An influential theory on how open economies can drive down wages

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The Economist explains

This week, “The Economist Explains” is devoted to the economy. For each of the six days through Saturday, this blog will post a brief explainer on a basic idea.

Does trade hurt wages? Or, more specifically, are imports from low-wage economies harming workers in high-wage economies? A lot of people assume so. Economists take a little more conviction. In the 1930s, a trade economist, Gottfried Haberler, argued that “the working class as a whole has nothing to fear from international trade” – at least in the long run. This confidence was based on three observations. Labor, unlike many other productive resources, is needed in all sectors. It will therefore remain in demand, even if globalization disrupts a country’s industrial mix. Over time, the workforce is also versatile. Workers can move and retrain; new entrants may turn to emerging sectors rather than declining industries. Finally, workers are also consumers, who often buy foreign products from local stores. Even if competition from cheap imports lowers their (nominal) wages, they will prevail if prices fall further. Haberler’s confidence was not, however, universally shared. Wolfgang Stolper, a Harvard economist, suspected that competition from labor-rich countries could hurt workers elsewhere. In 1941, he joined forces with Paul Samuelson, his Harvard colleague, to prove it.

Their Stolper-Samuelson theorem concluded that removing a tariff on labor-intensive goods would lower wages more than prices, hurting workers as a class, even if the economy in his whole was winning. The logic of the theorem is based on the interaction between industries with different degrees of labor intensity. Perhaps this is best explained by an example. Suppose a high-wage economy is divided into two industries: growing wheat (which uses a lot of land) and watchmaking, which makes heavy use of labor and shelters behind a tariff of 10 %. If this protection were removed, the prices of watches would fall by 10%. This would force the industry to contract, lay off workers and leave land. This in turn would put downward pressure on wages and rents. In response, wheat producers would expand, taking advantage of the newly available land and labor. This dance will continue until watchmaking costs have fallen by 10%, allowing the industry to compete with duty-free imports.

Stolper and Samuelson paid particular attention to the combination of rents and wages that would achieve this cost reduction. One would assume that both would drop by 10%. But that would be wrong. As watchmaking is labor intensive, its contraction frees up more labor than land, putting more downward pressure on wages than rents. Conversely, the expansion of wheat producers would put more upward pressure on rents than on wages. The end result is that wages would have to go down by more than 10% because rents would go down less. Paradoxically, rents would increase. The combination of much cheaper labor and slightly more expensive land would restore modus vivendi between the two sectors. This would stop the contraction of watchmakers (because cheaper labor helps them more than more expensive land hurts them). It would also hold back the expansion of wheat growers (because more expensive land hurts them more than cheap labor helps them).

Trade liberalization, in this example, lowers wages more than prices, which hurts labor in real terms. This grim conclusion has proven to be remarkably influential. It even appears 75 years later in debates over the Trans-Pacific Partnership between America and 11 other countries, many of which are low-wage economies. Some economists lament this influence, arguing that the theorem’s clear conclusion does not stand outside the stylized frameworks in which it was first conceived. Even the co-author of the theorem, Paul Samuelson, was ambivalent about the result. “Although he admits this as a slight theoretical possibility,” he later wrote, “most economists are still inclined to think that his grain of truth is outweighed by other more realistic considerations.”

Previously in this series
Monday: Akerlof lemon market

To come up
Wednesday: Nash’s Balance
Thursday: The Keynesian Multiplier
Friday: Minsky’s financial cycle
Saturday: The Mundell-Fleming Trilemma

In the last few weeks The Economist published two-page memoirs on six fundamental economic ideas. Read the full brief on the Stolper-Samuelson theorem, or click here to download a PDF containing all six articles.

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