Introduction

It is difficult to reconcile inter-industry wage differentials, which are very persistent empirically, with the neoclassical structure of computable general equilibrium (CGE) models. Studies show that the wage differentials persist even after accounting for the obvious explanations such as differences in human capital or job hazard. This raises an important question for the applied modeler – what is the best way to incorporate the observed wage differentials into a model to represent the base data accurately? In the CGE literature, two approaches have been adopted. Ballard et al. (1985) adjust tax and depreciation rates to equalize factor returns across all sectors in CGE models of tax analysis. Dervis et al. (1982) hold intersectoral wage differentials constant in counterfactual policy simulations. This approach is common in CGE models for analysis of tax and trade policy in developing countries and trade policy analysis generally. In the latter class of models, the wage differentials are exogenous, suggesting that factors acquire sector-specific skills upon entry into the sector and lose those skills upon exit.

In this chapter, we examine the welfare implications of trade and tax policies when there are sector-specific wage differentials. Furthermore, we explicitly model the behavior that can generate the observed wage differentials. In our analysis, the wage differentials are endogenous and reflect optimizing behavior in the labor market. We consider two types of labor behavior – the need to pay either efficiency wages or a union premium. For comparison, we maintain a version of the model with exogenous wage differentials.