Economics 3403 International Economics and Policy Keith Maskus
Spring, 2001
Policy Paper One: Trade, Technology, and Wage Inequality
Probably the most important economic and political force of the current era is globalization of production, trade, and investment. Political success today is determined (scandals aside) by an ability to manage pressures that arise from globalization. One of the great intellectual challenges for economists and international legal scholars is to devise international rules for promoting the benefits of globalization and ensuring that those benefits are widespread, while minimizing its costs. These are complex issues that do not lend themselves to easy solutions, and you should be skeptical of anyone (scholars, politicians, columnists, neighbors,...) who claim to know how to resolve them without deep thought and sustained policy effort.
To define the basic term, globalization is the reduction in natural barriers and policy restrictions that segment national and regional markets, leading to market integration. These markets include those for goods and services, productive factors (capital and labor), and technology and information. Moreover, we can think of markets for national policies, in which governments choose policies to compete for business, protect domestic interests, or promote social goals. Globalization can also be a force for reducing differences in policies.
Natural barriers to market integration include transport costs, communication costs, and so on.
Clearly there have been significant improvements in communication technologies, promoting international diffusion of production. In particular this trend has made services more tradable. Lower transport costs also promote more trade. Policy restrictions include taxes on trade (eg, tariffs), investment barriers, and a host of non-tariff barriers to trade and investment. These restrictions apply to goods but even more so to trade and investment in services. Technology and information flows may be blocked by various policies limiting investment, joint ventures, and licensing. Note that intellectual property rights may be used to limit the spread of technology but properly structured they may also raise such flows.
Undoubtedly there have been significant reductions in policy barriers to trade in goods, services, and investment in recent decades. This has happened unilaterally as many developing countries have chosen to deregulate and liberalize their economies. It has happened regionally through various free trade agreements. And it has happened, most importantly, at the multilateral level through the negotiation of freer global trade and investment through the World Trade Organization (WTO) and other organizations. We will study these processes later in the course.
The basic result of globalization (market integration) is price (or policy) arbitrage through the various channels of globalization . These channels include trade in goods and services, capital flows (both financial capital and through multinational entrerprises -- MNEs), labor migration, and technology transfers.
Note that MNEs largely exist to find best locations for using their technological advantages, so they are implicit conduits of technology trade.
Finally, the economic outcomes of globalization are what most people argue about. Let me just list the main ones that economists have identified and analyzed.
First, keeping in mind that segmented markets are inefficient in economic terms (though they may exist to promote certain objectives), globalization generates efficiency gains of various forms. There is allocative efficiency, or movements along PPF toward goods of comparative advantage, which is beneficial in the long run. There is so-called “X-Efficiency” (that’s the old term; now it’s called improvements in total factor productivity), resulting from higher productivity as the economy gains greater access to advanced technologies, new management techniques, and more competition. This refers to both movements up toward the existing PPF and also increases in the PPF due to technical improvements. There is scale efficiency as firms take advantage of greater scale economies when they have access to wider markets. And there is rationalization efficiency as uncompetitive firms shut down (exit) and new firms (or re-organized firms, perhaps through being taken over by foreign investors) come to life (entry). All of these outcomes are well established empirically by economists though the extent to which they emerge depends on particular country characteristics.
Second, there are distribution effects within the economy. Globalization (arbitrage) harms owners of assets and skills with “artificially” high prices (due to scarcity) and benefits those with low prices (due to

2 abundance). People are affected as factor owners (that is, workers of various skill levels, capital owners, land owners; note that workers may also be capital owners, which changes the distributional payoffs from liberalization). Note that some factors will be forced to move to new employment and/or regions and the associated short-run adjustment costs can be severe. People are also affected as consumers. Generally we expect that market liberalization is beneficial for consumers, both because lower import prices generate greater competition and because a greater variety of goods becomes available.
Finally, it must be pointed out that economic liberalization of trade barriers, capital restrictions, and currency markets often takes place in the presence of other economic distortions (such as pollution, monopoly, and output subsidies or taxes) and an inadequate regulatory framework (such as poor banking supervision, limited requirements for transparency, no anti-trust rules, lousy environmental protection rules, poor labor rights, an absence of political competition). In these cases the gains from liberalization may be offset by economic and social costs of the poor regulation and other distortions, causing at times real problems such as worse pollution and market volatility. Obvious recent problems include the Asian financial crisis (associated with inadequate bank supervision, directed lending, property speculation, and non-transparent business relations), the Russian economic collapse (same basic problems and no ability of the government to collect taxes), and so on. Consider also the worsening environmental problems in
Eastern Europe since movements toward liberalization. Keep in mind that these problems are not necessarily arguments for maintaining protectionist barriers. Rather they are arguments for fixing the other regulatory problems.
Wage Inequality
Let’s focus on the main social problem in the U.S. that people associate with globalization, which is rising income (wage) inequality between high-skilled workers and low-skilled workers. There has been a considerable increase in measured inequality in the U.S. since 1980, with the Gini coefficient of income distribution rising from 35 to 38 in the 1980s (the higher is this coefficient the less equally distributed is income). Real hourly manufacturing wages of production workers stagnated in the 1980s when measured on the basis of the consumer price index. The lifetime discounted real difference in incomes between those with a four-year college degree and those with a high-school degree rose from about 15% in 1980 to over
30% today. While these trends moderated in the mid-1990s (and actually seem to be reversing themselves now), there undoubtedly has been rising inequality over the long term.
The situation is similar in Canada and is now emerging in Japan. The problem is somewhat different in Western Europe, where unemployment rates among unskilled workers have risen to very high levels, while social transfer programs have maintained lower income and wage disparities. In many developing countries rising inequality has been massive after programs of liberalization (Mexico, Brazil,
Argentina, and Indonesia are good examples). In all of these cases there has been a marked rise in demand for skilled workers and a (relative) fall in demand for low-skilled workers.
These changes took place during and after the marked rises in market integration in the 1970s and
1980s. Thus, many people tend to “blame” (“credit”?) them on increasing international competition from imports, outsourcing of jobs by MNEs, and other channels of globalization. This is an issue of the first importance and has attracted much research by economists, political scientists and sociologists, among others. I will report on the evidence raised by economists, who tend to take a more model-based and sober approach to analyzing wage disparity and trade. In short, the evidence is mixed but there is something going on.
Before looking at the evidence, consider first most of the possible sources of wage inequality.
These are: a. international trade in goods and services; b. rapid technology diffusion through MNEs; c. capital flows that shift employment to lower-wage areas, such as outsourcing; d. labor migration; e. technological change favoring skilled workers (in information technologies); f. declining wage-setting power on the part of labor unions; g. relatively poor educational efforts that do not produce appropriate skills.
Not all of these are considered “globalization” factors in the popular mind. But note that they are all interrelated in various ways and it is quite difficult to sort them out through research. This means in turn
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To focus on globalization, recall our theory of factor price equalization (FPE). The conditions for
FPE include: free trade (and/or free factor mobility); identical, constant-returns-to-scale (CRS) technologies in all countries; and countries produce the same goods (that is, they are not specialized and the products are close substitutes). Then the FPE theorem claims that real returns to factors will be the same everywhere. That is, workers of identical (or similar) skill characteristics will have the same real wages in
China as they do in the United States. The common fear here is expressed by the question: “Are your wages set in Beijing?” The basic answer is that if you produce low-skilled labor-intensive goods that are relatively freely imported (textiles and apparel are restricted, but electronics, services, shoes, many others are examples) you will certainly feel downward pressure on your real wages. On the other hand, skilled workers find their services in greater demand as a result of trade.
From the 1970s through today the U.S. imported increasingly more goods from lower-wage economies such as China, those in Southeast Asia, and South America. This process has raised labor incomes in many of those countries (spectacularly so in Korea, Malaysia, Singapore, etc.) but has placed pressure on wages here. Note the “global labor pool” indicates that this process could go much further.
The way this process works must be remembered. Rising global labor supplies at the low-skill end imply falling global prices for labor-intensive goods, such as apparel and consumer electronics. This is great for consumers, but bad news for low-skilled workers in high-wage economies. If these imports compete directly with domestic products (that is, if the U.S. produces apparel that is not much higher in quality than imports), the falling goods prices translate into lower real wages for low-skilled workers. In turn, because these workers could move into other low-skilled jobs, the lower wages spill over into services and other sectors. At the same time, skilled-worker wages rise.
Overall this process promises significant net gains. But the redistribution problems could pose political difficulties and social fragmentation. I will characterize loosely (and somewhat unfairly) the U.S. policy response as “benign neglect”, which may be an equilibrium because losing wage earners haven’t mounted much effective political opposition. In Europe the approach basically (and loosely) is to buy off the losers through generous unemployment compensation, a policy that is proving unsustainable. I do not know how much longer these solutions can hold together. Certainly as the U.S. and Europe tip into recession they will become more difficult to support.
Consider now technical change, which is overwhelmingly the use of microprocessors in economic activities. In the view of many historians of technology, this is the most fundamental technical change in history because of its potential for raising productivity, developing new products, and solving complex problems. It also has impacts on factor demands that are not entirely understood. Whether it is a source for greater wage inequality or equality depends on how the technology is used. On the one hand, processors can “dumb down” complicated tasks like operating cash registers, raising the demand for lower-skilled workers. On the other hand, they allow people with talent and skill to serve a wider audience. Consider what an architect can do with CAD programs or a movie director can do with special effects. Television and musical technologies may be disseminated far wider than before, raising demands for talent and skills.
Further, the ability to develop software is in great demand, generating huge incomes for those who can establish software standards (think of Microsoft). This effect raises inequality. Note that it does so in a fairly irreversible way; it doesn’t make much sense to try to train untalented people to be musicians or athletes. However there are avenues for upgrading one’s skills to the point of being able to use standardized software effectively. We do need training programs to allow people to work with information technology as well as possible.
What does the evidence say about trade, technology, and other factors and their impacts on wage inequality? Remember this is a difficult issue to address because the factors are interrelated. For example, it doesn’t make much sense to think of trade and technology separately, because trade liberalization can spur technical change, while technical change also affects international prices and trade. Economists have not been very successful at sorting all this out, so there is an active debate ongoing.
Economists such as Paul Krugman of MIT and Robert Lawrence of Harvard argue that import competition from low-wage countries cannot be of much importance for wages in the U.S. because such imports amount to no more than 3 percent of U.S. GDP (overall imports are around 12-15 percent of GDP).
They have other arguments to make as well, but that’s basically it. They “blame” technical change as a result of the low impacts of trade.
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Economist such as Adrian Wood of Sussex University and Edward Leamer of UCLA argue that
Krugman and Lawrence are wrong, both because they don’t account for the trade-technology interactions and because they fail to recognize that at the margin, even small import volumes can have large price impacts. They find trade to be the main contributor to wage inequality.
Both of these views are overstated. Although it is impossible to be precise about these proportions, the bulk of evidence suggests that international trade is associated with perhaps 15-20% of rising inequality in the U.S., immigration perhaps 5-10%, declining power of labor unions perhaps 25-30%, and technical change (including outsourcing) perhaps 40-55%. Research continues.
Some Observations on Policy
Suppose we thought import competition was an important source of rising inequality and wanted to do something about it. What policies are suggested? The obvious one is trade protection through tariffs and quotas. The difficulty is that this costs more than it gains, it sacrifices the benefits of competition, and is basically a strategy of trying to fight off inevitable global change. It is a short-run solution at best and does not get at the real problem of limited skills. A second choice is trying to limit international technology diffusion through preventing MNEs from operating abroad or erecting large barriers to technology trade.
The same problems apply. And slowing down technological change has never worked.
The way to do good policy is to figure out what the underlying problems really are and aim policies at those problems. It really does not matter much whether workers are laid off because of technical change or international trade. What matters is that they suffer costs of adjusting into new employment and may end up with lower wages. So appropriate policies for managing income-distribution and adjustment problems include having an active social safety net of supplemental unemployment compensation, opportunities for retraining, relocation assistance, and tax relief for low-income workers.
Another attractive option stems from noticing why incomplete specialization is important for FPE.
A country or region that does not produce low-skill, labor-intensive goods does not face import competition, meaning that lower-priced imports simply represent a benefit to consumers. Thus, the trick is to have the economy specialize in high-wage, high-skill sectors. Consider Switzerland, Seattle, and Boulder as examples of “high-tier” places that simply don’t produce goods that compete with such imports, thereby maintaining high prices and high wages, even for relatively low-skilled workers. How do countries manage this outcome? By being sure to endow their workers with adequate skills, that is by promoting technical education and higher education. If the work force is dominated by high-skill workers the local economy will specialize in skill-intensive goods. In this case, trade is an unambiguous benefit.
In contrast, the U.S., Los Angeles, and Dallas are examples of “middle-tier” economies that produce both high-tech goods and services and low-skill apparel and electronics. Here, immigration and inadequate skill acquisition support local production of goods that compete with low-wage imports. Trade benefits skilled workers but harms low-skilled workers, generating rising inequality.
What about “low-tier” economies, such as Mexico, China, and Shanghai, which are abundant in low-skilled labor? They produce labor-intensive goods cheaply for export and their workers should benefit from trade. But note that Mexican workers are far more at risk from Chinese competition than are
American workers. So skill acquisition is important there as well.
So the trick is moving up these “tiers” through building appropriate skill endowments. How?
Through education and training, obviously. That is perhaps the most important lesson one can learn from this paper. It also helps to build infrastructure for learning skills in information technology, subsidizing computer training and internet connections, etc. However, building effective education systems is hard and politically painful for various reasons.
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