Effect of Trade on Real Wages

This is “Effect of Trade on Real Wages”, section 4.8 from the book Policy and Theory of International Economics (v. 1.0). For details on it (including licensing), click here.

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4.8 Effect of Trade on Real Wages

Learning Objectives

Learn how to measure real wages in the immobile factor model.
Learn how real wages change when a country moves from autarky to free trade.

We calculate real wages to determine whether there are any income redistribution effects in moving to free trade. The real wage formulas in the immobile factor model are the same as in the Ricardian model since perfect competition prevails in both industries. However, the wage paid to cheese workers no longer must be the same as the wage of wine workers. Cheese workers’ wages could be higher since wine workers cannot shift to the cheese industry to take advantage of the higher wage.

When the countries move from autarky to free trade, the price ratio in the United States, P_C/P_W, rises.

The result is a redistribution of income as shown in Table 4.4 "Changes in Real Wages (Autarky to Free Trade): ". Cheese workers face no change in their real wage in terms of cheese and experience an increase in their real wage in terms of wine.

Table 4.4 Changes in Real Wages (Autarky to Free Trade): P_C/P_W Rises

	In Terms of Cheese	In Terms of Wine
Real Wage of U.S. Cheese Workers	$\frac{w_{C}}{P_{C}} = \frac{1}{a_{L C}}$ (no change)	$\frac{w_{C}}{P_{C}} = \frac{1}{a_{L C}} \frac{P_{C}}{P_{W}}$ (rises)
Real Wage of U.S. Wine Workers	$\frac{w_{W}}{P_{C}} = \frac{1}{a_{L W}} \frac{P_{W}}{P_{C}}$ (falls)	$\frac{w_{W}}{P_{W}} = \frac{1}{a_{L W}}$ (no change)
where P_C = price of cheese P_W = price of wine w_C = wage paid to cheese workers w_W = wage paid to wine workers a_LC = unit labor requirement in cheese production in the United States (hours of labor necessary to produce one unit of cheese) a_LW = unit labor requirement in wine production in the United States (hours of labor necessary to produce one unit of wine)

In Terms of Cheese

In Terms of Wine

Real Wage of U.S. Cheese Workers

\frac{w_{C}}{P_{C}} = \frac{1}{a_{L C}}

(no change)

\frac{w_{C}}{P_{C}} = \frac{1}{a_{L C}} \frac{P_{C}}{P_{W}}

(rises)

Real Wage of U.S. Wine Workers

\frac{w_{W}}{P_{C}} = \frac{1}{a_{L W}} \frac{P_{W}}{P_{C}}

(falls)

\frac{w_{W}}{P_{W}} = \frac{1}{a_{L W}}

(no change)

where

P_C = price of cheese

P_W = price of wine

w_C = wage paid to cheese workers

w_W = wage paid to wine workers

a_LC = unit labor requirement in cheese production in the United States (hours of labor necessary to produce one unit of cheese)

a_LW = unit labor requirement in wine production in the United States (hours of labor necessary to produce one unit of wine)

Thus cheese workers are most likely better off in free trade. Wine workers face no change in their real wage in terms of wine but suffer a decrease in their real wage in terms of cheese. This means wine workers are likely to be worse off as a result of free trade.

Since one group of workers realizes real income gains while another set suffers real income losses, free trade causes a redistribution of income within the economy. Free trade results in winners and losers in the immobile factor model.

In France, the price ratio, P_C/P_W, falls when moving to free trade. The result is a redistribution of income similar to the United States as shown in Table 4.5 "Changes in Real Wages (Autarky to Free Trade): ". Cheese workers face no change in their real wage in terms of cheese and experience a decrease in their real wage in terms of wine.

Table 4.5 Changes in Real Wages (Autarky to Free Trade): P_C/P_W Falls

	In Terms of Cheese	In Terms of Wine
Real Wage of French Cheese Workers	$\frac{w_{C}}{P_{C}} = \frac{1}{a_{L C}}$ (no change)	$\frac{w_{C}}{P_{C}} = \frac{1}{a_{L C}} \frac{P_{C}}{P_{W}}$ (falls)
Real Wage of French Wine Workers	$\frac{w_{W}}{P_{C}} = \frac{1}{a_{L W}} \frac{P_{W}}{P_{C}}$ (rises)	$\frac{w_{W}}{P_{W}} = \frac{1}{a_{L W}}$ (no change)

Thus cheese workers are most likely worse off in free trade. Wine workers face no change in their real wage in terms of wine but realize an increase in their real wage in terms of cheese. This means wine workers are likely to be better off as a result of free trade.

Since one group of workers realizes real income gains while another set suffers real income losses, free trade causes a redistribution of income within the economy. Free trade results in winners and losers in both the United States and France. In both countries, the winners are those workers who work in the industry whose output price rises, while the losers work in the industry whose output price falls. But because the price changes are due to the movement to free trade, it is also true that the output price increases occur in the export industries in both countries, while the price declines occur in the import-competing industries. Thus it follows that a movement to free trade will benefit those workers who work in the export industry and harm those workers who work in the import-competing industry.

Key Takeaways

When countries move to free trade and labor is immobile, in the export industry the real wage with respect to the exported good remains constant, but the real wage with respect to the import good rises in both countries.
When countries move to free trade and labor is immobile, in the import industry the real wage with respect to the imported good remains constant, but the real wage with respect to the import good falls in both countries.
When countries move to free trade and labor is immobile, in general, workers in the export industry benefit, while workers in the import-competing industry lose.

Exercises

According to an immobile factor model, which groups are likely to benefit very shortly after trade liberalization occurs? Which groups are likely to lose very shortly after trade liberalization occurs?
Suppose two countries, Brazil and Argentina, can be described by an immobile factor model. Assume they each produce wheat and chicken using labor as the only input. Suppose the two countries move from autarky to free trade with each other. Assume the terms of trade change in each country as indicated below. In the remaining boxes, indicate the effect of free trade on the variables listed in the first column in both Brazil and Argentina. You do not need to show your work. Use the following notation:

+ the variable increases

− the variable decreases

0 the variable does not change

A the variable change is ambiguous (i.e., it may rise, it may fall)

Table 4.6 Real Wage Effects

	In Brazil	In Argentina
P_c/P_w	+	−
Real Wage of Chicken Workers in Terms of Chicken
Real Wage of Chicken Workers in Terms of Wheat
Real Wage of Wheat Workers in Terms of Chicken
Real Wage of Wheat Workers in Terms of Wheat