CIAO DATE: 3/00

Labor Costs and International Trade

Stephen Golub

Conference Series
March 1998

The American Enterprise Institute for Public Policy Research

Labor Costs and International Trade

On January 13, 1998, Stephen Golub, professor of economics at Swarthmore College, led the sixteenth seminar in AEI’s series Understanding Economic Inequality. Mr. Golub’s presentation sought to dispel fallacious but widespread views concerning the effects of competition from low–wage countries in international trade, including the view that such competition has significantly increased wage inequality in the United States.

The argument that low foreign wages provide an unfair competitive advantage has been widely believed in the United States for at least 150 years, and it was a powerful factor last year in defeating President Clinton’s request for “fast track” trade authority. Nevertheless, that argument has two important flaws: it fails to recognize a fundamental distinction between comparative and absolute advantage, and it fails to grasp the link between low wages and low productivity.

 

Classical Trade Theory

Classical trade theory, going back to the writings of David Ricardo early in the nineteenth century, teaches that the difference in average wages between two countries is determined by the difference in average productivity, while trade patterns are determined by sector–specific variations in productivity and hence costs. As a hypothetical illustration, the United States has an advantage over Honduras in making computers, despite our high wages, while Honduras has an advantage in making shirts, where the productivity of Hondurans lags by less and the lag is more than made up for by their much lower wages.

The simplest proof that the classical theory is correct is that trade in manufactured goods of the industrial countries as a group with the developing countries is roughly balanced, despite the huge gap in wages. The high–wage countries sell as much as they buy. In recent years, imports from low–wage countries into the United States have grown, but so have exports to them. If high labor costs rendered U.S. products noncompetitive, this would be impossible.

What is more, while imports from the low–wage countries have grown, they are still very small in comparison with the U.S. economy as a whole, 3.5 percent of gross domestic product in 1995, for example. Contrary to popular impressions, productivity growth in manufacturing rather than trade with low–wage countries is the primary cause of the decline in the proportion of total employment accounted for by manufacturing in the United States and in other industrial countries.

Lawrence Mishel of the Economic Policy Institute, who was a respondent at the seminar, disagreed with Mr. Golub’s view that competition from low–wage countries is not a serious problem for U.S. workers. Mr. Mishel pointed to the U.S. trade deficit in manufactured goods with low–wage countries and to the fact that U.S. employers often threaten to shift production to such countries.

 

The Power of Productivity

Mr. Golub argued that the key to understanding the puzzle of international trade competitiveness lies in productivity. Differences in wages largely reflect differences in productivity—the output of labor for each hour or day worked. Thus while wage rates are lower in the poor countries, total labor costs for each unit of output are generally not, although labor costs in a poor country can be lower or higher than those of the United States in individual sectors.

The well–publicized figures on the huge growth in employment in recent years in the United States demonstrate clearly that international trade does not cost the United States jobs in total, but it can change the industry mix of employment. Without a doubt, some individual jobs are lost to imports from low–wage countries, but the economy as a whole gains from increased foreign trade.

Recently the argument has been made that classical theory is partly obsolete in a world of mobile capital—that firms can locate advanced, high–productivity plants anywhere in the world, taking advantage of low wages. The fallacy of the simple version of this argument is revealed by the fact that the countries with the lowest wages—such as Bangladesh, Bolivia, and many countries in Africa—have attracted very little foreign direct investment. Furthermore, capital flows in the form of direct investment to the developing countries are much smaller than is widely believed. In the period 1991–1995, foreign direct investment accounted for only 6.4 percent of domestic gross fixed capital formation in the developing countries as a group, although in some countries the share was higher.

The link between low wages and low productivity can be measured for individual countries. For some periods in some countries, of course, the figures on wages, expressed in dollars, are artificially depressed by dramatic drops in a country’s exchange rate, caused by such external shocks as debt crises. Nevertheless, a plot of wages and productivity, country by country, shows a general conformity with classical theory. Mr. Mishel commented in this connection that the plot showed some low–wage countries with relatively high productivity, making them a real challenge despite classical theory. He asserted that low–wage countries have a unit labor cost advantage in a large and growing number of industries, including many high–technology industries.

 

Wage Inequality in the United States

On the question of whether competition from low–wage countries is the cause of the widening income gap in the United States, many agree that wage inequality reflects greater demand for skilled labor, as evidenced by the growing wage premium earned by college graduates. There are two possible causes of the increasing demand for more sophisticated skills—international trade and skill–biased technological change. International trade does increase the demand for relatively higher skilled labor, as would be expected from the theory of comparative advantage. But many studies of this issue, Mr. Golub pointed out, conclude that trade with low–wage countries has played, at most, a secondary role in income inequality. According to a recent survey of the literature, nearly all of this research finds only a modest effect of international trade on wages and income inequality. It appears that technological change is mainly responsible for the shifts in the demand for labor.

In this connection, trade with the poor countries is very small relative to U.S. GDP (as noted above), and more than half of imports of manufactured goods come from other industrialized countries, many of which have wages roughly comparable with those in the United States. Thus, shifts in purely domestic demand for labor appear to count for much more than the effects of trade.