When Does Trade Hurt? Market, Transition and Developing Economies 1 Kala Krishna Pennsylvania State University and NBER Cemile Yavas Pennsylvania State University September, 2002 1 We are grateful to Don Davis, Elhanan Helpman, Abhijit Banerjee, Jim Anderson, and participants at the 2001 ITI Summer Institute at the NBER, the Fall 2001 Midwest Trade Conference, the IEFS session at the ASSA in 2002, and the ETSG meetings in 2002 for comments. Abstract This paper argues that labor market distortions present in transition and devel- oping economies coupled with indivisibilities in consumption may help explain the resistance to globalization prevalent in many of these economies. We assume that workers differ in ability. In a market economy their earnings depend on their ability. However, earnings are independent of ability due to a common wage set in manufacturing in a transition economy and because of family farms in a developing economy. Trade can have significant adverse effects in this setting. When the economy is productive enough, a high income autarky equilibrium can be sustained in a distorted economy through a high income, high demand, high income virtuous circle. However, the distortion tends to make trade operate in a way that destroys this. Our work suggests that trade liberalization without structural reform can have serious adverse effects in transition and developing economies: there can even be mutual losses from trade. 1Introduction This paper argues that labor market distortions (LMDs) present in transition and developing economies may help explain the resistance to globalization that is prevalent in many of these economies. For example, it is often argued that trade had significant adverse effects in transition economies, in particular, on the ability of workers to afford highly valued but inherently lumpy consumer durables. Prior to trade, manufacturing wages were high. These high wages supported a high demand for consumer durables, which in turn supported the high wages. Even if these goods were not exactly competitive with those in the West, at least most citizens could afford them. Trade liberalization resulted in the import of these goods as they are made more competitively in the West. Consequently, their price fell and those individuals whose income did not fall were made better off. However, these imports destroyed the domestic demand for labor in the import competing sectors and this led to large reductions in real wages in these sectors. However, this fall in wages did not make the economy more competitive, as the quality of workers fell along with the wage, which worked to raise costs. It did destroy the market for manufactures as the middle class, composed of factory workers which could previously affordsuchgoodswas essentially wiped out. It is well understood that in the presence of existing distortions, trade lib- eralization may have adverse effects. While there has been a large literature in the area of trade with factor market distortions, much of it focuses on minimum wages in manufacturing, see for example Brecher (1974a,b) and Davis (1998). See Magee (1973) for a survey of this work.1 In contrast, we focus on features of the organizational structure of labor markets in the economy which lead to the distortion. Even more important, all of the substantial literature on fac- tor market distortions in a general equilibrium trade setting assumes identical homothetic preferences. As a result, the effects of trade through their effects on the distribution of income are assumed away. Our focus is precisely this channel. We develop a simple competitive general equilibrium model with two final goods, one of which is indivisible,2 and labor which differs in its productiv- ity. The labor market distortion we focus on is that in some or all sectors, all workers are paid the same independent of their ability. We consider four kinds of economies. The one with no factor market distortions is called the market economy. If this distortion is in the indivisible good sector only, the economy is called the transition economy, while if it occurs in both sectors it is called the socialist economy. If the factor market distortion occurs only in the divisible good sector, we call the economy a developing economy. The reader may prefer to think of the four cases as the factor market distortion being in neither sector, 1 Grossman (2002) also looks at imperfect labor markets, but he focuses on how differences in the distribution of talent can be an independent source of comparative advantage when labor market contracts are imperfect. 2 Indivisibility refers to either zero or one unit of the good being purchased by a consumer. As a result, the marginal rates of substitution between goods need not equal their price ratio. 1 only in indivisibles, in both sectors, or only in divisibles. We assume that there are no distortions in a market economy. As a result, trade must be welfare improving. If a good is imported, it is because its price is lower and as a result consumers gain from trade. In a transition economy, workers in indivisibles earn a common market clear- ing wage unrelated to their ability. This is meant to capture the idea that work- ers get a common wage, especially in state owned sectors which make indivisible consumer goods. As a result, low productivity workers who cannot earn more in divisibles are attracted to indivisibles. These workers are paid more than their marginal product in divisibles which makes the cost of producing indivisibles higher than that in a market economy with the same technology. On the other hand, the higher income earned by less able workers increases the potential market size for indivisibles. Trade can reduce social welfare in such an economy when it involves importing the indivisible good. Such trade has adverse effects as it lowers production of indivisibles, which reduces wages, and hence the abil- ity to afford the indivisible good. Trade also reduces price of indivisibles, which is beneficial. If the transition economy importing indivisibles is large, there is no price effect and trade is, in fact, weakly Pareto inferior to autarky!3 In a socialist economy, all sectors earn the same wage irrespective of where they work as the factor market distortion occurs in all sectors. In such an economy, there is no effect of the factor market distortion on the relative costs of divisibles and we show that trade does not have adverse effects.4 In developing economies, family farming in agriculture is the norm. This results in workers earning their average rather than marginal product in agricul- ture. In a developing economy workers in the divisible good sector, interpreted as agriculture, work in family farms and obtain the average product of labor in the farm. When labor is of differential productivity, as in our model, only lower quality labor remains in agriculture. As a result, the marginal worker produces more than the average product of labor in agriculture, so that too few workers remain in agriculture rather than too many.5 Low productivity workers who cannot earn more in indivisibles are attracted to divisibles. These workers are paid more than their marginal product in indivisibles which makes the cost of producing indivisibles lower than that in a market economy with the same tech- nology. Also, higher incomes earned by less able workers increase the potential market size for indivisibles. Increased output of the indivisible good reduces 3 This is an example of the theory of the second best at work. Reducing one distortion in the presence of multiple distortions can worsen the outcome. See, for example, Ethier(1982). 4 It is worth noting that in transition and socialist economies, if productivity is high enough, the outcome under autarky, using a utilitarian social welfare function, may give a higher level of welfare than the outcome under autarky for the otherwise identical market economy. Since a competitive equilibrium is Pareto optimal even in the presence of indivisibilities, not everyone can be better off in a socialist or transition economy. It is shown that the very able are worse off, while the less able are better off. 5 When workers have diminishing marginal product in agriculture, their average product exceeds their marginal product so that too many workers remain in agriculture. In the develop- ment literature this distortion has been linked with the concept of "Disguised Unemployment", see Sen (1960). 2 the labor force and average quality of labor in agriculture, thereby reducing the earnings of those in agriculture, and hence the ability to afford the indivisible good. Trade can reduce social welfare in such an economy when it involves importing the divisible good. Our work suggests that trade liberalization without structural reform can have serious adverse effects in transition and developing economies. An unusual possibility is mutual losses from trade which occur when a developing country exports the indivisible good to a transition economy. Before beginning we want to make clear the role of indivisibilities in our results. We choose to use the indivisibility assumption for two reasons. First, indivisibilities in consumption provide an easy way to make demand depend on the distribution of income rather than aggregate income alone. With the standard assumption of identical homothetic preferences, demand depends on aggregate income and is independent of its distribution. If preferences are not identical and homothetic then excess demand functions have few restrictions on them in general equilibrium so that this approach is not tractable. Quasi linear utility, used in the industrial organization and strategic trade literature, removes all income effects. Our modelling approach provides a simple way for income distribution to affect aggregate demand. Second, our model provides a setting where the location of the factor market distortion, in divisibles or indivisibles, matters.