Thursday, June 19, 2008

Wage insurance to combat inequality?

Some days back, I had posted on the ongoing debate about whether trade is contributing towards widening inequality in the US and the role of Stolper-Samuelson theorem in explaining this. Now Dani Rodrik has claimed that the fall in wages of unskilled workers in the US is not due to any Stolper-Samuelson permanent wage compression, and makes a case for wage insurance to cushion the affected workers.

The general version of the Stolper-Samuelson theorem states that at least one factor of production must experience a decline in real income from trade as long as trade causes the relative price of some domestically produced good to fall. This is understandable, since the loss incurred by way of lower prices have to be borne by someone (either labour or capital).

As to who will bear the loss, it is logical that the most abundant factor in the good (experiencing fall in price) should bear the greater burden of the loss. It has therefore been argued by proponents of the "trade-is-causing-inequality" theory that the lower prices have led to a Stolper-Samuelson permanent wage compression on American unskilled workers. It has been claimed that this has in turn more than offset the benefits that have accrued to American consumers by way of cheaper imports from China(Christian Borda and John Romalis).

Rodrik quotes from a recent paper by Raphael Auer and Andreas Fischer, who argue that the fall in prices of some goods produced in the US have come more from increases in Total Factor Productivity (TFP) and not so much from fall in returns to unskilled labour. So there is the possibility that the Stolper-Samuelson reduction in wages of American workers has been covered by the TFP increases due to import competition.

Dani Rodrik writes, "The mechanical link between prices and factor costs--which I appealed to above in the proof of the generalized S-S theorem-breaks down whenever there is productivity change. After all, if TFP increases, employers can afford to pay unchanged wages even if the prices they face decline."

Rodrik suggests that this TFP improvement comes about from an industry restructuring, causing the exit of the least efficient firms and attendant lay-offs. This appears to imply that "the main threat to workers is not a Stolper-Samuelson type permanent compression in wages, but the more temporary (and limited) wage losses incurred by displaced workers." This, he claims, is the kind of problem that wage insurance is ideally suited for.

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