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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.
A major issue concerning the establishment of a North American free trade agreement (NAFTA) is its impact on wages in Mexico and the United States. One argument is that the agreement will result in higher wages for unskilled labor in Mexico but lower wages for unskilled labor in the United States. This view can be derived from the Stolper–Samuelson theorem, which links changes in wages and profits to the changes in product prices caused by trade liberalization. Mexico is abundant in unskilled labor relative to the United States, and trade reform will increase Mexico's relative price of manufactured goods that it exports to the United States. According to the theorem, unskilled wages will fall in the United States and rise in Mexico as Mexican exports displace U.S. production of labor-intensive goods.
There are a number of difficulties in applying the Stolper–Samuelson theorem to the case of NAFTA. First and foremost is that the two countries are linked by more than trade in commodities. In particular, there is a long history of labor migration between Mexico and the United States, and one would expect that such migration would be sensitive to wage changes brought about by NAFTA. When using the Stolper–Samuelson theorem, one assumes that aggregate factor supplies are constant and that shifts in labor demand curves determine wage changes. However, the effects of trade liberalization on wages can be ambiguous when there is international labor mobility, which shifts the labor supply curve as well.
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