countries. • The principle of comparative advantage underlies all decisions about trade with others. • Individuals have the incentive to specialize in the production of goods or services in which they have comparative advantage and buy from others the goods or services they would find more expensive to produce themselves.

7. 16.1 Why Does Trade Take Place? The Incentives for Trade across Different Countries • Economists generally agree that international trade has the potential for enlarging the output of the countries engaging in it. Production Possibilities without Trade Simplifying Assumptions: • In the past, trade between two countries was severely limited by either the imposition of tariffs on imported goods or by technological restrictions. • Countries A and B can produce two goods: clothing and food with their available resources and a given level of technology. • Production possibilities curvediffers between both countries because productive resources are different.

8. Figure 16.1Production Possibilities for Country A In the absence of trade (autarky), line XY is the production possibilities curve for country A whose slope is –1/2, that is, 1C = 2F or 1/2C = 1F. Without trade, the mix of production/consumption would lie somewhere along line XY based on its preferences. With trade, line ZY is the production possibilities curve for country A whose slope is –1, that is, 1C = 1F.

9. Figure 16.2Production Possibilities for Country B In the absence of trade (autarky), line X’Y’ is the production possibilities curve for country B whose slope is –2, that is, 1C = 1/2F or 2C = 1F. Without trade, the mix of production/consumption would lie somewhere along line X’Y’ based on its preferences. Line X’Z’ is the production possibilities curve for country B with trade where slope is –1, that is, 1C = 1F.

10. 16.1 Why Does Trade Take Place? Comparative Advantage • Identifying comparative advantage starts with calculating the domestic (internal) opportunity costs of production as indicated below: • The opportunity cost of producing food in Country A is lower than in Country B, thus, Country A has the comparative advantage in food production, which implies its has a comparative disadvantagein the production of clothing. • The opportunity cost of producing clothing in Country B is lower than in Country A, thus, Country B has the comparative advantage in clothing production and comparative disadvantage in producing food.

11. 16.1 Why Does Trade Take Place? Production Possibilities with Trade • Each country (A and B) would be better off by specializing in making the good for which it has comparative advantage and trading for the other good. • With trade, the production possibilities of Country A shifted out from line XY to line ZY, which means it can obtain a unit of clothing at a cost of only one unit of food – trade enables it to consume more of both clothing and food. • With trade, the production possibilities of Country B also shifted out from line X’Y’ to line X’Z’ , which means it can also obtain a unit of food by giving up only one unit of clothing. • For both countries, trade can be thought of as creating a new technologyfor making goods for which they have comparative disadvantage.

12. 16.1 Why Does Trade Take Place? Reallocating Resources • For potential gains from trade to be realized in both Country A and Country B, resources must flow from one sector to another withineach country. • From clothing production to the food production sector in Country A • From food production to the clothing production sector in Country B • Sectoral shifts or changes in both countries are costly and often painful for those workers and owners who are displaced. • The promise of ultimate gains from specialization and trade has provided a powerful argument among economists for encouraging and/or supporting international trade. • Empirical evidence on whether an increase in international trade (“openness”) causes an increase in the overall output of a country is debatable because causality between “openness” to trade and faster economic growth could run in the opposite direction.

13. 16.2 Effects of Trade on the Demand for Labor • Both trade and technological change open up new opportunities for acquiring goods and services, therefore, expanded trade affects the demand for labor. • Recall that the demand for a given type of labor is derived from: (a) conditions in the product market, and (b) the prices and productivities of other factors of production. • Trade affects both product demand and the availability of other factors of production.

14. 16.2 Effects of Trade on the Demand for Labor Product Demand Shifts • When exports increase, the demand for workers involved in the production of those exports will shift to the right, due to the expanded scale of production. • An increase in imports associated with increased trade will tend to directly or indirectly reduce the demand for some domestically produced goods or services. • The shifts in product demand associated with increased international trade also create shifts in labor demand. • Expanded employment opportunities and higher wages for workers if the labor demand curve shifts rightward. • Downward pressure on both employment and nominal wage levels for workers if the labor demand curve shifts leftward.

15. 16.2 Effects of Trade on the Demand for Labor Shifts in the Supply of Alternative Factors of Production • Production sharing, due to international trade, has effectively brought a huge number of lower-paid foreigners into direct competition for jobs with higher-paid Americans. • Access to lower-paid workers in other countries has reduced the cost of an alternative source of labor for American firms. • What are the effects on American labor when lower-wage labor becomes available in other countries? • There is a cross-wage effect on the demand for labor; that is, the overall effect on the demand for a given kind of labor is the summation of the substitution and scale effects, which work in opposite directions

16. 16.2 Effects of Trade on the Demand for Labor The Substitution Effect • In order to substitute foreign labor for American labor, employers consider the ratio of wages to the marginal productivity in both countries. • Only if the ratio of wages to marginal productivity is lower for foreign workers will firms consider substituting foreign workers for Americans. • Analysis of the size of a potential substitution effect requires that we must use/review two Hicks-Marshall laws of derived demand. • One law suggests that the size of the substitution effect depends in part on the supply response of American workers, which means that the substitution effect will be greater if the supply of Americans to the relevant occupations is more elastic • The other Hicks-Marshall law strongly related to the substitution effect is the ease with which foreigners can be substituted for Americans– many workers are in manufacturing production jobs that could be transported across borders to lower-wage countries, other jobs cannot be performed in a remote location.

17. 16.2 Effects of Trade on the Demand for Labor The Scale Effect • Substituting lower-cost labor in poorer countries for American labor in a particular industry will lead to a fall in production costs and thus a fall in product price and an associated increase in product demand. • The substitution effect of offshoring will push toward reducing the demand for American labor, the scale effect associated with lower costs will tend to increase it – not clear that overall jobs in the affected sectors will fall. • The size of the scale effect that accompanies the use of lower-wage labor or workers depends principally on two factors: • the elasticity of demand for the final product in the industry that is cutting its labor costs, • the share of labor (in this case, foreign labor) in total cost. • If the foreign workers’ wages constitute a larger part of production costs, the resulting effect on production costs and product price will be greater, and the larger will be the associated scale effect.

18. 16.2 Effects of Trade on the Demand for Labor Changes in the Elasticity of Demand for Labor • Given that increased international trade will cause the labor demand curve to shift rightward or leftward, reducing the barriers to international transactions will tend to increase the elasticity of demand for labor, for two major reasons: • A greater ability to substitute foreign for domestic workers will increase the strength of the substitution effect, other things equal. • As foreign-made goods and service are allowed to compete with those produced domestically, the elasticity of product demand will tend to increase. • Those American workers who face more elastic labor demand curves will experience greater employment losses if their wages are raised by some nonmarket force – minimum wage or a collective bargaining agreement.

19. 16.2 Effects of Trade on the Demand for Labor The Net Effect on Labor Demand • Increased trade in goods and services (including production sharing) with foreign countries will benefit some workers but displace others. • Often, less-skilled workers are most likely to lose from trade because foreign workers can readily perform in these jobs. • Displaced workers suffer greater losses if it is difficult or costly for them to switch occupations or industries. • Workers most likely to gain are those in sectors that have comparative advantage in production or are in jobs that are complementary with production workers overseas.

20. 16.2 Effects of Trade on the Demand for Labor Estimates of Employment Effects • It is difficult to isolate the effects of trade on employment levels because there are many other factors (immigration, technology, personal incomes, and consumer preferences) that affect labor supply and demand. • A study that estimated the effect of the Canadian-United States Free Trade Agreement found that employment fell by 12% in those Canadian industries most affected by the tariffs reduction on imports from the United States, but the overall employment rate in Canada was the same in 2002 as it was in 1988. • Estimates from studies on the job losses in the United States from offshoring of jobs to foreign countries suggest that the percentage losses have been considerably smaller.

21. 16.2 Effects of Trade on the Demand for Labor Estimates of Wage Effects • Trade is but one of many factors that affect demand for labor and the level of wages in a country. • Focusing on relative wages – the differences between wages received by skilled and unskilled workers within a country of interest – some estimates of the effects of trade on wages in the United States suggest that these effects are small (less than 10% of fall in wages) when compared to the contributions of other forces. • Studies that examined the wage effects of trade and production sharing on poorer countries – the recipients of offshored jobs – suggest that these countries have also experienced increased differences between the wages of skilled and unskilled workers that can be traced to increased trade and outsourcing.

22. 16.3 Will Wages Converge across Countries? • Recall that when firms consider moving production to the lower-cost country, they compare the costs represented by the ratio of wages to the marginal productivity of workers (W/MPL = MC) in each country. • If firms are free to move production from a higher- to lower-cost country, the profit-maximization process would produce a result consistent with thelaw of one price– equalization of wages (factor prices or product prices) across countries. • Wages would equalize only if marginal productivities are equalized. • Cross-country differences in educational levels, work practices, managerial and organizational skills, and the technology used in the production process could all affect the degree to which wage levels are equalized.

23. 16.3 Will Wages Converge across Countries? • Even though differences in W/MPL = MC across countries lead firms to consider shifting production to the lowest-cost location, it does not imply that firms will actually do so. • The costs of moving and trading across national borders are very high, and there are other significant costs of: • communicating in other languages • transporting goods (especially from poorer countries) • dealing in foreign currencies • acquiring information on local laws and regulations • enforcing contracts internationally • These costs which are associated to international transactions reduce the incentives for firms to relocate to lower-cost areas, and they impede the convergence of W/MPL ratios predicted by the law of one price. • One study of increased trade between the United States and Mexico found no evidence of wage convergence.

24. 16.4 Policy Issues • As discussed in Chapters 1 and 4, we concluded that society as a whole is better off with some policy (technological) change if: • everyone gains from it, • some gain and no one else loses, or • some gain and some lose, but the gainers fully compensate the losers. • Since enhanced trade does displace some workers in a society, normative considerations require that those who gain from reducing the barriers to international transaction compensate those who lose from this policy change.

25. 16.4 Policy Issues Subsidizing Human-Capital Investments • Those workers who are displaced by enhanced trade experience spell of unemployment and they may have to: • Invest in training to qualify for another job • Invest in moving to a new city or state to secure employment • Government programs that subsidize these human-capital investments, if paid for by those who gain from expansion of international transactions, can have two important purposes: • Compensate workers who are displaced due to policy change • Help displaced workers qualify for and find new jobs

26. 16.4 Policy Issues • The Trade Adjustment Assistance (TAA) program, as amended in 2002, is an example of a program that is designed to subsidize human-capital investments by displaced workers. • Those who are certified to be eligible for the TAA benefits receive: – up to 104 weeks of training or remedial education, during which they also receive unemployment benefits. – up to $1,250 as a reimbursement for job search costs and another $1,250 to help subsidize relocation costs. • Workers most likely to benefit from investing in mobility and training, or find an employer willing to share these costs with them, are those young enough to have long labor market stay during which the benefits of investment can be “collected.”

27. 16.4 Policy Issues Income Support Programs • A solution to the problem that some training or relocation investments may not be worth making is for the government to offer extended unemployment benefits for displaced workers or provide funds so that older workers affected by displacement can retire early. • Another form of income support, which encourages employment, is to directly subsidize targeted individuals who work – an example is the Earned Income Tax Credit (EITC) Program, even though it does not currently target workers who are displaced by enhanced trade. • A program that targets those displaced by trade is “wage insurance,” under which affected workers receive a payment from the government if their current wage is less than previous.

28. 16.4 Policy Issues Subsidized Employment • Another solution to the problem that not all training will create net social benefits is for the government to subsidize the employers of displaced workers for whom training costs are relatively high or expected benefits are relatively low. • Empirical studies suggest that payroll subsidies to employers who hire displaced older or lower-skilled workers are more effective than training in speeding the reemployment of workers. • The other form of subsidized employment is for the government to become the “employer of last resort,” by directly employing targeted workers to perform public works projects for a period of time.

29. 16.4 Policy Issues How Narrowly Should We Target Compensation? • Recall that there are a myriad of other factors that also serve to shift the demand for, and supply of, workers in a dynamic economy. • Since expanded international transactions are but one force causing worker displacement, it is difficult to justify a set of compensation programs targeted only to trade-related displacement. • Very few workers receive the benefits of the TAA program because it takes time and resources to verify that it was international trade or product sharing that caused displacement of a particular set of workers.

30. Figure 16.3Comparing the Outcomes of Equal Vertical Shifts of Inelastic and Elastic Labor Demand Curves D0 and D1 depict relatively inelastic and relatively elastic demand curves, respectively, and with the given supply curve, equilibrium wage and employment are W* and E*. Equal vertical (ab) shift in both demand curves will lead to W and E equilibria at point x (with the inelastic demand curve) and at point y (with the elastic demand curve). The employment and wage losses created by the fall in labor demand curve are much larger when the demand curve is more elastic.

31. 16.4 Policy Issues Summary • Reduction in the barriers to international transactions has reinforced the labor-market effects caused by other forces. • Given the rising returns to educational investment, and as workers are put at greater risk of having to adjust to changes in labor demand over their careers, the case for governments to extend and improve schooling has been strengthened. • Providing youth greater access to a high-quality education is perhaps the single most important program a government can undertake to help its workers cope with the changes in labor demand associated with an expansion in international transactions.