Chapter 14
Structural Adjustment:
Agriculture, Trade, and the
Labor Market
© Pierre-Richard Agénor
The World Bank
1




Price Reform in Agriculture
Trade Liberalization
Trade and Regional Economic Integration
Reforming Labor Markets
2
Structural Adjustment


Structural reforms: policy measures that increase
productive capacity or degree of flexibility of the
economy.
Structural policies have implications on both micro
and macro dynamics:
 micro: ultimate objective is to improve efficiency in
resource allocation by reducing various
distortions;
 macro: make markets more flexible and enhance
the economy’s ability to absorb domestic and
external shocks.
3
Price Reform in Agriculture
4



A common argument: agricultural policy has a
high implicit tax burden.
Subsides: government marketing boards pay
domestic producers less than world market prices for
output.
Logic: alter the distribution of income in the
economy.
Two problems with food subsidies:
 Inefficient means of redistributing income relative
to direct and well-targeted transfers.
 Lower food prices artificially reduce domestic
production, increase migration to urban areas
urban unemployment.
5

Result: policy not only may impose a direct drain on
the budget buy also exacerbate balance of
payment and unemployment difficulties.
Taxation leads to similar effects:
 Export tax: for a long time the principle mechanism
through which agriculture was taxed.
 Price ceiling: effective tax on output and subsidy on
consumption.
 Deaton and Benjamin (1993): Coffee and cocoa
pricing policies raised almost 40% of government
revenues in Cote d’Ivoire in early 1980s.
6
Agricultural tax burden:
 Schiff and Valdes (1992): urban bias; marketing
boardsdisincentive for agro-production; add overvalued exchange rate  distributional shift against
the rural sector.
Reforms
 Elimination of export duties, reduction in world and
domestic price gaps.
 Sub-Saharan Africa: deregulation of agricultural
prices and the dismantling of agricultural boards.
7
infrastructure,
(rural credit
markets, why?)
and
encouragement

of small-scale
production
methods...
Effectiveness
World Bank (1994, see Tables A9 and A18): average
domestic terms of trade for export crops improved
in only 10 of 27 sub-Saharan African countries
between 1981-81 and 1989-91.
8
infrastructure,
(rural credit
markets, why?)
and
encouragement
of small-scale
 production
methods...


World Bank (1993): urban-rural income gap
relatively small in high performing Asian countries.
Lower gap:
reduces incentives to migrate out of agricultural
employment;
 reduces urban unemployment;
 reduces government revenues.
First best methods of promoting greater income
distribution:
Reform of agricultural taxation coupled with land
reform, increased provision of infrastructure,
development of rural credit markets, and
encouragement of small-scale production methods.
9
Trade Liberalization
10




Recognition of the severe allocative distortions of
import substitution strategies has led to more
liberal external trade regimes among developing
countries.
Why?
Reduction in trade barriers (tariffs, import quotas)
fosters relative price adjustments, leads to a
reallocation of resources toward exportable sector.
Leads to an expansion of output of exportables visà-vis import-competing industries.
Static output gain and dynamic gains from free
trade. Removal of barriers to trade may lead to
permanent increase in economy’s growth rate as a
result of technological spillovers.
11
The Gains from Trade
 Understanding gains from trade requires
understanding the efficiency loss associated with the
imposition of a tariff in the first place.
Hekscher-Ohlin-Samuelson model:
Model assumptions:
 perfectly competitive and efficient markets;
 incomplete specialization with relative factor
endowments;
 international immobility of factors;
 exogenous terms of trade in the domestic
economy.
12



See Figure 14.1: Case of small open economy
producing one importable good partial equilibrium
setting.
Imposition of a tariff:
Deadweight loss associated with the loss of
consumers’ surplus far outweighs increase in the
producers’ surplus and the increase in government
revenue.
Welfare loss due to the tariff:
W  J/2
 J: change in imports;
: tariff rate.
13
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
If free trade price, P*J, equals unity, then  J equals 
JJ with J: price elasticity import demand, Meade
formula,
W  2 JJ /2.
16
General Equilibrium setting
Figure 14.1 (bottom):
 PP: production possibility frontier; maximum physical
production of X and J producible given economy’s
productive capacity and state of technology.
 Marginal Rate of Transformation: slope of PP.
 I0 and I1: social indifference curves; combination
baskets of X and J among which society obtains
equivalent utility.
17



Marginal Rate of Substitutions: slope of society
indifference curves.
: For X (exports) and J (imports) measures relative
price of importables/exportables, MRS, taken as
exogenous.
Tariff,  on J distorts domestic relative price ratio
from * to,
 = (1 +  )PJ /PX


Exportable (importable) sector contracts (expands).
Tariff is sub-optimal.
18
Can an import tariff be optimal?
Aizenman (1987):
 In the absence of collection costs for tariffs and an
inelastic labor supply, optimal tariff is,
 = /( - )
: cost of collecting alternative taxes (in percent);
: price elasticity of import demand.
19
Dixit (1985):
 criticized above argument;
 possible to generate same revenues as tariff w/
neutrally levied tax on both domestic and foreign
goods;
 collection costs may be low but enforcement costs
could still be quite high.
20
Dynamic gains from trade
Romer and Rivera-Batiz (1991):
 Lowering barriers to trade can affect growth through
at least 3 mechanism:
 Transmission of technology: accumulation of
knowledge, as a public good, increases rate of
technical progress.
 International integration of sectors characterized
by increasing returns to scale raises output
without requiring more inputs.
 Trade liberalization reduces price distortions,
reallocating resources across sectors and
increasing economic efficiency.
21
about Rodrik’s
study that
implicates tariff
reductions on
the downside.
Not explained in
the
 text, i don’t
think.
Strategic Trade Theory
Helpman and Krugman (1985):
Scale economies and externalities: larger
producers have advantage, e.g. larger market sizes
ceteris paribus optimal.
Rodrik (1988):
 Considered a country with high tariffs and imperfect
competition.
 Net effect of tariff reduction was a priori
ambiguous.
 Trade reform affects welfare through traditional (e.g.
volume of trade effect) channels and also
assumptions about market structure.
22
about Rodrik’s
study that
implicates tariff
reductions on
the downside.

Not explained in
the
 text, i don’t
think.
Baldwin (1992):
Strategic trade theory not easily generalizable.
Contingent on assumptions about market structure,
entry and exit restrictions, and intersectoral
linkages.

Information that is in practice very difficult to obtain.
23
World Bank
Recent
Evidence on Trade Reforms
User:
Four reasons to be careful about using nominal
tariffs as a proxy for openness;
Instrument substitution: nominal tariffs may be
lowered, but other restrictions--such as anti-dumping
measures--may take its place.
Nominal tariffs and effective tariffs may differ due to
certain exemptions.
Tariff redundancy: after reform, overall structure
may become more protective.
Other anti-export biased policies, e.g. overvalued
exchange rate etc., ultimately help account for degree
of trade liberalization.
Yo, what the
&^%^ are you
talking about
here…




24
Effective Protection Rates:
(value added at domestic prices - value added in int’l prices)
value added in international prices

better way of looking at bias of trade regime;

dependent on input coefficients and tariffs on
inputs;

detailed input-output tables necessary;

thus, nominal tariffs, despite their limitations, are
frequently used as indicators of changes in the
trade regime.
25
Figure 14.2: nominal tariffs, developing countries,
1980-95:
 Average tariff rates fell substantially in several
developing countries.
 India: maximum tariff on imports; 400% in 1990 
50% in 1995, average tariff rates; over 80% to
under 30% over the same period.
 Latin America: tariffs lowered from 41.6% in 1985 to
13.7% in 1995 (Lora and Olivera, 1998, p. 13).
26
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27



South Asia: unweighted tariff averages on
manufactured goods fell in the early 1990s to 11%
in Korea, 15% in Malaysia, and 11% in Taiwan;
remained at 42% in Thailand, 56% in India, 64% in
Pakistan, and 85% in Bangladesh (Bandara and
McGillivray, 1998).
Figure 14.3: reduction in mean tariffs associated
with a reduction in dispersion of tariff rates.
Sub-Saharan Africa: region with least progress in
trade liberalization:
 sub-Saharan Africa’s exports: 3% of world
exports in 1955; by 1990, barely above 1%;
28
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29
decline in global demand for sub-Saharan
products and a substantial erosion of its market
shares;
 World Bank: if sub-Saharan Africa had
maintained its 1962-64 export shares, region's
exports would now be more than double their
current value;
 antiexport bias still characterizes many trade
regimes in region (Ng and Yeats, 1997).

30
Trade Reform, Employment, and Wage
Inequality
Short- and intermediate-run impact of trade reform
on wages and employment remains imperfectly
understood.
Evidence:
 World Bank study in early 1980’s, inconclusive:
 manufacturing sector employment either fell or
remained stable after liberalization program;
 however, study did not distinguish between
traded and nontraded manufacturing goods and
didn’t look at aggregate unemployment rate.

31
More recent studies
 Rama (1994): Lower tariffs in manufacturing sector
in Uruguay had no impact on wages, negative effect
on employment. Reducing tariff inclusive import
prices by 1%, decline in employment by .4-.5%.
 Revenga (1997): Reducing tariffs by about 10% in
Mexico led to a 2-3% decline in manufacturing
sector employment and an increase in average
wages.
 Currie and Harrison (1997): Morocco, 1984-1990
coverage of import licenses reduced from 41% of
imports in 1984 to 11% 1990, reduction in the
maximum tariff rate from 165% to 45%---formal
manufacturing sector, small, significant impact, also
32
pronounced sectoral shifts in employment.



Márquez and Carmen Pagés-Serra (1998): effect of
trade openness and real exchange rates on demand
for labor in manufacturing sector in 18 countries in
Latin America and the Caribbean. Found that trade
reform has a negative but small effect on
employment, reinforced by real exchange rate
appreciation.
Income distribution: openness, since 1980s, has
coincided with an increase in the relative wages of
skilled versus unskilled labor.
Revenga (1997): for Mexico, rise in average
manufacturing wages caused by change in labor
composition, e.g. shift towards high-skill, high-wage
workers.
33


Currie and Harrison (1997): for Morocco, found
similar divergence in relative wages and demand for
labor.
Chile: wages of university graduates rose by 56%
relative to those of high-school graduates between
1980 and 1990. 1990s suggest that wage
differentials may have remained largely unchanged
in Argentina, Chile and Costa Rica (Lora and
Olivera, 1998).
34
Hecksher-Ohlin-Samuelson (HOS) Model
 Principle of comparative advantage: pattern of
trade across countries based on relative factor
abundance.
 Two theorems derived from HOS Model:
 Factor price equalization theorem (FPE): Under
HOS assumptions, prices of production factors
will equalize across trading partners.
 Stolper-Samuelson (S-S) theorem: A(n) decrease
(increase) in the tariff on a good will decrease
(raise) the real price of the factor of production
that is used relatively intensively in producing that
good.
35
 See Figure 14.4 for graphical illustration.
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Explanations for the fall in unskilled wages:
S-S Theorem
 Reduction in the relative price of unskilled laborintensive goods brought about by a tariff reduction
will unambiguously reduce unskilled labor wages.
Capital goods, skill-intensive goods spiral: an
alternative explanation.
 Trade liberalization is associated with the
introduction of higher-level technology.
 Assumption that the cost of capital falls alongside
trade liberalization, leading to increased imports of
capital goods, and expansion of exports of skillintensive goods. in turn, the wage gap between
37
skilled and unskilled labor widens.
Obstacles to Trade Reform
Progress has remained slow in some countries,
particularly in sub-Saharan Africa.
Matusz and Tarr (1999)
 Adjustment costs associated with trade liberalization
typically very small compared with benefits.
Then why is trade reform unpopular?
 Influence of powerful groups.
 Political considerations instead of cost/benefit
analysis.
 Rent-seeking activities.

38
Rodrik (1995c):
 Two obstacles to trade reform:
 status quo bias, associated with individual
uncertainty;
 high political costs compared with efficiency
gains.
Fernández and Rodrik (1991):
 Idiosyncratic uncertainty: since individual winners
and losers can’t be identified before
implementation;
 ex ante individuals may oppose reforms;
 even if ex post everyone should support them.
39
Example:
Idiosyncratic uncertainty in action:
 economy with 100 workers;
 employed in two sectors, W and L;
 40 in W, 60 in L.
Faced with a reform in which:
 each worker in W gains 0.2;
 each worker in L loses 0.2;
 20 workers will move from L to W.
40
Full information
 Ex post: a majority will approve, 60 (in W) vs. 40 (in
L).
Individual uncertainty

Ex ante results change by the following logic:
Suppose each person in L faces identical odds of
staying (40/60) in L and walking to W (20/60):
 expected gain from reform;
0.2  (1/3) - 0.2(2/3) < 0,
majority in L will rationally vote against reform;
 paradox: a benevolent dictator could produce the
optimal ex post outcome.

41
Overcoming status quo bias:
 can try to design more appropriate transfer
schemes;
 can try to create an insurance market to allow
individuals to protect against uncertain outcome.
High Political Costs:

Welfare costs of trade distortions, measured by
Harberger triangle, are relatively small, (2% or less
of GDP).

Simultaneously, trade liberalizations typically involve
large reallocations of income, with high political
costs that may generate resistance to reform
42
(Rodrik, 1992).
Rodrik’s political resistance to reform ratio:
 Rodrik considered a small open economy with:
*
 price of importables/exportables, p ;
*
 initial tariffs, pd > p ;
*
 then a convergence of pd  p implying a loss of
government revenues, a gain in consumer surplus
and a loss of producer’s surplus (see Figure
14.1).

Political resistance to reform ratio: total income lost
both by the government (foregone tariff revenue)
and producers divided by the total efficiency gain.
43
Rodrik (1998):
 Large distributional effects of trade reform explain
low credibility in sub-Saharan African countries.
 Opposition to trade reform often more localized and
organized than political opposition to
macroeconomic stabilization (Tommasi and Velasco,
1996).
44
Calvo (1989)
Lack of credibility as a distrotion or a
production tax that limits beneficial effects of trade
reform.



Situation where authorities announce permanent
tariff abolition but private sector discounts a policy
reversal.
Low credibility of the tariff reform can trigger
speculative accumulations of inventories.
While profitable to private sector, not pareto optimal
for the society as inventory accumulations may
crowd out alternative acquisitions with higher social
returns.
45
Social cost of policy uncertainty: function of
capital markets structure;


perfect capital mobility facilitates unlimited foreign
capital for inventory speculation;
capital controls can limit speculative process.
Adverse revenue effects: a further explanation
of trade liberalization procrastination;



countries reliant on trade taxes display slower trade
reform;
trade liberalization may lower revenue in short term;
however, some liberalization measures (e.g. tariff
instead of quota) possible w/out meaningful declines
46
in revenues.
Increase in revenue possible:
 if lower tariffs are accompanied by volume
increases (import elasticity vital);
 trade liberalization concomitant with exchange rate
liberalization,
 fall in exchange rate leads to increase in
domestic-currency price of imports to offset loss
of percentage tariff revenue in local currency
terms.
47
Trade and Regional
Economic Integration
48
Composition of exports
 Manufacturing goods share of total exports
 Asia: from 42% of total exports in 1970 to 48% in
1980 to 74% in 1990.
 Latin America: from 12% in 1970 to 18% in 1980
to 34% in 1990.
 Africa: from 15% in 1970 to 27% in 1980 and fell
to 22% in 1990.
49
Export composition changes resulting from
removal of domestic market distortions lower trade
barriers and most significantly,


shift in comparative advantage; lower relative
wages and greater investment leading to increased
competitiveness in manufactured goods;
in Asian countries: high domestic saving and
investment rates leading to increases in the stock of
capital.
50
Export diversification and intraregional trade:
Figure 14.5: displays export diversification
between 1984 and 1994.
 Asia: nearly 40% of the region's exports now going
to other Asian countries.
 Latin America: export diversification more limited,
almost 50% of region's exports shipped to North
America.
 African countries: relatively undiversified, almost
50% of the region's exports going to Europe, and
level of intraregional trade remains modest.
 Middle East and Europe: diversification relatively
small; importance of intraregional trade actually
diminished between 1984 and 1994.
51
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54
Preferential trade agreements:
Mercosur agreement:
 Brazil, Argentina, Paraguay, and Uruguay.
 Commenced January 1, 1995.
 Common external tariff (CET) structure
 0 to 20% on about 85% of all traded goods;
 can only be modified with consent of all four
partners;
 15% of goods outside the CET structure, divided
into three categories subject to adjustment
schedule to converge with CET rates within next 56 years.
55
Three categories of goods currently outside CET:
 National exceptions: Each country can identify up
to 300 items for temporary exemption from the
CET. Tariffs on these goods must converge with the
CET by the year 2001.
 Capital goods: exempted from the CET structure
for all countries but convergence timetable varies.
 2001: Argentina and Brazil;
 2006: Paraguay and Uruguay.
 Computer goods: convergence to the CET set to
occur by 2006. Average tariff rate in Brazil, 30%,
scheduled to fall to 15% by 2006.
56
No tariffs on intraregional trade with exception of,
 Adjustment Regime: allowed each country to
maintain tariffs for items on a preapproved list until
January 1, 1997, for Argentina and Brazil, and
January 1, 2000 for Paraguay and Uruguay.
Benefits of regional trade:
 allow firms to spread R&D costs over a larger market,
reducing unit costs and encouraging innovation;
 positive spillovers: as successful innovations are
applied more broadly;
 integration can boost productivity growth, allowing
increased specialization;
 efficiency gains from increased competition,
57
reinforced by foreign direct investment.
Policy issues raised by preferential trade agreements
.
Bhagwati and Panagariya (1996):
 Preferential trade agreements may conflict with
multilateral agreements (e.g. WTO).
 Preferential trade arrangements not only can lead
to trade creation, but also trade diversion;
imports switching from more efficient nonmember
suppliers to less efficient member suppliers.
 Higher trade volumes between member countries
may lead to greater losses to an individual member
Z that joins from a set of high initial tariffs levels.
58
Trade creation vs. diversion: partial equilibrium
setting
Viner (1950):
 Given, two countries, A and B, producing the
same good and considering forming a
preferential trade arrangement with a customs
union.
*
 A and B both face constant world price, P .
 Suppose A is an importer of the good from B and
the rest of the world.
 B is a net exporter.
 Before custom union, A imposes
nondiscriminatory tariff rate, , on all imports.
59





B initially has no tariff.
Before union B exports only to A.
With union, two countries are self-sufficient at price PU
> P* < (1 + )P*.
See Figure 14.6.
Three types of effects on A:
 trade creation effect;
 trade diversion effect;
 consumption effect.
60
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Customs unions and welfare, the analytical evidence:
 More competitive and complementary union partner
production structures increase likelihood that
customs union increases welfare.
Reason:
 more scope for trade creation among countries
whose production structures are similar, because
less efficient domestic production tends to be
replaced by imports from partner countries.
 Larger cost differentials increase scope for gains
from trade creation effects.
 Higher initial tariffs between union partners, increase
scope for trade creation and welfare gains.
62



Lower tariffs imposed on non-members decrease
trade diversion.
The smaller the share of goods imported from
nonmember countries in total consumption prior to the
union, the greater the higher the benefits for
members.
Assessing net welfare effects of these arrangements
requires examining dynamic effects associated with
greater scope for economies of scale, increased
competition, and larger investment and technology
flows across member countries (see Baldwin and
Venables, 1995).
63
Reforming Labor Markets
64
Labor market flexibility and economic growth:
 Observers have argued that key feature of the East
Asian growth miracle (mirage) was the limited
impact of trade unions and other distortions on the
labor market (Fields and Wan, 1989).
 Asia was also able to sustain high levels of
employment growth without wage pressures.
 Viewed as a result of effective investments in
primary and secondary education, which have
ensured an ample supply of skilled workers and
helped to prevent large changes in relative incomes
(Fields, 1994).
65
Labor market reform advocates support the
following as having positive effects on growth:





circumventing the scope of hiring and firing
regulations;
reducing nonwage labor costs;
eliminating (or restricting the scope of) minimum
wage laws;
limiting unemployment benefits;
curtailing the role of trade unions in the wage
bargaining process.
66
We take a more balanced approach:
 review some known facts about labor markets in
developing countries;
 consider various types of labor market reforms
aimed at increasing economic flexibility;
 conclude by examining the link between labor
market regulations and growth.
67
Labor Markets in Developing Countries
Typically consists of three sectors:
 Rural sector: particularly large in sub-Saharan
Africa.
 Informal urban sector:
 mostly self-employment and limited hired labor;
 characterized by high wage flexibility and low
employment security.
 Formal urban sector:
 explicit contracts;
 high compliance with labor market regulation;
68

wage determination departs from market
clearing mechanisms due to legal restrictions,
labor unions, and considerations internal to firms.
69
Employment Distribution and
Unemployment




Proportion of wage earners; high in Asia/Latin
America, very low in sub-Saharan Africa (about
10%).
Public sector absorbs a large share of formal wage
employment in some countries.
Share of informal sector employment in total
urban employment is sizable, exceeding 60% in
India and Kenya.
In many countries in Latin America, the informal
sector grew in importance during the 1980s and
early 1990s, accounting for more than 50% of total
70
employment in 1992 (see Agénor, 1996).
Disguised unemployment

Underemployed workers in the informal and rural
sectors

Published unemployment only captures the formal
sector.

25-60% of labor force in some countries.


Unemployment insurance, not well developed,
desirability questionable:
Negative: disincentive to search for (or to accept)
employment, incentive to enter the labor force in
order to collect unemployment benefits.
Positive: encourages labor force participation and
regular over marginal, employment (Atkinson and
Micklewright, 1991).
71
Empirical evidence difficult to capture:
 elasticity of unemployment with respect to
replacement rates (benefits before taxes as a
percentage of previous earnings) may be relatively
low;
 but whether high unemployment benefits tend to
increase unemployment remains an open issue.
72
Wage Formation and Labor Market Segmentation
 Labor market segmentation: situation where
observationally identical workers receive different
wages depending on their sector of employment.
Induced by various factors:
 government intervention in the form of minimum
wages;
 trade unions imposing wage premium for members;
 efficiency wages: resulting from nutritional factors
(Bliss and Stern, 1978), turnover costs (Stiglitz, 1974)
or productivity considerations (Stiglitz, 1982).
73
Efficiency wages:
 Firm set wages to minimize labor costs per
efficiency unit rather than per worker costs:
 level of effort may be positively related to the pay;
 firms wage-setting decision may be a markup of
the formal sector over the informal sector;
 as the efficiency wage may exceed the marketclearing wage, such models also help to explain
the existence of involuntary unemployment;
See Annex A for a model of the urban labor
market in developing countries.
74
Minimum Wages
Arguments in support of a minimum wage:
 has positive nutritional effects;
 is an instrument of income redistribution and social
justice;
 can raise productivity.
75




Arguments against minimum wage:
prevents downward adjustment in wages, leads to
an excess supply of labor, imposes an implicit tax on
employers in the formal economy;
creates unemployment, induces labor market
segmentation, and lowers wages in informal urban
sector;
increases the cost of employing unskilled workers
relative to capital, accelerates substitution of capital
for unskilled labor;
over time a high minimum wages restrains the
aggregate expansion of the labor market.
76
Empirical evidence
 Mixed and inconclusive.
Difficulties:
 Lack of legal compliance renders studies based on
the formal sector highly imprecise.
 Large share of workers in one formal-sector industry
may be paid below minimum wages whereas the
other share may earn wages in excess of the
minimum wage.
 Controlling for differences problematic, not a
function of worker or firm characteristics.
77
Nevertheless, some recent studies have
suggested that the employment effects of changes
in minimum wages are either limited or even
positive.
Bell (1997):
 Although changes in the minimum wage seemed to
affect the distribution of wages in Colombia and
Mexico, they appeared to have a limited impact on
employment.
Rama (1995):
 Minimum wages did not significantly effect economic
growth.
 Higher minimum wages appeared positively
78
correlated with employment growth.
But changes in the minimum wage are likely to have
important distributional effects among workers, for
instance, between those employed in the formal
sector and those in the informal sector.
Trade Unions and the Bargaining Process
 Trade union in developing countries typically are not
very centralized.
 Collective labor action is difficult to organize.

However, the degree of unionization is a highly
imperfect measure of trade union influence.
79
Strategic sectors or industries may exert
considerable influence on wage formation and
working conditions at the national level, even if
overall union membership is low in proportion to the
work force.
Calmfors (1993):
 Relationship between the degree of centralization in
wage bargaining (the extent to which unions and
employers cooperate in wage negotiations) and
wage pressures is an inverted U-shape.
 Wage push is limited when bargaining is highly
centralized and when highly decentralized.

80
Highest influence on wage formation tends occur
when centralization is in the intermediate range,
that is, at the industry level.
Explaining inverted U-shape (see Calmfors, 1993):
 High degree of centralization implies a high level of
cooperation between unions and employers that
leads to an internalizing of wage increases,
lowering the marginal benefit of an increase in
wages.
 Competitive forces lead decentralized bargaining
systems to produce real wage moderation.

81
Under intermediate centralization, neither
internalization effects nor competitive forces are
sufficiently strong to restrain unions' incentives to
demand higher wages.
 Recent research disagrees.
Cukierman and Lippi (1998):
 Higher centralization has two opposite effects on
real wages:
 less effective competition among unions; this
competition effect tends to raise real wages;
 strengthens the moderating influence of
inflationary fears on the real-wage demands of
each union; this strategic effect tends to lower
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wages.

Direct impact of unionization on wages:
 Nelson (1994) argued that in Latin America, unions
lead wages to rise above the opportunity cost of
labor through a combination of union pressure,
minimum wage legislation, and wage policies in the
public sector.
 In Taiwan and Korea, unions have limited power in
bargaining over wages (Fields, 1994).
 Park (1991): blue-collar workers in the unionized
manufacturing sector in Korea are paid on average
only 4 percent more than their counterparts in the
nonunionized sector.
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
Panagides and Patrinos (1994): union-nonunion
wage differential in Mexico was about 10 percent in
the late 1980s.
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Labor Market Reforms and Flexibility
Adverse consequences of job security provisions:
 General loss of profitability, reduced flexibility at
the firm level, distortions in favor of more capitalintensive production techniques.
 Tokman (1992): during the 1980s labor regulations
accounted on average for a 20 percent increase in
labor costs in a group of Latin American countries;
fringe benefits and social security contributions.
 High hiring and firing costs lead employers to hire
less. opting instead for casual labor and temporary
contracts.
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High mandatory severance payments as a
contingent tax on labor use; tend to impede the
speed of adjustment to adverse sectoral and
aggregate shocks.
Fallon and Riverso (1989)
Labor as a quasi-fixed factor of production:
 Incidence of long-term unemployment increased
through reduced labor turnover.
 Regulations may reduce acquired skill-set of the
chronically unemployed and reduce the downward
pressure exerted by the unemployed on wages.

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Negative reinforcement of labor regulations: high
minimum wages and job protection legislation may
together price unskilled workers out of new jobs and
reducing incentives to invest in new skill acquisition.
 Removing these provisions would then reduce
nonwage labor costs and eliminate rigidities that
impede labor mobility and the efficient allocation of
resources.
View reconsidered:
 In industrial countries little empirical evidence that
employment protection measures cause
unemployment persistence.

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Abraham and Houseman (1994): Germany, France,
and Belgium in mid-1980s; no evidence that
provisions affect speed of labor market adjustment.
 Developing countries: poor compliance with
existing regulations (Freeman, 1993) results in de
facto flexible wages and little direct effect of job
security provisions on employment.
Standing (1991)
 Benefits of employment security regulations:
 improve workers' commitment to the enterprise
and raise work motivation and productivity;
 reduce employment transactions costs and labor
turnover;

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improve job and work flexibility; willingness of
workers to accept occupational and work
environment changes;
 induce workers to accept lower wage rises;
 reduce probability of frictional unemployment.
In emerging markets, a more balanced
evaluation of employment protection regulations
seems warranted.

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