Free trade and labour demand elasticities: theory and international evidence

South African Journal of Labour Relations: Vol 32 No 1 2008 7

Free trade and labour demand elasticities:theory and international evidence

by Abdulkader Cassim Mahomedy*

AbstractIn the debate between ”free traders” and those who plead for protectionist policiesone of the areas of contention is the impact that free trade has on the labourmarket of an economy. South Africa is no exception in this regard. One area ofconcern among policymakers is whether the country’s recent trade liberalisationhas contributed to its weak employment performance over the last few years.Traditionally, trade economists have attempted to analyse this relationship byutilising factor endowments models that operate directly through product prices.More recently, researchers have identified yet another pathway through which theimpact of trade openness could be transmitted to the labour market: the impact oftrade on labour demand elasticities via a substitution effect through increasedfactor substitutability and/or via a scale effect brought about by an increase inproduct market elasticities. This article explores the theoretical underpinnings forthis linkage and highlights its implications for workers, and then reviews studiesundertaken in several countries to test empirically for this relationship. Finally, thearticle concludes with specific implications and recommendations for SouthAfrican policy makers.

1 IntroductionNearly 200 years ago, David Ricardo demonstrated with the aid of simple economiclogic why trade between countries benefits all the trading partners. Although mosteconomists accept, theoretically at least, the logic and policy conclusions of Ricardo’stheory, the debate on free trade continues to rage unabated. With several emergenteconomies such as those of South Africa, India, Brazil and China recently opting todismantle their trade barriers, with South Africa’s commitment even exceeding itsinternational obligations, several questions have been raised about the impact ofdismantling trade barriers on both their own economies and those of their tradingpartners. These differences have not been confined to academic forums; conflictingpositions on the extent and nature of international economic integration have led to thevirtual collapse of negotiations at several policy-making institutions such as the WTO. Itis thus clearly evident that certain segments of society are feeling increasinglythreatened by policies that encourage an integrated world economy.

* Mr AC Mahomedy is a lecturer at the School of Economic and Finance at the University of KwaZulu-Natal.

South African Journal of Labour Relations: Vol 32 No 1 20088

2 Background to the studyGiven the intensity of the debate and the far-reaching implications of pursuing either aprotectionist economic policy or an open economy one, several empirical studies havebeen undertaken to try to establish whether there is any significant relationshipbetween free trade and a number of economic variables of interest.1 One such area towhich a considerable amount of research has been dedicated is the impact of tradeliberalisation on labour markets. Despite the large number of analyses and thesignificant improvements in the (econometric) techniques adopted, no clear consensushas been reached on several important aspects.2 For example, during the early yearsof South Africa’s extensive trade liberalisation, several studies were undertaken to testfor any causal relationship between increased economic integration and the pooremployment growth characteristic of the economy during the same period. Much of thisresearch produced inconclusive results.3

Notwithstanding the important contribution of all of these empirical studies, a carefulexamination reveals that until recently, the primary focus of this research hasappropriately (but only) been on the indirect impact of trade on employment and wages,that is the impact of trade on product prices and, via the Stolper-Samuelson theoremparticularly, its resultant effect on factor prices. A second limiting implication ofanalysing labour market changes via this channel is that pressure on wages can onlycome from trade with countries with different relative factor endowments.

Are there any other channels then, through which trade could exert pressure onlabour markets, which hitherto have not been considered? This article explores anotherlinkage between trade openness and labour demand: the impact of increased trade onthe elasticities of the demand for labour; a relatively new aspect first emphasised byRodrik (1997). He argues that one of the reasons why trade economists discount the(negative) effects of trade on factor markets is that the (predominant) mechanismthrough which its impact is empirically tested is through product prices. And if oneconsiders that the bulk of developed countries’ trade is with each other, then given thefact that they have similar factor endowments, the standard approach (vis-à-visHecksher-Ohlin) is unlikely to reveal that trade will have any bearing on factor prices.Rodrik goes on to demonstrate, intuitively at least, that the main impact of economicintegration on labour markets is more likely to be on elasticities than on prices. Thegreater elasticity of factor demands is then shown to lead to negative outcomes,especially for workers.

The two main channels through which trade can render demand more elastic weresubsequently elaborated upon by Slaughter (1997). The first corresponds to thesubstitution effect: trade openness allows for increased substitution possibilitiesbetween domestic labour services and foreign factors of production. The second is thescale effect: trade liberalisation leads to the greater availability of substitutes for manyproducts which, through Hicks-Marshallian laws of factor demand, increases thesensitivity of factor demands.

3 Objective of this articleThe above arguments are intuitively appealing.4 But do they have any theoreticalunderpinnings and have they been empirically tested and verified? This paper firstlyestablishes the theoretical framework for the derivation of factor demand elasticitiesand then shows the mechanisms through which trade openness can affect theseelasticities. The implications of increased labour demand elasticities for workers are


then explained with the aid of the model developed by Rodrik. Finally, a number ofrecent empirical attempts to test for the supposed link between trade and factordemand elasticities in both developing and developed countries are appraised, afterwhich some implications of this study for economic policy in South Africa are outlined.

4 Determinants of labour demand elasticitiesThe elasticity of labour demand is one of the most important concepts in the field oflabour economics because of its central importance in economic and public policyissues (Marshall et al 1976; Ashenfelter & Hallock 1995; Kaufman & Hotchkiss 2003).Since firms are inclined to hire less labour when wage rates increase, the elasticity oflabour demand provides a measure of the extent to which firms adjust the quantity oflabour they are willing to employ when the price of labour changes. Consequently, amore elastic labour demand implies that workers are more easily substitutable andhence firms would be more willing (and able) to employ fewer workers if wagesincrease. Clearly then, elasticities quantify the size of the trade-off between the wagerate and the level of employment. The various ways in which higher elasticities(negatively) impact on workers are discussed below (see “Economic significance”).

Given that the demand for labour is a derived demand, Alfred Marshall identified fourrules in 1890 on which the elasticity of derived demand depends (Hicks 1963). Theserules were subsequently developed mathematically and refined by John Hicks himselfin 1963, so that they are now often referred to as the “Hicks-Marshall rules of deriveddemand” (McConnell et al 1999).

These laws can be summarised as follows (Hicks 1963):The higher the elasticity of substitution between labour and other factors, the higherthe own price elasticity.The demand for anything is likely to be more elastic, the more elastic the demand isfor any further thing to the production of which it contributes.The more elastic the supply of other factors, the more elastic the labour demand.The higher the share of labour in total costs, the higher the own wage elasticity.

To illustrate these rules mathematically we assume that there are only two factors ofproduction, labour and capital (which makes sense, since these two factors constitutethe two largest components of value added in most industries (Hamermesh 1993)), andthat production exhibits constant returns to scale as described by the linearhomogenous production function F, such that:

K)F(L,Y (1)

where Y is output, and L and K are homogenous labour and capital services,respectively. If the firm maximises profits ( ) then,

rKwLK)F(L, (2)

where PWw is the real wage and r the exogenous price of capital services. If weassume that the competitive product price is one, maximising (2) yields

wFL (3)

and

rFK

(4)


The profit-maximising firm equates the value of marginal product of each factor to itsprice. For equilibrium, the relative usage of factors is such that the marginal rate oftechnical substitution between them is equal to the given factor-price ratio (Allen 1959),that is

rw

F

F

K

L (5)

If output remains constant, the elasticity of substitution between capital and labourmeasures the ease of substituting one input for another when the price of one or bothinputs changes (Allen 1938). In the two-factor linear homogenous case the elasticity ofsubstitution is

LK

L

YF

FF

)F/Fln(d

)L/Kln(d

)r/wln(d

)L/Kln(d K

KL

(6)

and by definition, is always negative. If we keep output and r constant, then Allen(1938) shows that the price elasticity of labour demand can be expressed as

,0]s1[LL

(7)

where s = wL/Y, the share of labour in total revenue. As Hamermesh (1993) explains,when labour’s share in production is high,

LLis smaller (less negative) for a given

technology since there is relatively less capital towards which to substitute when thewage increases. The ease of this substitution is also likely to be constrained byinstitutional factors such as union work rules and government safety regulations incertain industries (Kaufman & Hotchkiss 2003). Conversely, as technology changesover time input substitutability may increase, thereby leading to higher demandelasticities in the long run (Marshall et al 1976). For example, Edwards (2003), usingmanufacturing data from South African firms, has found evidence that technicalprogress post liberalisation has led to the increased substitution of (especially unskilled)labour with capital. Equation (7) reflects the first of the four Hicks-Marshall laws referredto above, called the “substitution effect” (Bowles & Boyer 1995).

Correspondingly, the cross elasticity of demand for labour to a change in the price ofcapital services is

,0]s1[LK

(8)

and (7) and (8) both reflect substitution between inputs (Hamermesh 1993).Because the demand for labour is a derived demand, the elasticity of demand for the

output of labour will influence the elasticity of demand for labour (Hicks 1963;McConnell et al 1999). An increase in the wage rate causes an increase in the cost ofproducing a given output. In competitive product markets a one percent rise in a factorprice raises cost by that factor’s share in the production process, causing firms toincrease their product prices in order to maintain profit margins. If the demand for theproduct is very elastic, the result of this price increase will be a large decrease in thequantity of the product demanded and consequently, a relatively large decrease in thedemand for labour.

The “scale effect” or “output effect” is thus the factor’s share times the productdemand elasticity, which must be added to (7) and (8) to obtain the total demandelasticity for labour (Slaughter 1997). Hence

ssLL ]1[ , (9)


and

].][1[ sLK

(10)

The scale effect is therefore a reflection of Marshall’s second law of deriveddemand,5 and together with the substitution effect, constitutes what Hamermesh (1993)describes as “the fundamental law of factor demand”. The same relation is alsoobtainable if ones uses cost functions instead of production functions, as derived byDixit (1990), who minimises total costs instead of maximising profits.

In our analysis we have assumed that labour and capital services are suppliedelastically to the firm, implying that if wages decrease, the additional labour demandedwill be readily available or that the prices of other inputs such as capital would beunaffected by a change in the demand for them. While this assumption may be valid forindividual firms under conditions of perfect competition, it may not always be realistic(McConnell et al 1999). This is because an increase in the wage rate relative to theprice of capital induces firms to substitute capital for labour. However, as the demandfor capital increases the resultant increase in its price may dampen the substitutionprocess. The extent of the increase in the price of capital depends, ceteris paribus, onthe elasticity of its supply: the more inelastic the supply curve, the higher the rise in theprice of capital will be and the lower the incentive for the firm to substitute away fromlabour. In such cases the labour demand elasticities are reduced (Hicks 1963), and areillustrative of Marshall’s third law of factor demand.

The fourth law, which is based on conditions describing the other three, is that thedemand for a factor that accounts for a large share of costs will be more elastic, otherthings being equal (Hamermesh 1993). Consequently, in labour-intensive sectors suchas the service industries labour demand can be expected to be highly elastic.Conversely, in highly capital-intensive industries where the labour costs are smallrelative to total costs, a wage increase is unlikely to lead to any significantdisemployment effect. This is because the scale effect in such instances is very small,a phenomenon which is sometimes referred to as the “importance of beingunimportant” (Kaufman & Hotchkiss 2003). In fact, Hicks (1963) shows that if productdemand is sufficiently inelastic and factor substitution elastic, this (fourth) rule actuallyworks in reverse.

To sum up, when wages increase, both the substitution and scale effects reducelabour demand; firms substitute away from labour towards other factors, and as costsincrease less output is produced and therefore demand decreases for all factors. Thus

0LL

: labour demand slopes downwards (Slaughter 1997).

5 Impact of trade openness on elasticitiesThere are several models of trade which clearly predict the impact of international tradeon labour demand. It is therefore somewhat surprising that the bridge between tradeand labour demand elasticities has only been formed relatively recently. Equation (9)visibly shows that this elasticity depends on both the scale effect s and thesubstitution effect ]1[ s . It would therefore be instructive to consider the impactof trade upon

LLthrough each of these two channels.

The scale effectMost trade models, of both the neoclassical and the new trade theories, predict that acountry’s product markets will become more competitive with trade. One’s intuitive


feeling is that the opening up of a country’s economy would result in local producershaving to compete with international suppliers for the domestic (product) market.Heightened competition increases consumers’ ability to switch to alternativesubstitutes, making each firm’s product demand curve more sensitive to the price itcharges. Different models predict different magnitudes for (Slaughter 1997). In termsof the Heckscher-Ohlin neoclassical framework, the Factor Price Equalisation Theorem(or more appropriately, the Factor Price Insensitivity Theorem) asserts that underconditions of perfect competition would be infinitely elastic and hence an infinitelyelastic

LL, that is, trade would transform the “local labour demand curve into a global

labour demand curve” (Leamer 1995:5).Panagariya (1999) contends, however, that such a conclusion is only reached under

rather restrictive and unrealistic assumptions and that therefore it need not necessarilyhold. He also illustrates the possibility of a locally horizontal labour demand curve evenin a closed economy, and under certain conditions, where the labour demand can bemore elastic in a closed economy than in an open one. Conversely, it could be arguedthat Panagariya’s assertions are also predicated upon exceptional circumstances.Nonetheless, empirical estimates of

LLhave never approached infinity and these

models alone therefore leave a gap (as usual) between theory and data (Slaughter1997).

There are however, several new theoretical models of trade, which, even when theyincorporate conditions of imperfect competition, also predict that trade liberalisation willmake factor demands more elastic. Helpman and Krugman (1989) have constructed aseries of models showing the impact of trade policy on the behaviour of domesticfirm(s) operating under differing conditions of monopoly and, more realistically,oligopoly. They then illustrate how, when restrictions in the form of tariffs and quotasare relaxed, foreign competition forces these firms to reduce their output and price.Effectively then, this could result “in a monopolist with no monopoly power” (Helpman& Krugman 1989). Consequently the higher product demand elasticity will feed into thedomestic labour market and increase the elasticity of its labour demand. The effect ofchanging market conditions on labour demand elasticities is also neatly summarised byMarshall et al (1976).

The impact of removing trade barriers in these models can also be verifiedmathematically. Using Slaughter’s (1997) notation, let the demand for the product be

,)( bPxaQ (11)

where x is the level of the quota. If we further assume constant marginal productioncosts equal to c, then given this market structure the equilibrium

.0)(

)(

bcxa

bcax (12)

Relaxing the quota increases x. The effect of this on can be expressed as

,0)(

22cxa

bc

x(13)

and thus, as the quota relaxes, equilibrium becomes more elastic (Slaughter 1997).A second theory of product demand that can also be used to predict higher labour

demand elasticities is the one developed by Armington (1969). Although consumersdisplay a bias towards goods produced in their own country (Trefler 1995), foreign


product varieties are nevertheless still regarded as substitutes, albeit imperfect ones.With trade liberalisation, substitution between local and foreign goods increases owingto a reduction in the price of imported goods relative to domestic goods. Consequently,the overall industry product-demand elasticity (also) depends on the elasticity ofsubstitution between local and foreign varieties. In South Africa, however, earlierestimates of these Armington elasticities appear to be low when compared todeveloped countries (Gibson 2003). Consequently, the pass-through effects into factormarkets may have been relatively small. But once product markets are fully integratedinternationally and substitution possibilities increase, the product demand elasticity andhence the derived elasticity of demand for labour will also increase (Trefler 1995).

A similar result obtains in monopolistically competitive industries when consumerswho value product variety are likely, post liberalisation, to switch some of theirpreferences to foreign varieties, triggering increases in and consequently

LL

(Slaughter 1997).6

The substitution effectThe second mechanism through which international trade could increase labourdemand elasticities is through the elasticity of substitution, , between labour and otherfactors. The pass-through from to

LLoccurs essentially via two channels: directly

through Foreign Direct Investments (FDIs) by multinational enterprises (MNEs) andindirectly through the incentive to outsource (Riihimäki 2005).

The ability of firms to relocate production across geographic boundaries has led tothe emergence of multinational corporations. The ramifications of their activities forlabour markets have been investigated by a number of authors in recent years (Faini etal 1998). Helpman (1984), for example, has developed a general equilibrium model ofan integrated world economy, in which he shows under what conditions firms find itprofitable to become multinational, and whether their emergence brings about factorprice equalisation (FPE). He demonstrates that freer trade gives greater access toforeign factors of production as well as domestic ones. Consequently, FPE can occureven without corporations actually invoking decentralisation across countries; the mereability to do so is sufficient. Barker (2007) also argues that with the Southern Africanregion rapidly integrating with regard to labour, South African firms may find it easier toaccess cheaper labour inputs across national borders.

Besides the increase in the potential to substitute foreign labour for domesticworkers, the removal of exchange rate controls and transaction costs brought about bythe integration process increases the international mobility of capital (Rodrik 1997).Hence, any negative shock at home may induce firms to “pack up and leave for saferterritory”. The phenomenon of “runaway shops” that moved from the North to the Southin certain industries, and its implications for the survival of entire towns, was of majorconcern even before the current wave of liberalisation that has swept through manydeveloping countries.7 In the South African textile industry, for example, afterliberalisation certain large clothing enterprises relocated some of their low-value addedproduction activities to foreign affiliates in Malawi and Botswana.

The second (albeit indirect) transmission mechanism through which trade opennesscan cause an increase in

LLis through outsourcing, that is the importing of

intermediate inputs by domestic firms. One of the features of globalisation is thefragmentation of production into discrete activities, whereby industries becomevertically integrated into a number of production stages (Feenstra & Hanson 1997).With international trade, firms can then “move abroad” by purchasing the output of


certain stages from foreign enterprises. The archetypal example of this phenomenon inthe South African context is that of the motor industry, which imports almost all of itscomponent parts from parent firms based in Japan, Germany and the United States,and then uses local assembly plants to produce the finished product.8

In an extension of his (1984) model to include vertical integration, Helpman (1983)shows that even multinational corporations end up importing intermediate inputs fromtheir production facilities in host countries, bringing about intra-firm trade betweencountries. Similarly, in an empirical framework developed by Baldwin and Hilton (1984)and adapted by Feenstra and Hanson (1997) to US manufacturing industries, it hasbeen demonstrated that outsourcing had contributed substantially to changes in therelative demand for certain types of labour and its consequent impact on wage shares.In an empirical study covering more than ten thousand companies located in elevenEuropean countries observed in the period 1993-2000, Checchi et al, (2003) havefound that employment adjustment in MNEs is faster than in purely domesticcompanies. Several studies9 have also recently indicated the increasing role andimpact of MNEs on labour services in Africa generally and South Africa specifically. Thecountry has also been identified as an increasingly important participant in certainoutsourcing industries globally.

In other studies, Brakonier and Ekholm (2000) and Konings and Murphy (2001) havealso found evidence of substitution between employment in parent companies and inforeign affiliates located within the EU. It is therefore not surprising that Fabbri et al(2003) have been able to show that over time the wage elasticity of demand forproduction labour in the UK has been rising faster in plants belonging to MNEs. What isclear then, is that trade expands the set of factors industries can substitute indirectly inresponse to higher domestic wages. Substitution can go beyond domestic non-labourfactors to include foreign factors (Slaughter 1997).

Finally, differentiating (9) with respect to yields:

0]1[ sLL (14)

showing that labour demand becomes more elastic (i.e.LL

falls) as this substitutabilityincreases. Furthermore, as labour’s share in the firm’s costs decreases, the strongerthe pass-through from to

LLbecomes.

To sum up, international trade can, in theory at least, increase the elasticity ofdemand for domestic labour by increasing either (the scale effect) or (thesubstitution effect).

6 Economic significanceThe impact of international trade on labour markets has always been an area of intensedebate among both economists and policy makers.10 But the potential impact of tradeopenness on labour demand elasticities has only recently been emphasised. AlthoughLeamer (1995) and subsequently Wood (1995) were the first to explicitly alertresearchers to this link, there were much earlier allusions to the relationship, wheneconomists suggested that labour demand elasticities were likely to be more elastic inthe long run owing to the increased mobility of capital internationally (Marshall et al1976).


Nonetheless, it is Rodrik (1997) who is credited with developing the idea into atheoretical model, and particularly, for elaborating on its implications for labour(Slaughter 1997; Hasan et al 2003; Krishna et al 2001). More specifically, Rodrik wasable to show how increased labour demand elasticities could have a negative impacton the fortunes of (especially unskilled) workers. Consequently, he identified three keyaspects of the employment relationship affected by the increased substitutability ofworkers across borders:

IncidenceThe proposed inclusion of a “social clause” as part of the WTO Agreements hasprovoked a fierce debate among policy makers and trade negotiators in internationalforums, to such an extent that it contributed to the failure of the Seattle ministerialmeeting in 1999 (McCulloch et al 2001). Not surprisingly, much of the opposition tosuch measures have come from the developing nations in view of the cost implicationsof implementing minimum labour standards. While a detailed critique of the debate isbeyond the ambit of this study, what is nonetheless relevant for our purposes is thequestion of who is ultimately likely to bear the burden of the costs of improved workingconditions.

As Rodrik (1997) explains, when the demand for labour is more elastic it becomesmore difficult to share the costs of higher labour standards with employers andconsequently workers themselves have to bear a higher burden. This is illustratedwithin the supply-demand framework below:

Figure 1

The initial labour market equilibrium is at point A, with wages at w0 and employment ate0. The financial implications of improving labour standards, for example introducing ahigher safety standard, from the perspective of the employer at least, are reflected asan upward shift of the labour supply curve to LS2 by an amount equivalent to theadditional costs incurred. At the new equilibrium, as in the case of the usual tax

LS2

wage rate

LS1

B

A

LDO

LDC

e2 e1 e0 employment

w0

w1

w2

C


incidence, this cost is borne by both employers and employees. Quite clearly, if thelabour demand curve is more elastic, as in LDO compared to LDC, then workers bear ahigher burden of the increased costs, in terms of both lower wages (w2 vis-à-vis w1) andlower employment (e2 vis-à-vis e1).11

VolatilityA second implication of higher labour demand elasticities is that it triggers more volatileresponses by wages and/or employment to exogenous shocks to the labour market(Slaughter 1997). These shocks could take the form of a sharp decline in the demandfor a product, or shifts in productivity etc (Rodrik (1997). To illustrate how the effect ofthese shocks is magnified in proportion to increases in elasticity in the demand forlabour, let us return to our supply-demand framework discussed earlier:

Figure 2

A negative exogenous shock to labour demand, say via the Stolper-Samuelson effect,will cause both demand curves to move downwards by an equal amount. For the lesselastic labour demand the new equilibrium is at point B and for the more elasticdemand the equilibrium is at point C. Quite evidently, the decrease in wages andemployment is much larger for the more elastic labour demand schedule than the lesselastic one.

Various international and domestic studies have recorded an increase in volatility inlabour market conditions. In the United States for example rising wage inequality andjob insecurity have characterised the US labour market (Farber 1996; Leamer 1996). InSouth Africa various studies point to a similar scenario (Fallon 1992; Fallon & Lucas1998; Chadha 1995); ore recently, Barker (2007) has also suggested that tradeliberalisation in South Africa may have contributed to increased inequalities in thecountry, at least in the short term. This trend may be reversed in the long run but thishas yet to be proven empirically. Nevertheless, Rodrik (1997) links this instability inlabour markets to the fact that participants (viz workers) are becoming increasinglyaware that globalisation has made their services more easily substitutable than before.

LDC

wage rate

LS

A

LDO

e2 e1 e0 employment

w0

w1

w2C

B

LDC


Collective bargainingLabour unions have always been aware of the importance of the slope of the labourdemand curve in terms of both bargaining power and negotiating strategy (Marshall etal 1976; McConnell et al 1999). Consequently, the ability of unions to bargain withemployers on various aspects of the employment relationship is determined by theelasticity of labour demand.

One of the key issues highlighted by Rodrik (1997) in this respect is that consequentto greater factor substitutability, the bargaining power of labour vis-à-vis capital hasbeen considerably weakened. He cites the evidence of various studies (Katz &Summers 1989; Blanchflower et al 1996) that indicate the presence of labour rents inmanufacturing, and subsequently argues that the increase in the substitutability ofworkers has undermined the clout of unions when negotiating rent distribution in firmsearning supernormal profits. As a result, this has led to the deunionisation of the labourmarket in some countries.

Various studies tend to confirm these conclusions: using industry-level data from theUS manufacturing sector between 1975-1984, Cebula and Nair-Reichert (2000) havefound compelling evidence for the hypothesis that import competition negatively andsignificantly affects union rent seeking. MacPherson and Stewart (1990) have alsofound that international competition has had a greater (downward) impact on the wagesof unionised workers than on those of of non-union workers in the United States.Similarly, in an empirical study conducted for Italian industries, results seem to supportthe idea that international integration leads to workers and unions finding themselves ina weaker bargaining position (Faini et al 1998). In view of these and other studies,12 it istherefore not surprising that the labour market has been characterised by decliningunionism in North America and most of Western Europe (McConnell et al 2004).

A similar pattern of declining union membership pursuant to economic liberalisationhas also been reported for many countries on the African continent (Schillinger 2005).South Africa has often been cited as an exception to this trend (Whiteley 2001;Orr 2004) by virtue of the labour movement’s ability to continue to attract unionmembership. However, their strength derives predominantly from the important role thatthe trade unions played in the political transformation process and their subsequentalliance to the ruling ANC led government. Given the strength of the persistent tensionsthat seem to be characterising the alliance on some key political and economicissues,13 it remains to be seen for how much longer the trade unions will be able tomaintain their influential position in the various bargaining forums.

7 What do the empirical studies tell us?Subsequent to Rodrik’s (1997) emphasis on the potential impact of trade openness forfactor demand elasticities, a growing body of literature on international trade has triedto investigate this relationship.

Various empirical analyses have been conducted, within both developed anddeveloping countries, to test the hypothesis that greater openness increases labourdemand elasticities. Since 1997 at least fifteen country studies have been reported inthe literature. A synopsis of the results presented below is taken from studies coveringthe United States (Slaughter 1997), Italy (Faini et al 1998), Uruguay (Cassoni et al1999), Brazil (Barros et al 1999), France (Jean 2000), Peru (Saavedra & Torero 2000),Chile, Colombia, and Mexico (Fajnzylber & Maloney 2000), Russia (Konings &Lehmann 2001; Tcherkachine 2003), Turkey (Krishna et al 2001), India (Hasan et al


2003), Tunisia (Haouas & Yagoubi, 2003), Colombia (Cardenas & Bernal 2003), theUnited Kingdom (Mirza & Pisu 2004) and, more recently, South Africa (Mahomedy2005).

The first systematic and rigorous empirical investigation of the hypothesised effect oftrade on labour demand elasticities was that of Slaughter (1997). Using four-digitindustry-level data for the US for the period 1961-91, he finds mixed support for thehypothesis, in that the demand for production labour has become more elastic inmanufacturing overall and in five of the eight industries, whereas he finds no such trendfor non-production labour. However, he also finds that time, by itself, is a betterpredictor of elasticity patterns than his trade-related variables. Drawing partly onSlaughter’s approach, Faini et al (1998), using panel data from fourteen Italianmanufacturing industries, find some support for the hypothesis that increasedglobalisation is associated with larger elasticities and has consequently placed workersand unions in a weaker bargaining position.

Using industry-level data disaggregated by states, Hasan et al (2003) also find apositive impact of trade liberalisation on labour demand elasticities in the Indianmanufacturing sector. They find that trade reforms impacted not only on theseelasticities but also on wage and employment volatility, as predicted by trade-labourtheory. In a somewhat different framework than that of the Allen-Hamermesh model,Jean (2000) also links trade measures with the elasticity of labour demand. His work isbuilt on a perfectly competitive world in general equilibrium with an Armington typehypothesis on the demand side and a Leontief production function on the supply side.Implementing the model on data obtained from all French industries (excluding energyand quarrying) in three different time periods, Jean shows that trade openness canindeed have a significant impact on labour demand elasticities.

Mirza and Pisu (2004) also test the relationship between increasing integration andlabour demand elasticities, but on the modelling framework of Dixit (1990), in whichtotal costs are minimised rather than profits being maximised. The flexibility of thismodel allowed them to explore the relation based on imperfect competition in particular,under the assumption of oligopolistic market conditions. In so doing, they illustrate howthe average elasticity of labour demand also depends on import penetration rates.Applying the model to UK firm level data from 1993 to 1999, they find general supportfor their hypothesis that as import penetration ratios increase labour demand elasticitiestend to increase as well.

Various studies (Broadman & Recanatini 2001, Brown & Earle 2001) have beendedicated to an examination of the impact on labour markets in Russia after itstransition towards market reforms, but very few of them have focused specifically onlabour demand elasticities. The first study in this regard, by Konings and Lehman(2001), although originally designed to test Marshall’s rules of derived demand, foundthat medium and large enterprises did become more sensitive to wage changes in theiremployment decisions. In a subsequent study by Tcherkachine (2003), the specificimpact of Russia’s accession to the WTO on labour demand was analysed. Using alarge six-year panel data set covering approximately 14 000 enterprises, he found thatlabour demand elasticities had increased significantly after liberalisation.

Whilst the above studies tend to indicate an undeniable link between trade opennessand labour demand elasticities, a different pattern begins to emerge when we examinesimilar studies conducted for less industrialised or developing countries. FollowingPeru’s significant trade liberalisation programme in 1991, Saavedra and Torero (2000)


use establishment-level panel data sets spanning the pre-liberalisation and post-liberalisation periods to analyse empirically any significant changes to factor demandelasticities. They could only find mixed support for the hypothesised link between tradereform and wage elasticities. Since the post-liberalisation period in Peru was alsocharacterised by labour legislation reforms, after controlling for this effect, they wereunable to find evidence of different behaviour among firms exposed to differentchanges in effective protection.

Using monthly Brazilian manufacturing survey data spanning over twelve years, andbroadly following the approach of Slaughter, Barros et al (1999) also failed to find anysignificant impact of trade openness on own wage elasticities. In a similar studyconducted for Uruguay by Cassoni et al (1999), the researchers found that an increasein sectoral trade leads to a lower total own-wage elasticity, the opposite of thatpredicted. In a comparative study of three other Latin American countries, Chile,Colombia and Mexico, Fajnzylber and Maloney (2001) use establishment level data toprovide consistent dynamic estimates of labour demand functions across trade policyregimes. In this study they show how the theoretical link between the two variables maybecome diluted under different market conditions; furthermore, their empirical resultsprovide “only very mixed support for the idea that trade liberalization has an impact onown-wage elasticities, and no consistent patterns emerge(d)” (Fajnzylber & Maloney2000:23). A subsequent study, again for the Colombian economy, carried out byCardenas and Bernal (2003) also failed to find any significant effect of tradeliberalisation on labour demand elasticities.

Estimating static demand equations using micro-panel data from Turkey spanningthe course of its dramatic trade liberalisation, Krishna et al (1999) found that the linkbetween greater trade openness and demand elasticities may be quite weak. Similarly,in an almost replicated study for Tunisia, Haouas and Yagoubi (2003) also found that inthe vast majority of industries considered they could not reject the hypothesis of norelationship between a liberal trade regime and factor demand elasticities. Using SouthAfrican manufacturing data covering almost 28 sectors, Mahomedy (2005) could find, atbest, only limited empirical support for his hypothesis of a positive and significantimpact of trade liberalisation on labour demand elasticities. Although demand for labourappeared to have become more elastic for manufacturing overall and in some of thesectors within manufacturing, the results are fairly mixed for most of the other industriesconsidered.

The preceding analysis therefore illustrates that although the putative link betweentrade openness and factor demand elasticities has been strongly observed in almost allof the larger, more industrialised countries, this relationship has not shown up asconvincingly among the smaller, developing economies.

8 Conclusions and implications for South AfricaDespite the somewhat mixed empirical results obtained from our analysis, it is clear thatcountries that move towards greater trade openness need to consider carefully thepossible implications of doing so. This is particularly important for an emergenteconomy like that of South Africa which, in addition to structural adjustments that arenormally required for integration, also has to factor in the potential impact of unintendedconsequences on its objective of redressing the socio-racial disparities of the past.Furthermore, in responding to the inevitable negative shocks of economic liberalisation,the government needs to avoid knee-jerk reactions (as was recently the case when


import quotas on clothing and textiles from China were unexpectedly announced).What is therefore required is for policy makers to adopt an integrated package of long-term policy measures that will ensure that the benefits of economic integration aresustainable and self-supportive.

For several decades, the high rate of unemployment generally and the consequentproblems of inequality and poverty have continued to plague the South Africaneconomy. One of the more successful mechanisms for addressing this problem is for acountry, after liberalisation, to attract foreign direct investment (FDI). This strategy hasworked extremely well for China, but not so for South Africa. Hartzenberg and Cassim(2007) have suggested that the high levels of market concentration in the domesticeconomy may have served as a deterrent for increased foreign investment. These highlevels of concentration have not only acted as barriers to entry but have also impededthe growth of small and medium-sized enterprises, which is critical for employmentgrowth. Despite the significant steps that the country has taken vis-a-vis its competitionpolicies, the economy continues to be dogged by dominant firms in most markets. Itremains a particular challenge for policy makers to unbundle these firms and ensurethat the abuse of market power is kept in check.

Notwithstanding the sharp improvement in South Africa’s export performancerecently, available research suggests that trade liberalisation has not had the positiveimpact on employment that was expected (Barker 2007). The reason for this is thatalthough the country has an abundant supply of unskilled labour, the skills compositionof its exports (and the manufacturing sector generally) has increasingly moved towardshigh-skill intensive industries. Clearly, this reflects that South Africa’s emergingcomparative advantage in the international economy appears to lie in highly skilledintensive production techniques. While the government’s efforts to address the severeskills shortage through the Skills Development Act are commendable, these findingssignify the urgent need to improve the quality of our human resource base. They alsohighlight the need for a set of coordinated policies and strategies not only from withinthe Department of Labour but also across and between the Departments of Education,and Trade and Industry, among others.

One of the other important findings of this study is that workers, especially unskilledlabourers, are particularly vulnerable to negative shocks to the economy after it hasopened itself to the rest of the world. This is because their services become easilysubstitutable by other factors of production, both local and foreign. At the same time,the empirical evidence also tends to suggest that not all manufacturing sectors are(negatively) impacted upon to the same extent. Consequently, the government needsto identify the affected industries carefully and consider policies that will help toalleviate the plight of workers in these sectors. Strategies such as social welfare grants,public works programmes and training opportunities may help to facilitate the transitionof those affected to other more competitive sectors of the economy.

The (economic) implications of the proposed inclusion of a “social clause” in tradeagreements help to explain why this issue is a controversial one. Although the linking oftrade with labour rights may ostensibly appear to promote workers’ interests, ouranalysis revealed that the actual costs of improved working conditions would have to beborne primarily by workers themselves in the form of lower wages and fewer jobs.Moreover, (some) trade economists argue that (developed) countries use the socialclause as a smokescreen to deprive developing countries of their most importantcomparative advantage – cost-efficient labour (Barker 2007). Consequently, decisions


and trade policies that impact on a broad range of labour issues such as minimumlabour standards and mandatory non-wage benefits need to be cautiously approached.

Finally, regardless of the finding of this study that the bargaining power of labourunions after liberalisation can be expected to decline, the general experience in SouthAfrica at least is that organised labour continues to play a dominant role. The recentwave of labour strikes sweeping the country in both the public and private sectors isindeed indicative of this. Notwithstanding the political undercurrents that may havebeen at the root of some of these developments, and despite concrete attempts toadopt principles of consensus and co-operative governance through institutions suchas NEDLAC (Bhorat et al 2002), it appears that the legacy of adversarial tendenciescontinues to plague industrial relations in South Africa. While a detailed discussion ofthis complex issue is beyond the scope of this study, it is nonetheless critical for allstakeholders to appreciate that crippling strikes characterised by conflict (and violence)do not augur well for a country wanting to compete effectively in international markets.

9 Closing remarksThere is no doubt that rapid advances in communication and transportation willinvariably drive the world towards a globalised economy. The process is hardlyreversible. Recent developments at several international institutions such as the WTO,UNO and G8 indicate that the emerging economies of India, South Africa, Brazil andChina, which hitherto were considered as relatively insignificant, are increasingly beingrecognised as important role-players on the international stage. The opportunities aretherefore tremendous for these countries. Having said that, however, it is important forSouth Africa, given the huge disparities in income and wealth, to manage the processof change wisely and (somewhat) cautiously. Only then can the benefits of economicintegration be shared equitably and fairly across the various sectors of society.

List of referencesAllen, R. 1938. Mathematical analysis for economists. London: Macmillan.Allen, R. 1959. Mathematical economics. London: Macmillan.Armington, P. 1969. A theory of demand for products distinguished by place ofproduction. IMF Staff Papers 16(1):159-178.Ashenfelter, O & Hallock, K. 1995. Labor economics: the international library of critical

writings in Economics 47, Vol I. Aldershot, England: Elgar.Baldwin, R & Hilton, R. 1984. A technique for indicating comparative costs and

predicting changes in trade ratios. The Review of Economics and Statistics66(1):105-110.

Barker, F. 2007. The South African labour market. 5th edition. Pretoria: Van Schaik.Barros, R, Corseuil, C & Gonzaga, G. 1999. Labor Market Regulations and the

Demand for Labor in Brazil. Institudo de Pesquisa Economica Aplicada.Bhorat, H, Lundall, P, Rospabe, S. 2002. The South African labour market in a

globalizing world: economic and legislative considerations. Employment Paper.Geneva: International Labour Organization.

Blanchflower, D, Oswald, A & Sanfey, P. 1996. Wages, profits and rent-sharing.Quarterly Journal of Economics 111(1):227-251.


Bowles, S & Boyer, R. 1995. Wages, aggregate demand, and employment in an openeconomy: an empirical investigation, in Macroeconomic policy after the conservativeera, edited by G Epstein, & H Gintis. Cambridge, UK: Cambridge UniversityPress:143-171.

Brakonier, H & Ekholm, K. 2000. Swedish multinationals and competition from high andlow-wage locations. Review of International Economics 8:448-461.

Broadman, H & Recanatini, F. 2001. Is Russia restructuring? New evidence on jobcreation and destruction. Policy Research Working Paper No 2641, July.Washington, DC: World Bank.

Brown, C, Gilroy, C & Kohen, A. 1982. The effect of the minimum wage on employmentand unemployment. Journal of Economic Literature 20(2), June:487-528.

Brown, J & Earle, J. 2001. Gross job flows in Russian industry before and after reforms:has destruction become more creative? CEPR Discussion Papers 2951.

Cardenas, M & Bernal, R. 2003. Determinants of labor demand in Colombia:1976-1996. NBER Working Papers 10077.

Cassoni, A, Allen, S & Labadie, G. 1999. Unions and employment in Uruguay, in(forthcoming) Labour market regulation and employment in Latin America, edited byD Hamermesh, J Heckman & C Pages-Serra.

Cebula, R & U Nair-Reichert. Union rent seeking and import competition in U.S.manufacturing. Journal of Labor Research 21(3):477-487.

Chadha, B. 1995. Disequilibrium in the labor market in South Africa. IMF Staff Papers42(3), September.

Checchi, D, Navaretti, G & Alessandro, T. 2003. Adjusting labour demand: multinationalversus national firms: a cross-European analysis. CEPR Discussion Paper 3751.

Cline, W. 1999. Trade and income distribution: the debate and new evidence.Washington: Institute for International Economics.

Dixit, A. 1990. Optimization in economic theory. 2nd edition. Oxford University Press.Edwards, L. 2003. Firm level analysis of trade, technology and employment in South

Africa. Journal of International Development 15.Edwards, L & Behar, A. 2006. Trade liberalisation and labour demand within South

African manufacturing firms. Journal of Studies in Economics and Econometrics30(2):127-146.

Fabbri, F, Haskel, J & Slaughter, M. 2003. Does nationality of ownership matter forlabor demands? Journal of the European Economic Association 1 (2-3), April:698-707(10).

Faini, R, Falzoni, A, Galeotti, G, Helg, R & Turrini, A. 1998. Importing jobs or exportingfirms? A close look at the labour market implications of Italy’s trade and foreigndirect investment flows. CEPR Discussion Paper No 2033, December.

Fajnzylber, P & Maloney, W. 2000. Labor demand and trade reform in Latin America.World Bank Working Paper No 2491, November.

Fallon, P. 1992. South Africa: wage and employment behaviour. Informal DiscussionPaper on Aspects of the Economy of South Africa, No. 3. Southern AfricaDepartment, World Bank.

Fallon, P & Lucas, R. 1998. South African labour markets: adjustments andinequalities. Southern Africa Department, World Bank.


Farber, H. 1996. The changing face of job loss in the United States, 1981-1993.National Bureau of Economic Research Working Paper No 5596.

Feenstra, R & Hanson, G. 1997. Productivity measurement and the impact of trade andtechnology on wages: estimates for the US, 1972–1990. NBER Working PaperNo 6052.

Freeman, R. 1994. Working under different rules. New York: Russell Sage Foundation.Gibson, K. 2003. Armington elasticities for South Africa: long- and short-run industry

level estimates. TIPS Working Paper 12-2003.Gilroy, B M, Gries, T & Naude, WA (eds). 2005. Multinational enterprises, foreign direct

investment and growth in Africa: South African perspectives. Heidelberg: Physica-Verlag.

Hallak J & Levinsohn, J. 2004. Fooling ourselves: evaluating the globalization andgrowth debate. NBER Working Paper No 10244.

Hamermesh, D. 1993. Labor demand. Princeton, NJ: Princeton University Press.Haouas, I & Yagoubi, M. 2003. Trade liberalization and labour demand elasticities:

evidence from Tunisia. Working Paper of CED of Bordeaux (France), No 94:1-12.Hartzenberg, T & Cassim, R. 2007. South Africa in the world trading system, in Africa

and the world trading system, edited by A Oyijide & D Njinkeu. Asmara, Eritrea:Africa World Press: 323-361.

Hasan, R, Mitra, D & Ramaswamy, K. 2003. Trade reforms, labor regulations and labor-demand elasticities: empirical evidence from India. NBER Working Paper No 9879.

Helpman, E. 1983. Multinational corporations and trade structure. Cambridge, Mass:MIT.

Helpman, E. 1984. A simple theory of international trade with multinationalcorporations. Journal of Political Economy 92(3):451-471.

Helpman, E. 1984. The factor content of foreign trade. Economic Journal, March.Helpman, E & Krugman, P. 1989. Trade policy and market structure. Cambridge, Mass:

MIT Press.Hicks, J. 1963. The theory of wages. London: Macmillan.International Labour Organisation (ILO). 1997. Labour market trends and globalization’s

impact on them. Bureau for Workers’ Activities.Jean, S. 2000. The effect of international trade on labour demand elasticities:

intersectoral matters. Review of International Economics 8(3):504-516.Katz, L & Summers, L. 1989. Industry rents: evidence and implications. Brookings

Papers on Economic Activity: Microeconomics: 209-275.Kaufman, B & Hotchkiss J. 2003. The economics of labor markets. 6th edition. Fort

Worth, TX: Dryden Press.Konings, J & Lehmann, H. 2001. Marshall and labour demand in Russia: going back to

basics. William Davidson Institute Working Papers, Series 392.Konings, J & Murphy, A. 2001. Do multinational enterprises substitute parent jobs for

foreign ones? Evidence from European firm level panel data. CEPR DiscussionPapers No 2972.

Krishna, P, Mitra, D & Chinoy, S. 2001. Trade liberalisation and labor demandelasticities: evidence from Turkey. Journal of International Economics 55:391-409.


Leamer, E. 1995. In Search of Stolper-Samuelson effects between trade and USwages. Yale and UCLA.

Leamer, E. 1996. In search of Stolper-Samuelson effect on US wages. NBER WorkingPapers No 5427.

MacPherson, D & Stewart, J. 1990. The effect of international competition on union andnon-union wages. Industrial and Labor Relations Review 43:435-446.

Mahomedy, AC. 2005. Trade openness and labour demand elasticities: is thereempirical evidence from South Africa? University of KwaZulu-Natal.

Marshall, F, Cartter, A & King, A. 1976. Labor economics. 3rd edition. Illinois:Irwin.

McConnell, C, Brue, S, Macpherson, D. 1999. Contemporary labor economics. 5thedition. Boston: Irwin/McGraw-Hill.

McConnell, C, Brue, S, Macpherson, D. 2004. Contemporary labor economics. 6thedition. Boston: Irwin/McGraw-Hill.

McCulloch, N, Winters, L & Cirera, X. 2001. Trade liberalisation and poverty: a

handbook. London: DFID/CEPR.

Mirza, D & Pisu, M. 2004. Trade and labour demand elasticity in imperfect competition:theory and evidence. University of Nottingham.

Orr, L. 2004. Gender and labour market liberalisation in South Africa. Jojhannesburg:National Labour and Economic Development Institute.

Panagariya, A. 1999. Trade openness: consequence for the elasticity of demand forlabor and wage outcomes.

Riihimäki, E. 2005. Economic integration and the elasticities of labour demand:econometric evidence from Finland.: Discussion Paper No 613. University ofHelsinki.

Rodrik, D. 1997. Has globalization gone too far?, Washington DC: Institute forInternational Economics.

Saavedra, J & Torero, M. 2000. Labor market reforms and their Impact over formallabor demand and job market turnover: the case of Peru. Inter-AmericanDevelopment Bank, Research Network Working Paper R-394.

Schillinger, H. 2005. Trade [Unions in Africa: weak but feared.Bonn: Friedrich-Ebert-Stiftung (FES), Africa Department.

Slaughter, M. 1995. Multinational corporations, outsourcing, and American wagedivergence. NBER Working Paper No.5253.

Slaughter, M. 1997. International trade and labor-demand elasticities. NBER WorkingPaper No 6262.

Tcherkachine, I. 2003. Russia's accession to WTO: labor demand story. Working PaperNo BSP/2003/064 E. Moscow: New Economic School.

Trefler, D. 1995. The case of the missing trade and other mysteries. AmericanEconomic Review 85:1029-46.

Whiteley, J. 2001. Trends in mobilisation and unionisation in South Africa andGermany: a comparative analysis. Master’s thesis, Rhodes University.


Wood, A. 1995. How trade hurt unskilled workers. Journal of Economic Perspectives9(3), Summer:57-80.

Endnotes

1 See Hallak and Levinsohn (2004) for a more recent review of some of these studies.2 See Cline (1999) for an interesting analysis of some of these debates.3 See Edwards and Behar ( 2006).4 These arguments can be made only in a partial equilibrium mode; see Panagariya (1999) for an

assessment of their application in a general equilibrium context.5 See Kaufman and Hotchkiss (2003) and McConnell et al (1999) for a detailed discussion of the

other important implications of this law.6 Mirza and Pisu (2004) have developed a mathematical model in which exact import penetration

rates can be explicitly included in (9).7 See for example Marshall et al (1976).8 Conversely. it could also be argued that outsourcing acts as a complement to, rather than a

substitute for, home country employment: See for example Faini et al (1998), Slaughter (1995).9 See for example Gilroy et al (2005).10 See ILO (1997) for a review of some of the arguments espoused by both the proponents and the

opponents of free trade.11 Alternatively, if countries choose to accept lower standards in order to avoid these negative

consequences it may lead to the well-known “race to the bottom argument”. See Freeman (1994)and McCulloch et al (2001) for a deeper analysis of this issue.

12 See Cebula and Nair-Reichert (2000) for an informative review of some of these empirical analyses.13 For example, the South African Government’s policies on GEAR, HIV/AIDS, privatisation,

Zimbabwe, and more recently, the “Zuma debacle” and the succession debate in the ruling ANC.

Free trade and labour demand elasticities: theory and international evidence

Documents

Transcript of Free trade and labour demand elasticities: theory and international evidence