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Does European Unemployment Prop Up American Wages?National Labor Markets and Global Trade

By DONALD R . D A V I S *

/ consider trade between a flexible-wage America and a rigid-wage Europe.In a benchmark case, a move from autarky to free trade doubles Europeanunemployment. American wages rise to the European level. Entry of the un-skilled "South" to world markets raises European unemployment. Europe'scommitment to the high wage wholly insulates America from the shock. Im-migration to America raises American income, but lowers European incomedollar for dollar, while European unemployment rises. Absent South-Northmigration of the unskilled from 1970-1990, Europe could have maintainedthe same wage with from one-eighth to one-fourth less unemployment. (JELF11,J31,E24)

1. A Global Approach

In recent years, factor market developmentsin the United States and United Kingdom havecontrasted sharply with those in continentalEurope. In the United States and United King-dom, the relative wage of the unskilled hasdeclined significantly. In the span of a decade(1979-1989) the wage of a U.S. worker in the90th percentile relative to that of one in thelOth percentile rose by over 20 percent(Richard B. Freeman and Lawrence F. Katz,1995). This rising wage inequality was muchless evident in continental Europe. However,unemployment has risen sharply in Europe.The early postwar decades are now thought ofas a "Golden Age" for Euroj)e, with unem-ployment rates of 2 to 3 percent. Beginning inthe l970's these rates have climbed dramati-cally, reaching double digits in many of thesecountries (Center for Economic Policy Re-search [CEPR], 1995).

* Depaitment of Economics, Harvard University. Cam-bridge, MA 02138, and National Bureau of Economic Re-search. I would like to acknowledge, without implication,lhe helpful comments of Richard Brecher, Carolyn Evans,John Leahy. Howard Shatz, David Weinstein. and JeffWilliamson. I am also grateful for the support for this proj-ect from the Harvard Institute for International Develop-ment (HIID).

An extensive empirical literature has con-sidered the provenance of these factor marketdevelopments. The studies are of two princi-pal types (Freeman and Katz, 1995). The in-dividual country studies provide a richaccount of local developments in institu-tions, factor supplies, and demand conditions.The comparative (cross-country) studies ab-stract from local idiosyncracies to search forcommon themes. However, even the compar-ative studies suffer from an important draw-back: they remain a collection of individualstories. They do not pretend to provide a com-mon framework—and the consistency thisenforces—to provide a unified account.

This suggests the value of a third approach,which may be termed "global." It is, in thefirst instance, a general equilibrium story.Consistency is enforced by the fact that thereis a simultaneous determination of equilibriumin all of the factor markets. Naturally, tracta-biiity limits the degree of local institutional de-tail that may be considered. Considering someimportant differences in factor market institu-tions will nonetheless be an important featureof such an approach.

However, a global approach is more thanjust general equilibrium. It aims at a unifiedexplanation of very divergent experience.There are two reasons for seeking such a uni-fied account. First, many of the shocks hittingthe industrial "Nor th" are common — for

478

VOL 88 NO. 3 DAVIS: NATIONAL LABOR MARKETS AND GLOBAL TRADE 479

example, the entry to the integrated worldeconomy of important new trading partnersfrom the newly industrializing "South."' Ifwe are to believe such accounts, we need tosee how these shocks interact with a variety oflocal institutions. A more subtle—but by thismore important — reason for considering aglobal approach is that the consequences evenof purely local institutions and shocks oftendepend crucially on the links to the globalmarket.

The paper joins two elements that have fig-ured prominently in these discussions, butwhose implications have not previously beenworked out in a consistent manner. The first isthe stylized characterization of America as aflexible-wage economy, and Europe as aneconomy in which a variety of institutions—unions, explicit minimum wages, etc.—make wages more rigid.^ The second is theHeckscher-Ohlin model, widely acknowl-edged to be the appropriate framework forexamining movements in relative wages (PaulR. Knigman, 1996).

Thus, we will build a model of world tradebetween a flexible-wage America and aminimum-wage Europe. In doing so, we buildon the classic work of Richard A. Brecher(1974a, b). The America versus Europe di-chotomy has been featured in a variety ofrecent work.^ The distinctive feature of the

' Another source of common shocks—those due toglobal technological change — is analyzed in Davis(1998).

^ There are alternative approaches to introducing un-employment into general equilibrium trade models. Forexample, Steven J. Matusz (1996) develops an elegantmodel merging elements of efficiency-wage unemploy-ment with monopolistic competition to show how the in-creased market size due to trade can raise real wages, soreduce equilibrium unemployment in both countries. Thisprovides insight for questions such as European integra-tion. The simpler mode! that is developed here, though,captures the essential elements of relative demand shiftsthat have been seen as the heart of recent developments inboth Europe and America. See, e.g.. Kevin M. Murphy(1995).

^ This includes Giuseppe Bertola and Andrea Ichino(1995), Ereeman and Katz (1995), Krugman (1994,1995), and Adrian Wood (1994). Bertola and Ichino de-velop an insightful approach that identifies rising volatilityof idiosyncratic shocks as a potential account of the grow-ing wage dispersion in the United States and rising un-

present work is the explicit focus on factormarkets in both countries, and particularly ontheir interaction owing to their link via tradein goods.

This paper confirms that national factormarket institutions matter. They profoundlyaffect global pattems of output, employment,and wages. Surprisingly, though, in the presentcontext they have no power in accounting forcross-country differences in the evolution ofrelative wages. Often forgotten in this contextis that even countries with distinctive factormarket institutions are linked by world com-modity prices and producers' zero proflt con-ditions. Hence an account of the observedwage trends must move beyond an appeal tolocal institutional differences.

This paper is comprised of seven parts. Sec-tion II examines the consequences of differinglabor-market institutions for countries linkedby world commodity trade in homogeneousgoods. Section III examines the contrastingimpacts on the stylized America and Europeposed by the appearance of newly industrial-izing countries. Section IV examines the ef-fects of factor accumulation in the twocountries on wages and unemployment. Sec-tion V considers the implications of South-North migration for unemployment in Europe.Section VI retums to the issue of divergentwage experience between America and Eu-rope. Section VII concludes.

n . National Labor Markets and Global Trade

A. Unemployment in the Global Equilibrium

The aim of this paper is to develop amodel of trade between two countries, one ofwhich has flexible wages, while the other im-poses a binding minimum wage on unskilledlabor. It is convenient to develop this in threestages. The first considers a conventional

employment in Europe. Their focus on homogeneouslabor suggests a story of growing within-group dispersion.The remaining papers are closer to the approach of thepresent paper, focusing on heterogeneous labor. Here Iprovide a consistent general equilibrium model integratingthe flexible/rigid dichotomy in the context of heteroge-neous labor.

480 THE AMERICAN ECONOMIC REVIEW JUNE 1998

two-sector general equilibrium model of aclosed economy and establishes some relationsthat are key to later analysis. The second in-troduces a binding minimum wage within theclosed economy. Finally, I show the isomor-phism between this economy and the two-country trading world of interest.''

Consider a closed flexible-wage economy.There are two factors of production: skill andlabor (also termed the unskilled). They areavailable in fixed supply given respectively by//^ and Z,"' (shortly these will be the worldendowments of a two-country world). Theseare used to produce two goods under constantreturns to scale. Assume that at any commonfactor prices, good X is skill intensive relativeto Y. Assume that preferences are homothetic,and that both goods are necessary in con-sumption. Let w be the return to labor, r thereturn to skill, and P the relative price of X interms of Y. Then the competitive cost condi-tions insure that for each sector price equalsunit cost:

the skill-intensive good. This relation can beexpressed as:

(1) cy{w,r)=

Assume that marginal products are alwaysstrictly positive. Then flexible wages insurefull employment. Factor market clearing re-quires that employment in the two sectorsequal the world endowment:

(2)

By Walras' law, goods market clearing is in-sured by equality of demand and supply ofgoodX.

Three relations are key to our analysis. Thefirst is a relation between the price P in aclosed economy and the endowment ratio,/!**• = H'^IL'^, of that economy. TheHeckscher-Ohlin theorem insures that a rise inskill abundance reduces the relative price of

•* Two additional papers have independently consideredtwo-country models with unemployment. N. Boccard etal. {1996) develop a political economy model focused onredistribution and "social dumping." Paul Oslington(1996) considers trade patterns and "false" comparativeadvantage in a factor price equalization (FPE) setting,suggesting that transport costs may resolve indetermina-cies in the cross-country distribution of unemployment.

(3) , where \ ' ( ; i ) < 0 .

The second is the Stolper-Samuelson rela-tion between goods prices and factor prices.Given the assumption that X is always theskill-intensive sector, this defines a monotonicrelation, of which I focus on only a part. ByStolper-Samuelson:

(4) = iff(P), where I}J'(P) < 0.

Thus given the endowment ratio of the closedeconomy, h^, one can determine directly theequilibrium goods price in the flexible-wagecase, F'' = \(h^). Likewise, one can derivethe resulting flexible wage, >v' = ipiP'') -i//(\(/i^)), as well as the associated skilledwage. These suffice to establish the basic char-acteristics of the world equilibrium.

I now introduce within the closed economya binding minimum wage for labor at ratew* > w'^.This will be consistent with an equi-librium featuring diversified production if andonly if the relative goods price is P* =(/'"'(w*) < P''. However, these will be theequilibrium goods and factor prices if and onlyif employed factors are in the ratio h* =k'\i{j-'(w*)) > h"^. The flexible rental forskill insures that it will always be fully em-ployed. However with a binding minimumwage, this need not be true for labor. Thus themanner in which relative employed factors riseto h* is for the denominator to fall via un-employed labor. With w* given, h* is deter-mined, and Z/"' and L"' are the fixed worldendowments. Let A be the level of laboractually employed. Then simple algebrashows that unemployment in this economy,U = L^ — N,is given by the third key relation(Brecher):

(5)

where ^'(ft*) > 0.

These three key relations characterizing theminimum-wage economy can be considered

VOL 88 NO. 3 DAVIS: NATIONAL LABOR MARKETS AND GLOBAL TRADE 48!

in Figure 1. The Heckscher-Ohlin relation,P = X.(/i), appears in quadrant one. TheStolper-Samuelson relation, w = ipiP), ap-pears in quadrant two. Finally, the linkbetween endowments, the employment ratio,and the level of unemployment is depieted inquadrant four. In the flexible-wage ease, theemployment ratio equals the endowment ratioh^. This determines wages, priees, and un-employment as w'', P'^, and zero, respec-tively. In the minimum-wage case, the pathof determination is different. The given min-imum wage w* > w'' direetly determines thegoods price, the employment ratio, and theunemployment level as P*, h*, and U*,respectively.

The basic link between the minimum wageand the appearance of unemployment in thiseconomy is very simple. For competitive firmsto pay the high wage w*, this must be sup-ported by an appropriate goods price P*.When the minimum wage binds, the appropri-ate goods price will be attained only if the rel-ative scarcity of the labor-intensive good risesrelative to the flexible-wage equilibrium. Andthis will occur only if a sufficient amount oflabor is unemployed.

I now establish an isomorphism between theclosed economy with a minimum wage and atrading world in which one economy imposesa minimum wage while the other maintains aflexible wage. This relies on a concept intro-duced by Avinash K. Dixit and Victor F.Norman (1980) known as the integrated equi-librium. This establishes conditions underwhich trade in goods alone suffices to establishthe same world equilibrium as occurs in theclosed economy with both goods and factormobility.

Consider, then, a world of two countrieswith free trade and zero transport costs. Onecountry — America — has flexible wages.The other country—Europe—has imposeda minimum wage at the level w*. The tech-nologies and preferences in the two coun-tries are identical to those in the closedeconomy. The technologies are constant re-turns to scale, while the preferences areidentical and homothetic. Let a har over avariable represent the level of that variablein the integrated equilibrium. Let i indexgoods and 7 index countries. The set of di-

H-0

U Brecher

FIGURE 1. UNEMPLOYMENT IN GENERAL EQUILIBRIUM

visions of world endowments among thetwo countries consistent with replicatingthe integrated equilibrium can then be de-scribed. This is called the FPE set, and isdescribed as:

FPE=

such that

i = X,Y j=A,E

These conditions are very intuitive. If the in-tegrated equilibrium is to be replicated, thenworld unemployment must be at the samelevel as in the integrated economy. But un-employment cannot arise in the flexible-wage America. Hence Europe must endurethe entire integrated equilibrium level of un-employment, U*, to maintain the wage w*.Beyond this, we need only satisfy the con-ventional restrictions in terms of employedfactors. These require that both countries usethe integrated equilibrium techniques (withthe skill intensities /i* = H*/Lt and /i* =Hy/Ly), that the integrated equilibrium


output in both sectors be divided among thecountries, and that this exactly exhaust em-ployed factors in the two countries (whichexist in the ratio h*).^ The FPE set is de-picted as the bold parallelogram in Figure 2.The level of world (hence European) un-employment is indicated by the line segment

This allows me to state a key result: Underthe conditions noted above, international tradeequalizes factor prices between the flexible-wage and the minimum-wage economies. Theproof is simply that under free and costlesstrade, competitive producers in the two coun-tries face the same goods prices, have the sametechnologies, and are (at least weakly) diver-sified. The equality of factor prices then fol-lows directly from the common competitivecost conditions.

This is an important result. Even in the faceof sharply divergent factor market institutions,free commodity trade in a global market fullyequalized factor prices. As will be consideredmore fully below, this will sharply restrict thenature of shocks that can be appealed to inexplaining divergent wage trends between Eu-rope and America.^

^ Since preferences are assumed to be identical andhomothetic, the level of spending by the unemployed doesnot matter for the pattern of world spending. Implicitly,though, it is assumed that any spending by the unem-ployed is financed via lump-sum transfers.

* For analytic simplicity, 1 developed this within a con-ventional Heckscher-Ohlin framework. One feature of thismodel—that American and European goods are perfectlyhomogeneous — may appear crucial to the results on FPEand consequent international spillovers to European un-employment. However, such an impression would be in-correct, at least in the longer run with which this model isconcerned. It would be straightforward, although not asclean, lo consider a model in which the homogeneousgoods X and Y were replaced by two monopolisticallycompetitive industries, {X } and [Y], each with many va-rieties (see Elhanan Helpman and Knigman, 1985). In thiscase, all goods, wherever produced, arc imperfect substi-tutes for all others. Yet under the same institutional as-sumptions, one could still apply precisely the sameintegrated equilibrium approach to again demonstrate fac-tor price equalization with unemployment in Europealone. What is crucial for the strong result is that Europeanand American labor of the various categories are effec-tively homogeneous. In such a case, a disturbance may inthe short run introduce a divergence from unity in the rel-

FiGURE 2. UNEMPLOYMENT IN THE INTEGRATEDWORLD ECONOMY

B. Trade and Unemployment

I have shown how to construct a model oftrade between a flexible-wage economy andone with a minimum wage. But I have not yetexamined what impact trade has on theseeconomies relative to autarky. It is convenientto start with a highly stylized example that es-tablishes a benchmark. Further insight into theworkings of this model will be provided by themany comparative statics in later sections.

Take as a benchmark a world in which Eu-rope and America are alike in every respect—endowments, technologies, and preferences.The one exception is that America has a flex-ible wage, while Europe has a minimum wageat level w*, assumed to bind in autarky. Asbefore, technologies are constant returns toscale. For simplicity, assume that preferencesof the representative consumer are homothetic.

ative price of European and American varieties. This couldgive rise to cross-countiy factor price inequalities. How-ever in the long run. this will induce entry, exit, and otheradjustments that retum us to the integrated equilibriumand restore full factor price equalization. Thus, to departfrom this paper's results in the long run. it does not sufficeto observe that American and European goods are imper-fect substitutes. One must believe that on a deep level,American and European labor of the various classes aredifferent factors.


FIGURE 3. BENCHMARK: FRKR TRADE DOUBLESEUROPEAN UNEMPLOYMENT

Figure 3 depicts the salient aspects of theequilibrium/ The technological productionfrontier, CC, is common to America and Eu-rope. In Europe, to support the wage w*, theequihbrium price must be P*. The consump-tion ratio of y to X at P* is given by a{P*).Thus under full employment, production atprices F * in Europe would be at A, and demandat A'. This implies an incipient excess demandfor X, tending to raise P and lower w beloww*. The incipient fall in the wage is insteadstanched via a decline in unskilled employmentin Europe. With goods prices fixed at P*, thisis just the Rybczynski theorem in reverse, shift-ing output along a minimum wage-constrainedproduction possibility frontier (PPF) indicatedby AB. Autarky equihbrium in Europe is at E,at which the constrained supply exactlymatches the demand at prices P*. The shift ofproduction in Europe from A to £ reflects thecontraction of employment just necessary toehminate the excess demand indicated by AA'.By contrast, in America, the autarky equilib-rium features a price P > P* and so an un-skilled wage w < w* {not depicted). There isno unemployment in America.

Now consider the equilibrium when Amer-ica and Europe trade freely. In order to support

^ This builds on a diagram of Brecher (1974a); see alsoKnigman (1995).

the minimum wage w*, Europe still needs tomaintain the price P* in equilibrium. At pricesP*, the American net trade offer is indicatedby AA'. Thus world equilibrium at these pricesrequires that Europe be willing to make thistrade at prices P*. This requires that Europeanproduction be at point E, and absorption at F ' .As demand is homothetic, and production lin-ear at all points along AB. the loss of employ-ment in moving from £ to F matches thepreexisting unemployment indexed by AE.^

This implies a striking contrast between Eu-rope and America in the labor market. Eu-rope's commitment to a high wage gave riseto unemployment in autarky. In this stylizedexample the opening of Europe to trade withAmerica doubles European unemployment, asit is forced to absorb the full integrated equi-librium level of unemployment to sustain w*for both. In America, the absence of unem-ployment in autarky came at the cost to work-ers of a lower real wage. However once tradecommenced, American workers came to sharethe high European wage even as they sufferednone of the unemployment that sustains thatwage. The fact that they suffer no unemploy-ment is a consequence of the flexible wage inAmerica. The fact that they nonetheless sharethe European high wage under trade followsfrom the fact that trade links goods prices, thatboth countries remain diversified, and that pro-ducers still must meet price-equals-unit-costconditions. In effect, trade has forced Euro-pean workers to bear the burden of high un-employment to maintain not only their ownhigh wage, but that in America as well.

How robust is this result? This is most easilyillustrated by placing the same information in aframework of export supply and import de-mand. As we have seen, the minimum-wageconstraint makes European export supply atprice P* multivalued, corresponding to variouslevels of unemployment. Graphically, this im-plies that the constrained export supply curvehas a horizontal segment that corresponds to the

" An alternative way of seeing this is to note that ^(/i*;/ /* . /,*) is linear homogeneous in / / * and/..'*'for a fixedA*, and that opening to America is the same as doublingthe world endowmenis (since Europe absorbs all of theunemployment J.


A mertca

UHcanalrained

/-• . . J I EuropeC. onslrainea I -T

FIGURE 4. AMERICAN IMPORT DEMAND DETERMINES

EUROPEAN UNEMPLOYMENT

Rybczynski segment of the eonstrained PPF. InFigure 4 this is depicted along with the Amer-ican import demand curve for the case in whichthe countries are otherwise identical.

Now consider perturbations in the positionof the American import demand curve, andconsider their imphcations for unemploymentand wages. So long as the American importdemand curve cuts the export supply curve ofEurope between A and B, the equilibrium pricewill be P*, so the wage will be w*. In all suchcases, were Europe to abandon the minimum-wage policy, both European and Americanwages would fall in the free trade equilibrium.The effect of trade with America on Europeanunemployment depends on whether the Amer-ican import demand curve cuts the Europeanexport supply curve in the region TB, ET, orAE. If the equilibrium is in the region TB, thenEuropean unemployment will more than dou-ble, reaching its maximum at B. If in the re-gion ET, European unemployment will behigher than in autarky, although at less thanthe double rate. If, instead, the equilibrium isin the region AE, then trade with America ac-tually lowers European unemployment. It con-tinues to be true in all three cases, though, thatunder free trade high American wages dependon the European minimum-wage policy fullyas much as European wages do.''

m . Shocks from the South: Implications forEurope and America

The impact of growing trade with develop-ing countries on labor markets in developedcountries has been a source of great concern.It was at the heart of the vigorous oppositionof the AFL-CIO to the North American FreeTrade Agreement, and has figured prominentlyin the presidential campaigns of Ross Perotand Patrick Buchanan. Correlate concernshave been raised over rapid integration ofEastern Europe into the markets of the Euro-pean Union.

The evidence for the growing trade, partic-ularly in manufactures, is indisputable. In theperiod 1970-1990, the less-developed coun-tries (LDC) share in manufactured imports ofthe United States and Europe more thandoubled—rising to more than a third for theUnited States (Freeman, 1995). Correspond-ingly, the share of manufactures in total non-fuel exports from LDCs rose from less thanone-fourth in 1970 to nearly three-fourths by1989 (Wood, 1994).

However, what role—if any—this playedin the factor market developments in Europeand America is still in contest. Wood (1994)has been the strongest proponent of the viewthat trade with the LDCs has mattered. Qual-ified support for this view has come fromEdward E. Leamer (1995) . By contrast.Krugman and Robert Z. Lawrence (1993)have argued forcefully that the volume of tradeis insufficient to account for relative wagemovements in the United States. Similarly,Franco Modigliani (1995 p. 7) insists that theargument that increased trade with developingcountries raised unemployment in Europe is"nonsense, refiecting economic illiteracy."

Krugman (1995) examined the impact of atrade shock on a minimum-wage Europe anda flexible-wage America, concluding that itwould raise unemployment in the former andreduce wages in the latter. However his study.

' When contemplating the recent unemployment ex-perience of Europe, one should not read from this that itwas caused by increasing integration with America.

Rather this is designed to provide a simple window on thetrade-offs a country may face between a wage target andunemployment in an open economy. In the benchmarkcase, the unemployment cost of any given wage target ishigher by a factor of two.


on a theoretical plane, belongs to the categoryearlier identified as "comparative." That is,he examines this one country at a time. As wewill see, the results change importantly whenwe tum to a global approach, in which Europeand America exist within the same worldeconomy.'"

I begin again with a flexible-wage America,and a minimum-wage Europe. For simplicity,and without loss of generality, I shift the basecase to consider that in which P* is the Amer-ican autarky price. This is also the Europeanautarky price with the minimum wage in place.And so when free trade is allowed betweenAmerica and Europe, P* remains the equilib-rium price, with no actual trade taking place.Europe has the same level of unemploymentas in autarky, and both have the same wagesin autarky as under free trade.

I now consider the introduction of a previ-ously isolated region, which will be called theNICs, to the American and European free tradesystem. Assume that the NICs have a strictlydownward-sloping import demand curve, andat prices P* are importers of the good X. Myconcern will be to trace through the implica-tions of this for Europe and America. In thediagram, this can be represented as a rightwardshift of the joint American-NIC import de-mand curve. However, so long as Europe isnot completely driven out of the Y industry,and given Europe's commitment to its mini-mum wage, the world price P * does notchange (see Figure 5).

At an unchanged world price, the Americanimport demand is unchanged. So the UnitedStates absorbs none of the imports from theNICs. American wages continue to be pro-tected by the European commitment to a high-wage policy. In Europe, by contrast, there will

" This comparative theoretical approach is at work aswell in an argument by the Center for Economic PolicyResearch (1995 p. 53). It is argued there that evidence, asin Lawrence and Matthew J. Slaughter (1993), exculpat-ing Stolper-Samuelson in America, likewise refutes claimsthat trade with the newly industrialized countries (NICs)may have raised unemployment in Europe. However, asthe discussion here makes clear, one reason that increasedtrade with the NICs may not account for falling wages inAmerica is precisely that it does raise unemployment inEurope.

ur

FIGURE 5. A NICs SHOCK RAISES EUROPEAN

UNEMPLOYMENT, LEAVES AMERICA UNAFFECTED

be a surge of imports from the NICs.'' Theimpact of this is similar to that analyzed above.Given the European commitment to a high-wage policy, this will not show up in reducedwages, but rather in higher unemployment.

This integrated global economy presents animportant contrast with the results of Knigman(1995). There he treated the American andEuropean cases as though they were part ofdifferent global economies. However, as isseen here, the links via goods trade are crucialfor understanding the broader story. So longas Europe maintains a commitment to bothfree trade and a high-wage policy, America isfully insulated from the NIC shock.

IV. Global Labor Supplies, EuropeanUnemployment

A. Discussion

Leading labor economists have identifiedcross-country differences in the evolution ofthe labor force as an important explanatoryfactor in the divergent evolution of wagesbetween continental Europe and the United

'' The actual pattern of trade^whether NICs deliver-ies are to America or Europe—is inconsequential. Theimportant point is that the price P* defines the world netoffer to Europe. Europe must absorb this net offer to main-tain the price P*, and so accept the employmentconsequences.


States and United Kingdom (Katz andMurphy, 1992; Katz et al., 1995). As insight-ful as this line of research has been, it wouldbe more satisfying to consider this in a theo-retical framework in which the cross-countrystructure of labor demand is endogenous. Itmight seem obvious that cross-country differ-ences in the levels and growth rates of relativefactor supplies should help to explain differ-ences in relative wages. However, this neednot be true when countries are hnked by com-modity trade. In fact, the absence of such arelation is the central message of Paul A.Samuelson's factor price equalization theorem(1949). Under the conditions in which thattheorem is valid, the structure of relativewages depends on the evolution of the globallabor force.'' However cross-country differ-ences in the composition or growth rates of thelabor force will contribute nothing to an un-derstanding of divergent wage trends. Giventhat it has been seen that the model with un-employment likewise yields factor price equal-ization, it can likewise be concluded thatdifferential labor-force growth will not help toaccount for divergent wage pattems.

Although changes in relative factor supplieswill not play a role in accounting for cross-country differences in relative wages, they willbe essential for understanding the evolution ofunemployment in Europe. There will be a cor-relate to the factor price equalization theorem:The level of European unemployment dependson global—not local—factor supplies. Oneconsequence of this is that dramatic changesin American factor accumulation—the shiftsdue to baby booms and busts—may leavetheir most profound mark not on American buton European labor markets. By contrast, theunemployment rate in Europe will depend im-portantly on where factor accumulation oc-curs. The conditions under which Europeanunemployment falls are less stringent when

'^In fact, this extends to a more general setting. It isstraightforward to write down a model in which only asubset of the world enjoys factor price equalization (Davisetal.. 1997). Subject to the general restrictions underlyingFPE < see Dixit and Norman. 1980), the site of endowmentchanges among those sharing FPE matters neither forcomparative nor absolute wages.

factor accumulation is in Europe than inAmerica.

The model also features an important asym-metry. The fixed European minimum wage in-sulates America from all shocks caused byfactor accumulation in Europe. But the reverseis not true. Factor accumulation in Americahas very profound effects on Europe.

In the conventional Heckscher-Ohlin frame-work, the central theorem dealing with endow-ment changes is that of Rybczynski. It saysthat at fixed goods prices, an increase in theendowment of a factor leads to a more-than-proportional increase in output in the sectorthat uses that factor intensively, and a contrac-tion in the other sector. At the initial equilib-rium price this would be expected to create anexcess supply of the good that uses that factorintensively, lowering its equilibrium relativeprice, and by Stolper-Samuelson reducing theretum to that factor. In the conventional set-ting, at fixed prices, changes in the endowmentof one country have no effect on output sup-plies in the other.

B. Derivation of Principal Results

I now tum to a systematic evaluation of theimpact of factor accumulation in the presentmodel. I begin by considering the implicationsfor the global economy, and then tum to ex-amine how these effects are distributed ac-cording to where the accumulation takes place.It is assumed throughout that Europe's mini-mum wage at w* remains binding and thatboth economies are diversified.

Several observations will make the deriva-tion of the results more transparent. Europe'scommitment to maintain the high wage w* islikewise a commitment to maintain a domesticrelative price P*, as given by the zero profitconditions for the two goods. With free trade,this will also be the world relative price. Wesaw above that the common goods prices yieldfactor price equalization. Cost-minimizingfirms with identical technologies will then pickthe same factor intensities in both countries,denoted A ? and /i *. With P * fixed in all equi-libria that are considered, these factor inten-sities will also be fixed. Because of identicaland homothetic demand, P* also fixes the ratioin which A" and 7 will be consumed. This im-


plies directly that world output at equilibriummust be supplied in the same proportion.This absorbs factors in the proportion h*[ = \ - i ( p * ) ] . This represents both the mini-mum skill intensity that the world economyneeds to yield the wage w * in a fiexible-wageworld, and the actual skill abundance of totalemployed factors in the world with at least oneeconomy with a minimum wage at w*. Un-employment will arise when the actual worldendowment, h^, is such that h^ < h*. TheRybczynski theorem is usually stated for afixed exogenous price. Here we consider thecase in which the price is held fixed by thecommitment of Europe to maintain the mini-mum wage. Finally, recall that unemploymentcan be written as U* = L"" - H'^lh*.

Although my principal interest is in the ef-fects of factor accumulation, it is convenientto begin with a version of the Heckscher-Ohlintheorem for trade between a fiexible-wageeconomy and a minimum-wage economy. Leth^ denote the skill-to-labor ratio in fiexible-wage America. Given a minimum wage w*that binds where applied, and that both econ-omies are diversified, the world employmentratio of skill to labor is fixed at h*. Thefiexible-wage America will be an exporter ofthe skill intensive good if and only if h^ > h*.The minimum-wage Europe will have a com-plementary trade pattern. The easiest way tosee how the Heckscher-Ohlin theorem workshere is simply to delete Europe's unemployedfrom Figure 2. They do not contribute income,so consume only from transfers that they willspend in the same pattern as those employed.Having done this, the diagram just becomesthe conventional Heckscher-Ohlin model, al-though now in terms of employed factors.

I now tum to the results concerning accu-mulation of factors. A rise in the worid endow-ment of skill raises employment of labor so asto maintain employed factors in the ratio /i*.As a result, output of both goods rises propor-tionally. If the skill accumulation occursin flexible-wage America, it will have conven-tional Rybczynski effects, raising the output ofX more than proportionally and decreasing thelocal output of Y. However this also affectsEurope, which has a rise in employment. Re-calling that f/* = L^ - //"'//!*, it follows thatAt/* = -AH^/h*. Thus it has Rybczynski

effects skewed the other direction, with outputof y rising more than proportionally, and out-put of X declining. The net impact of the out-put changes in the two countries must, asnoted, raise output of X and Y in proportion tothe initial world output.

If instead the skill accumulation occurs inminimum-wage Europe, we have a very dif-ferent picture. In Europe we fail to haveconventional Rybczynski effects. Incipient ex-cess supply of X threatens to raise the wageabove w* at the initial level of employment.This allows employment to rise by AA =AH^/h*. That is, total employment of factorsin Europe has risen in exact proportion to totalinitial employment in the world as a whole,h*. Thus, output in Europe expands propor-tional to initial world output. America is en-tirely unaffected, as its net trade vector is fullydetermined by the constant price ratio P*.

Now consider the effect of accumulation oflabor. At the global level, unemployment risesby the full increment to the labor force,so AU* = AL^ > 0. There is no effect onglobal output. If the accumulation occurs inminimum-wage Europe, unemployment risesdirectly with no effect on output in eithercountry. However, if accumulation of laborhappens in America, there are very dramaticshifts. America continues to have conventionalRybczynski effects, raising the output of Ymore than proportionally, and reducing theoutput of X. Income in America rises linearly,so A/"* = w*AL'^. Europe is also strongly af-fected. In fact, European unemployment risesone for one with accumulation of labor inAmerica. And European income falls dollarfor dollar with the rise in American income.Its shift in output exactly offsets that of Amer-ica, so that global output is unchanged.

V. South-North Migration and Unemployment

A. Migration in a Model of Adjusted FactorPrice Equalization

In this section I develop a model of endog-enous South-North migration that builds onDaniel Trefler (1993, 1996), and use this toconsider the consequences for European un-employment. Think of a North composed ofEurope and America. They are just as before.


with Europe imposing a minimum wage andAmerica having a flexible wage. FollowingTrefler {1993), it is assumed that factor priceequalization between North and South holds,but only when labor is measured in efficiency(rather than natural) units. For simplicity I ne-glect the possibility that there are efficiencydifferences across countries in skill. Let LEand A^ be the world labor force and employ-ment when measured in efficiency units, andlet /i£ = H^/N"^. Then it is a straightforwardapplication of our previous model to show thatwhen Europe imposes a minimum wage at thelevel w*, unemployment of labor is given as

(6) -H^'/h

Consideration of the incentives for migra-tion forces us to consider an issue familiarfrom the standard Ricardian trade model,namely the reason for variation in efficiencyunits per natural unit of labor. Cross-countryvariation that refiects only individual charac-teristics of the workers would provide no mo-tive for migration, so are neglected.'^ If insteadthis also reflects cross-country technologicaldifferences, then labor will have a reason formigration—access to the superior Northerntechnology.'* Let < ' and < ^ reflect labor-augmenting productivity differences specificto the location of production. By choice ofunits, let <t)^ = I. Assuming that labor pro-ductivity is higher in the North restricts <p^ G(0 ,1 ) .

Let the efficiency equivalent labor force forthe North and South be LE and Ll respec-tively, where Z, + Z.| = L^. Let L^ be thenumber of nationals of the South, some ofwhom in the latter period move to the North.Let L^ be the number of nationals of the North

'•* Moreover this would be reflected in a native-immigrant wage gap. Since empirical estimates suggestthai such gaps are small (on the order of 10 percent) forworkers with similar backgrounds, these can safely be ig-nored for present purposes.

'"This also implies that "outsourcing" to the Southmay have the same implications as developed here formigration. The key element is the matching of Northerntechnology and Southern workers, which increases the ef-fective world supply of unskilled labor, rather than thelocale in which tJiis matching occurs.

(all of whom remain there). Then prior to mi-gration, the world labor force measured in ef-ficiency units is L'^ = L^ -\- <f>^LK Whenmigration of size M occurs from South toNorth, this changes to Lf ' = L~ -I- 4>^{L^ -M) + M. As labor was already in excess sup-ply, and noting that H^ and h* are unalteredby the migration, the change in the world laborforce measured in efficiency units is equiva-lent to the rise in European unemployment.This is given as:

(7)

Thus two parameters, ( ^ and M, identify thecontribution of South-North migration to Eu-ropean unemployment. In this world with FPEin efficiency units, technologically based dif-ferences in productivity {<j}^) will be identifiedby the increment in wages to those who mi-grate from South to North. M is the amount ofmigration from developing countries to theOECD.

B. Migration Induced by LargeEndowment Differences

I now consider an altemative way to modelthe impact of migration on unemployment inrigid-wage Europe. The most plausible alter-native yields conclusions which are qualita-tively similar, though quantitatively moredramatic. Consider the case in which the mo-tive for migration is a failure of FPE becauseof large differences across countries in factorcomposition. Let there be three goods, X, Y,and Z, in decreasing order of skill intensity.As before, the minimum wage in the North isset in terms of the numeraire, Y. For simplic-ity, assume the technologies are Leontief.Skill-abundant countries of the North producethe relatively ski 11-intensive goods X and Y,while the skill-scarce South produces y andZ.As in the conventional two-factor, multipleproduction cone Heckscher-Ohlin model, thelabor-scarce North enjoys higher wages, mo-tivating immigration from the South. Considerthe impact of the migration of a single workerfrom South to North. By the Rybczynski the-orem, the migrant leads to an expansion in Yproduction in the North, and a contraction inX output at the initial prices. Moreover, the


loss of an unskilled worker in the South leadsto an expansion of Y in the South {since thisis its relatively skilled industry), and a con-traction of Z output. Thus output movementsin both countries are putting downward pres-sure on the relative price of Y (upward pres-sure on prices of both A" and Z) . This suggeststhe conventional result that migration placespressure for wages to rise in the source countryand fall in the destination country. By howmuch would unemployment have to rise in theNorth to relieve this pressure? A full answerwould require a more complete specification.Note, though, what would happen if unem-ployment in the North were to rise exactly onefor one with immigration at the initial prices.Then the immigration would have left un-skilled employment, so output in the North ofX and Y, unchanged. However, there wouldstill have been the effect on output in theSouth, raising output of Y and reducing that ofZ. This suggests residual pressure for both theprices of X and Z to rise relative to Y to movetoward equilibrium. If in fact the price of Xdid rise, this would push the Northern un-skilled wage below the minimum. And thissuggests that to meet the minimum wage, un-employment in the North would have to riseby a factor of more than one for one relativeto migration from the South.

C. An Empirical Application

An extensive literature has considered theimpact of immigration on labor-market out-comes of natives. Rachel M. Friedberg andJennifer Hunt (1995) provide a valuable sur-vey. The analytic approach pursued here isclosest to that of George J. Borjas et al.(1992). I consider a simple counterfactualbased on the theoretical models developedabove: How would European unemploymenthave differed if unskilled immigration to theNorth (America and Europe) from 1970-1990 had been constrained to zero? The par-simonious specification of the two theoreticalmodels above imply that two parameters suf-fice to answer this question: (1) the number ofunskilled migrants from South to North; and(2) the wage gain for those who migrate. Forthe former, I will take a conservative defini-tion, using the estimate of the 1970-1990

flows of unskilled migrants from the Southwho entered the labor force in the UnitedStates, a figure calculated as approximately 4.4million (see the Appendix). For the latter Inote that Trefler (1993), using InternationalLabour Organization data that fit his FPE modelwell, calculated U.S. wages for aggregate la-bor relative to those of various other countries,for example coming up with figures rangingfrom a U.S. advantage of 20 to 1 relative toBangladesh, 5 to 1 relative to Yugoslavia, and3.3 to 1 relative to Colombia. No doubt animportant element in this is differences in skillcomposition. However, direct evidence on thewage gains of individual migrants suggeststhat the gains that motivated the migration maybe substantial. For the purposes of the calcu-lations for Model A, I will assume conserva-tively that the wage gain relative to that earnedpremigration ranges between a factor of 2 and3. Thus, under the hypothesis of the adjusted-FTE Model A, as reflected in equation (7), thecounterfactual yields incremental Europeanunemployment of between 2.2 million and 2.9million. Under the hypothesis of Model B, themulticone approach, the corresponding incre-mental unemployment would be somethinggreater than 4.4 million. If it is noted that in1993 there were 17 million unemployed in Eu-rope, the ceteris paribus figures suggest thatabsent this unskilled immigration, the samewage in Europe could have been targeted witha reduction of between one-eighth and one-quarter of this unemployment.

These figures are meant only to suggest anorder of magnitude—that these effects couldmatter empirically. The data underlying thesecalculations is rough, while the model towhich they are applied is sharp. Moreover, itwould be inappropriate here, as in any ceterisparibus experiment, to infer from this that un-skilled immigration "caused" the rise in Eu-ropean unemployment. Nevertheless, thepossibility that unskilled immigration to theNorth could matter for European employment,given a commitment to a specific wage, is notimplausible. This was in fact the point of thevery restrictive immigration policies of Europepost-1973. Yet while the front door may havebeen shut, the open door provided for un-skilled immigration to the United States im-plied incipient downward pressure on wages


on both sides of the Atlantic. Europe's com-mitment to high wages forced it to adjust tothese pressures via higher unemployment.

VI. Divergent Wage Experience

This paper began with the observation thatAmerican and European factor market expe-rience has diverged in two respects: rising un-employment in Europe, but not in America,and a growing skilled-unskilled wage gap inAmerica, but not in Europe. A great deal hasbeen said about the former, and so the latterwill be addressed here.

The conjunction of relative factor demandshocks and institutional differences has beenan important theme in explanations of the di-vergent relative wage experience of Americaand Europe. Thus the demonstration that thiswage divergence does not in fact arise in thestandard model is an important analytic con-tribution of this paper. However, the divergentexperience still needs to be understood.

From an analytic perspective the crucial in-sight is that shocks that move us from one in-tegrated equilibrium to another will notexplain the wage divergence. Thus endow-ment changes, demand shocks, and globaltechnology shocks are all consistent withmaintaining FPE across the countries, in spiteof the institutional differences.

This leaves a variety of amendments to thebaseline model that could potentially explainthe divergent experience. One class concernsdivergent evolution of policies or technologi-cal shocks. The factor price link comesthrough producers' zero profit conditions. ForFPE we need free trade, zero intemal taxes,common technologies, and diversified produc-tion, in addition to the conventional assump-tions. Thus differences in the evolution oftrade and fiscal policy, idiosyncratic technol-ogy shocks (e.g. convergence), or speciali-zation can lead FPE to break down, so offerpaths for interpreting the divergent wage ex-perience. The role of technical change in un-derstanding these factor market developmentsis considered at length in Davis (1998).

However one need not rely on divergentpolicies or technological shocks to explain thedivergent wage experience. If one adds a littlemore structure to the basic framework, alter-

native accounts are possible. For example,Davis and Trevor A. Reeve (1997) develop amodel of endogenous human capital accumu-lation in a framework that is otherwise iden-tical to that developed here. In their model, thethreat of unemployment has feedback effectson individuals' decisions to accumulate hu-man capital. Since unemployment is prevalentin Europe hut not in America, even commonshocks can lead to divergent accumulation de-cisions, hence wage outcomes.

Thus the basic framework that has been de-veloped is consistent with a variety of ac-counts of the divergent wage experiencebetween America and Europe. Importantly,the principal insights that have been developedin this paper are robust to consideration of anyof these variations.

VII. Conclusion

This paper has one overarching message.Even when factor markets are strictly national,with idiosyncratic institutional features, theycannot be considered in isolation when goodsmarkets are glohal. This strongly suggests theimportance of a unified "global" approach toexplaining recent factor market developmentsin Europe and America. This will be animportant complement to existing studies,which are either of individual countries orcomparative.

A striking example of the importance of theglobal perspective emerges in the contrastingeffects of trade on a flexible-wage Americaand a minimum-wage Europe. In the centralexample, a move from autarky to free tradedoubles the European unemployment ratewhile leading American wages to converge tothe high European level.'^

'• Why was European unemployment lower than thatin America pre-1973, yet higher thereafter? One accountwould be to think of there being two components ofunemployment—one frictional and the other due to rigid-ities. For a variety of reasons. America may have a higherbase frictional rate than Europe. If in one period the rigid-ities are nonbinding in Europe, it may be found that totalunemployment is relatively low. If in another period thoserigidities do bind, it may instead be found that unemploy-ment there is relatively high.

VOL 88 NO. i DAVIS: NATIONAL LABOR MARKETS AND GLOBAL TRADE 491

Moreover, commodity trade leads local in-stitutional features to have important spillovereffects on other countries. These go far beyondthe simple general equilibrium fact that theywill affect the level of wages and the compo-sition of production. They may fundamentallyalter the nature of a country's relation with theintemational environment. For example, if Eu-rope and America are both fiexible-wage econ-omies, then the entry of the NICs to woridmarkets may depress wages in each. However,we saw that when Europe imposed a minimumwage, it absorbed the full impact of the NICshock and wholly insulated America from itseffects. That is, a local European institutionalfeature has sharply altered America's relationto the trading world.

The local institutional features may likewiseintroduce important asymmetries in the rela-tions between the countries. As noted, Amer-ica is wholly insulated from extemal shocks,including factor-supply shocks in Europe. Bycontrast, factor-supply shocks in Americahave very powerful effects in Europe. A strik-ing example occurs with an increase in thesupply of labor in America. This raises Amer-ican income, yet towers European income dol-lar for dollar, while raising Europeanunemployment one for one.

The importance of considering the links viacommodity trade is particularly importantwhen thinking about the evolution of wages.In spite of important differences in factor mar-ket institutions, which in a closed economywould induce differences in factor prices,goods trade here insures full factor priceequaUzation. Thus insofar as policy makers ina country see a trade-off between the two, thewillingness of one to bear high unemploymentspills over to raise wages in both.

The major analytics of this paper have beenderived in a framework in which America andEurope replicate an integrated equilibriumwith factor price equalization. This contributesgreatly to the transparency of the results. Aswell, it has emphasized the important pointthat Europe's commitment to a minimumwage cushions the impact of a variety ofshocks on America. However it also suggestsan important respect in which additional in-quiry is indicated. A key stylized fact we wantto understand is the divergent relative wage

experience of America and Europe. Insofar asthe shocks considered here move the worldeconomy between equilibria featuring factorprice equalization, they will not account forthis fact. I have indicated a variety of direc-tions in which the framework may be amendedto account for this fact. This suggests the valueof extensions that may help to identify whichof these may matter most empirically.

This paper has derived these results in a styl-ized model. Care should be taken in readingthese results too readily into actual historicalexperience. Nonetheless the issue that it raisesof the powerful interaction between local fac-tor market institutions and global goods mar-kets is no doubt very important. And theresults are sufficiently provocative to warrantcloser examination.

APPENDIX: AUTHOR'S CALCULATION OF THE

CONTRIBUTION OF SOUTH-NORTH MIGRATIONTO THE WORLD EFFECTIVE STOCK

OF UNSKILLED LABOR

As discussed in the text, over the last twodecades Europe has pursued a restrictive im-migration policy, while America has hadstrong growth in immigration, particularlyamong the unskilled. The stock of foreign pop-ulation in Europe grew by 2.9 million from1981-1991 (John Salt etal., 1994). However,much of this growth is from the end of theperiod, and naturally the growth of the un-skilled labor force would be less than this.Since I want to be conservative, and since Eu-rope's policy was overtly restrictive, for thepurposes of my calculations I will assume thatthere was zero Southem unskilled immigrationto Europe.

The calculations for America (here just theUnited States) must of necessity be imprecise.The desired category of immigrants is notreadily available, so must be calculated. HereI detail those calculations, first for legal im-migrants. The stock of foreign-bom persons18 years of age or older in the United Statesin 1990 was 17.7 million (U.S. Department ofCommerce, Bureau of the Census [1990], Ta-ble 3: Social Characteristics of Selected An-cestry Groups by Nativity, Citizenship andYear of Entry: 1990). Of these, 6.9 millionentered between 1980-1990 (U.S. Depart-


ment of Commerce, Bureau of the Census,1990). The 1970's saw approximately 4.5 mil-lion immigrants to the United States (Boijas,1990 p. 6). Of these, close to 4 million wouldhave been aged 18 or over (Borjas, 1990 p.41). Summing, the 1970-1990 immigrationof those aged 18 and over would have beenapproximately 10.9 million. The labor-forceparticipation rate for male immigrants is ap-proximately 90 per cent (Borjas, 1990 p. 41),while that for women is lower, which I willestimate by the native female participation rateof circa 50 percent. Thus the average labor-force participation rate will be taken as 70 per-cent. This implies that of the 10.9 millionimmigrants aged 18 and over, approximately7.6 million would be in the labor force. Of the1990 stock, approximately 60 percent of thoseaged 18 or over had a high-school educationor less (U.S. Department of Commerce, Bu-reau of the Census, 1990). Thus of these 7.6million in the labor force, a little over 4.5 mil-lion would fall into the category of the un-skilled. Not all of these, though, come fromthe South. If we define the South operationallyas Asia (except Japan), Africa, and the Amer-icas (except Canada), approximately three-fourths of immigrants in the 197O's came fromthe South (Borjas, 1990 p. 230). If it is con-servatively assumed that the unskilled were nomore likely to come from the South than fromthe North, this would imply that the contri-bution of legal immigration from the South tothe unskilled labor force in the North is ap-proximately 3.4 million.

To this must be added the contribution tothe labor force by illegal immigration. Whilenewspaper reports of illegal immigration areoften huge, the work of Borjas et al. (1991)suggests that in 1980 the stock of Mexican il-legal immigrants to the United States was 1.8milhon. I do not have data that provide simi-larly careful estimates for illegal fiows for1970-1990, or that incorporate the fullcomplement of countries of the South. Real-izing that this leaves out flows from the 198O'sfrom Mexico, as well as all flows from othercountries of the South, while it includes somewho arrived prior to 1970,1 will (with a greatdollop of optimism) take the figure of 1.8 mil-lion as the relevant measure of inflows from1970-1990. If it is assumed, as above, that

approximately 90 per cent of these are aged 18and above, this reduces the figure to approxi-mately 1.6 million. Assuming that the labor-force participation rate again is 70 percent, thisimplies that approximately 1.1 million are inthe labor force. It is known that educationalattainment of typical Mexican immigrants isvery low, with over three-fourths having lessthan a high-school education (Borjas et al.,1992). If those with a high-school educationare included among the unskilled, then thiswill provide a figure of approximately 1 mil-Uon additional unskilled workers. If this issummed to the contribution of legal immigra-tion, a figure is arrived at which indicates thatSouth-North migration to the United Statesfrom 1970-1990 raised the labor force of theunskilled by approximately 4.4 million work-ers. This estimate should be considered veryrough.

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