International Trade and National Factor Markets.

• Author: Davis, Donald R.

Donald R. Davis [*]

Trade, Wages, and Unemployment

Of primary concern in international trade policy is the impact of trade on national factor markets. Such concerns have sharpened as the extent of international integration has risen both among OECD countries and between these countries and poorer non-OECD nations. How does trade affect unemployment, we wonder, or wages? Does it matter that countries have very different labor market institutions?

For the analyst, these questions raise both theoretical and empirical issues. What theoretical framework is appropriate for thinking about these issues? Is there a model of international exchange and national factor markets with enough empirical support to give us confidence in the comparative static assessments that we make? These questions have motivated my work in recent years.

One strand of this work explicitly focuses on the analytics of trade, wages, and unemployment when countries have different labor market institutions. This work is motivated by the contrast between the experience of the Anglo-American economies and that of many Continental European economies. In the Anglo-American economies after 1980 there was a large decline in the relative wages of unskilled workers, yet relatively low unemployment. In contrast in many of the European economies at that time, relative wages of the unskilled did not decline, but unemployment reached very high levels. The contrast in experience has been noted by many other researchers, and differences in the flexibility of factor market institutions often were cited as an important contributing factor.

One key question that had not been addressed, though, is how the costs borne by each of these country-types were affected by the fact that these countries trade in a unified global goods market. I address that question in a series of papers. The first paper considers a benchmark case between a stylized America and Europe, where the countries are identical except for one institutional difference: America has fully flexible wages while Europe targets an unskilled wage higher than what would prevail without intervention. [1] If the countries are in isolation, the resulting difference in outcomes is straightforward. Flexible labor markets allow America to have full employment, but at the cost of lower wages for the unskilled. Europe attains its higher target wage for the unskilled, but at the cost of high unemployment.

The outcome changes radically, though, when America and Europe trade freely. The key is the link between wages and goods' prices. If Europe is to achieve a high wage for unskilled labor, it must also target a high price for the good that uses that labor relatively intensively, since wages and prices move in lockstep. But it now must maintain this price not only in Europe, but also internationally, since the price is common. Trade with America incipiently lowers this goods price, and the target unskilled...