Trade policies and welfare in a Harris-Todaro economy.

• Author: Chen, Jiong

1. Introduction

   In many developing countries rising unemployment is often attributed to increases in foreign imports, triggered by declining foreign prices of imports. To correct the chronic unemployment problem, some developing countries chose an import substitution strategy by shutting off imports, whereas others adopted an outward-oriented policy by promoting exports. North American Free Trade Agreement (NAFTA) was favored by Mexico but opposed by organized labor in this country because it was feared that NAFTA may increase unemployment in the U.S. Which of these policies is more effective$in reducing unemployment and raising domestic income?

   Protection has been ardently supported as a practical cure for unemployment in Chile and Argentina and many other LDCs in Latin America.(1) Similarly, India adopted import substitution strategies behind high protection and a considerable bias against exports [1]. The literature has also justified the use of tariffs for small countries under uncertainty and unemployment [10; 9]. But in general, protection distorts the trade pattern and magnify the extent of the Leontief Paradox by limiting imports of capital intensive products into these developing countries that suffer from high labor unemployment [7].

   In the literature there have been two types of models that analyze trade problems in the presence of unemployment. The generalized unemployment models have been developed by Brecher [5; 6] and Batra and Seth [3].(2) In these models, wage rigidity is ubiquitous and unemployment exists in all sectors, and they are appropriate to analyze the impact of trade policies on unemployment in developed economies. The Harris-Todaro (HT hereafter) model [13], on the other hand, assumes sector-specific wage rigidity and permits unemployment only in the urban sector. Thus, the HT model is appropriate for investigating the impacts of trade policies of LDCs that suffer from urban unemployment, and it has been subsequently used by Hazari [14], Batra and Beladi [2], Chao and Yu [8], Hazari and Sgro [15], and Marjit [16].

   This paper uses the HT model to investigate optimal trade policies for a developing country with labor unemployment. As in Corden and Findlay [11], we assume that capital is mobile between sectors. It is shown that an import tariff is welfare-reducing in an HT economy. If an optimal production subsidy, which is negative, is used, however, the optimal tariff is zero. The negative production subsidy on the importable is equivalent to a production subsidy on the exportable. Our findings have an important policy implication on trade policies of a labor surplus economy; an import tariff is welfare reducing, and therefore, for instance, the reduced tariffs of Mexico implemented by NAFTA would probably improve welfare of Mexico, which may be viewed as an HT economy.(3)

2. The Basic Model

   Consider a small open HT economy which has two sectors, a rural sector and an urban sector. Unemployment exists only in the urban area because of a fixed urban wage, but rural workers are fully employed and paid a flexible wage. To analyze optimal trade policies of an HT economy, we employ the following assumptions:

   (i) Fixed supplies of capital (K) and labor (L) inputs.

   (ii) Capital is fully employed, but labor unemployment exists in the urban area because the fixed urban wage W is higher than the flexible rural wage w.

   (iii) The economy is small and imports the urban output X and exports the agricultural output Y, which is used as numeraire.

   Let [L.sub.j] and [K.sub.j] denote the labor and capital employed in sector j, respectively. The output of the urban manufacturing sector is

   X = F([L.sub.x], [K.sub.x]), (1a)

   and the output of the rural sector is

   Y = G([L.sub.y], [K.sub.y]), (1b)

   where F ([center dot]) and G ([center dot]) are linearly homogeneous production functions.

   Capital is a variable input and is mobile between the two sectors. Capital rental r is the same in both sectors and capital is fully utilized. However, due to wage rigidity in the manufacturing sector, some unemployment exists in the urban area.

   Profit of the urban sector is

   [[Pi].sub.x] = PF - W[L.sub.x] - r[K.sub.x], (2a)

   where P is the producer price of the urban output and W is the fixed urban wage. Profit of the rural sector is

   [[Pi].sub.x] = G - w[L.sub.y] - r[K.sub.y], (2b)

   where w is the flexible rural wage and the price of the numeraire Y is unity. Observe that marginal product of inputs are homogeneous of degree zero in K and L. In the short run, however, capital input is fixed, and marginal product of labor is decreasing in L.(4) The first order conditions for optimal labor employment are:

   P[F.sub.L] - W = 0, (3a)

   [G.sub.L] - w = 0. (3b)

   The solution of (3a) and (3b) yields conditional labor demand functions, [L.sub.x] = [L.sub.x] ([K.sub.x], P, W) and [L.sub.y] = [L.sub.y] ([K.sub.y], P, w).

   The rural wage w is equal to the expected urban wage. Thus, the relationship between the wages in the two sectors is given by the HT condition,

   w = [Beta]W = W/(1 + [Lambda]). (4)

   where [Beta] [is equivalent to] 1/(1 + [Lambda]) is the probability of employment, and...