Would a North-South Free Trade Agreement Hurt Unskilled Labor in the North?

Front. Econ. China 205, 0(4): 629 642 OI 0.3868/s060-004-05-0029- RESEARCH ARTICLE Chu-Ping Lo Would a North-South Free Trade Agreement Hurt Unskilled Labor in the North? Abstract I present a simple model to examine the impact of international outsourcing on the welfare of skilled and unskilled labor. In this model, specialied business services are to facilitate manufacturing production, creating additional welfare gains in the presence of positive production externalities. Policies that favor the business service sector contribute to the development of a larger bundle of specialied business services, generating more welfare gains to not only skilled but also unskilled labor. Thus, a country s unskilled labor is not necessarily worse off with open trade if the country is prosperous in business service provisions. Keywords international outsourcing, wage inequality, free trade agreement JEL Classification F3, F5, F6 Introduction International outsouricng, motivated by trade liberaliation, leads to a widening wage inequality between skilled and unskilled labor in the countries involved (e.g., Feenstra and Hanson, 996; inopoulos et al., 20; Unel, 200). International outsourcing is also driven by advancement in skill-biased technology, which is an important factor in rising wage inequality (Acemoglu, 2002a; Acemoglu, 2002b, Epifani and Gancia, 2008 and Van Reenen, 20). Furthermore, Bloom et al. (20) argue that China, the factory of the world, is another significant factor in the worsening wage inequality as China absorbs too many unskilled jobs from the rest of the world. Associated empirical analyses have been undertaken by Berman et al. (993), Sachs and Shat (994), Feenstra and Hanson (997), Baldwin and Cain (2000), Received October 3, 204 Chu-Ping Lo ( ) epartment of Agricultural Economics, National Taiwan University, Taipei, Taiwan, China E-mail: cplo@ntu.edu.tw

630 Chu-Ping Lo Haskel and Slaughter (200), and Attanasio et al. (2004), among others. However, the above literature emphasies the rising wage inequality between skilled and unskilled labor, and pays less attention to the welfare of unskilled labor. And so, this paper focuses on the impact of international outsourcing on the welfare of unskilled labor. With this purpose in mind, I present a simple model to demonstrate that trade liberaliation (e.g., the free trade agreement) does not have to lead to the deterioration of the welfare of unskilled workers if the economy is more prosperous in business service provisions. The existing literature suggests that unskilled workers might gain higher real wage rates from trade liberaliation only if the offshore activities are moderate (e.g., see Feenstra and Hanson, 996). Additionally, my model specifies circumstances where worsening wage inequality may be reduced. In this model, the general production cost reduces with an increase in the number of varieties of business services provided. I argue that a country that is able to provide a greater variety of business services tends to gain price competitiveness in the manufacturing industry, restraining wage inequality while hollowing out the manufacturing industry. Therefore, a government should create an environment favorable to the expansion of business services, which helps raise the real returns on unskilled labor and reduce wage inequality. The remainder of this paper is organied as follows. Section 2 presents a simple model that consists of manufacturing, personal services, and business service industries. While the personal services are for direct consumption, the business services facilitate production in the manufacturing sector. Section 3 illustrates the equilibrium where the difference in the development of the business services industry affects wage inequality. Section 4 presents the concluding remarks. 2 The Model Consider a world divided into North and South in which there is one manufacturing good and one personal service good. The manufacturing good is a Feenstra and Hanson-type (996) good and is produced by a firm whose headquarters are in the North. The final-good is assembled by a continuum of intermediate inputs, indexed by [0,]. Each unit of input exogenously uses al ( ) of unskilled labor and ah ( ) of skilled labor, with the labor required ratio a ( ) a ( ) increasing in. However, in contrast to Feenstra H L

Would a North-South Free Trade Agreement Hurt Unskilled Labor in the North? 63 and Hanson s (996) model, the production of the intermediate inputs in this current model requires not only skilled and unskilled labor but also a bundle of specialied business services. Thus, there are three industries in the North. The manufacturing industry is vertically integrated; both the business and personal services industries are facing monopolistic competition. The service goods are intangible, requiring proximity to consumers. For simplicity, I assume that manufacturing goods are tradable while both personal and business services are non-tradable, because rendering service provision to distant locations is not feasible due to proximity limitations. All individuals are assumed to share a utility function of the form: μ μ U = XM XS, () where X M represents the consumption of tradable manufacturing final-goods, X S represents the consumption of non-tradable personal services, and μ represents the share of income spending on manufactured final-goods. This paper s analysis focuses on the North. 2. The Personal Services Industry Personal services consist of the services from restaurants, retail trade, beauty salons, housekeeping, babysitting, and other home-related tasks, etc. Assuming symmetry in the cost function for personal services, while the provision of each variety of personal service not only requires al ( p ) unskilled workers but also a fixed number of ah ( p ) skilled workers. 2 For simplicity s sake, let s take a representative personal service into consideration and assume that each individual only consumes the representative personal service. The cost of the personal service in the North is then given by cs = qah( p) + wal( p) XS, (2) where q and w are the wage rates of skilled and unskilled labor in the North, respectively. Here, X S denotes total demand for the personal service in the North, which is positively related to total population. The unit price of the Even with a free trade agreement governments usually regulate some of the business services such as telecommunications and broadcasting quite heavily because of their economic importance and political sensitivity to the extent that the access of service providers from abroad is still largely obstructed (Garner, 2004). 2 For example, in restaurants, both the manager and chef are considered to be skilled workers, while the waiters and dish washers are unskilled workers.

632 Chu-Ping Lo personal service is given by demand for personal services. P S wal ( p) =, where σ denotes elasticity of σ 2.2 The Business Services Industry Specialied business services consist of financial services (e.g., banks), legal services (e.g., law firms), consulting services (e.g., Mckinsey & Company), transportation services (e.g., airline companies), marketing services (e.g., Era Ogilvy and broadcasting stations), telecommunication services (e.g., AT&T), distribution services (e.g., UPS), public services (e.g., water and electricity supply), and research and development services (e.g., Symbio). There exist specialied standalone firms in the North that provide these specialied business services. Following Ethier (982), Jones and Kierkowski (990) and Van Long et al. (2005), I apply a standard constant elasticity of substitution (CES) framework to formalie aggregate business services to reflect gains from specialiation: n S ( ) = sj ( ), (3) j= where 0< < and n denote the number of varieties of specialied business services that are endogenously determined in the North. In (3), each standalone business service provider in the North serves all the intermediate-goods producers along [,]. Assuming further that each producer at a specific manufacturing stage requires business services at the same amount s j ( ) = s, j. In (3), we then have s = n S( ) for all. That is, the aggregate business services S ( ) consist of a bundle of horiontal specialied business services s j ( ), j. Again, assuming symmetry as S ( ) = S,. The total demand for business services in the North is then Sd= ( ) ( ) S. In order to provide one variety of specialied business service to a specific intermediate-good producer in the manufacturing sector, a fixed amount of skilled workers ah ( b ) that have a high level of skills and competence is required to set up the program, while a ( b ) unskilled workers are needed to L

Would a North-South Free Trade Agreement Hurt Unskilled Labor in the North? 633 run a routine set of instructions. Thus, a specialied business service variety j has a labor requirement function cb = qah( b) + wal( b) s( ) d = qa ( b) + wa ( b)( ) n (4). H L Chanda and algaard (2005) examined 200 data from the U.S. and found that in the service industry approximately 65% of the population had some college education or more (educated labor is usually skilled labor), while the corresponding share in the manufacturing industry was 50%. It is then feasible to argue that the business services industry is more skilled labor-intensive than the manufacturing industry. In monopolistic competition, each business service provider equates marginal revenue with marginal cost. Having symmetric equilibrium for the specialied service providers, we obtain the price of each specialied business input as wal ( b p ) j = = p forj n, and wal ( b ) j p p = = forj n. (5) Eq. (5) implies that the unit price of a business service is higher in the North in comparison to the South as p > p, j. The price of aggregate business services in the North and the South is ( ) n ( ) ( ) PB = pj = p( n) and j= ( ) P = p ( n ). (6) B Eq. (6) shows that the price of aggregate business services decreases diminishingly with the number of specialied business service varieties n. Here, n denotes the number of specialied business service varieties that are provided by the South. It is reasonable to assume that n> n since the North is supposed to be more prosperous in the business services industry than the South. 3 As a result, the price of the aggregate business services in the North may be lower 3 The service sector roughly accounts for 70% of total labor input in most developed countries (e.g., the U.S., Chinese Taiwan, and Chinese Hong Kong) compared with 30% in many developing countries (e.g., China). It is then feasible to assume that the North is capable of providing more varieties of business services than the South.

634 Chu-Ping Lo than that of the South if n is sufficiently larger than n. Warynski (200) estimated the average mark-up in the U.S. manufacturing industry to range from 20% to 40%. This estimation was based on averaging 450 industries over the period 958 994. His estimation suggests that the elasticity 2 of substitution ranges from 3 to 5, implying = and = 0.8, respectively. 3 2 PB n w The relative price is then given by = PB n w when 2 =, and 3 4 PB n w = when 0.8 PB n w =. Based on the above calculation, I presume that n is sufficiently larger than n such that PB < PB in this model. 4 In this current paper, the price difference in the aggregate business services (e.g., PB < PB) is analogous to the capital rent difference (e.g., r < r ) in Feenstra and Hanson s (996) model. 2.3 The Manufacturing Industry Personal services are for direct consumption; however, specialied business services are in a horiontal fashion and are aimed at facilitating production in the manufacturing sector, which is not for direct consumption. Thus, I replace the capital factor in Feenstra and Hanson s (996) production function of intermediate inputs with aggregate business services: L ( ) H ( ) θ θ x ( ) = A[min, ] [ S ( )], (7) al( ) ah( ) where A denotes the technology parameter and A > A. Here, L ( ) denotes total unskilled labor while H( ) denotes total skilled labor in the sector in the North. S ( ) units of aggregate business services are required to facilitate the production of intermediate input x( ). Let the manufactured final good be assembled without cost: 4 In the case of Chinese Taiwan and Chinese mainland, the minimum wage in Taiwan relative 2 to the mainland is about 3, implying that we have PB < PB if n> 2n when = and 3 n>.5 n when = 0.8. Here, we can assume that n> 2n in this model.

Would a North-South Free Trade Agreement Hurt Unskilled Labor in the North? 635 0 ln X = ρ( )ln x( ) d, with M 0 ρ ( ) d =. (8) With (7) and (8), the minimum cost of producing one unit of x( ) in the North is calculated following a standard methodology as cwqp (,, S; ) = Bwa [ L( ) + qah( )] θ P θ B, (9) θ ( θ) where B = θ ( θ) A. Similarly, the minimum cost of producing one unit of x( ) in the South is given by c( w, q, PS ; ) = B [ w al( ) q ah( )] θ P θ θ ( θ ) + B, where B = θ ( θ) A. Here, w and q are the wage rates of unskilled and skilled labor in the South, respectively. With (6), the relative unit cost of producing an intermediate input between the θ cwqp (,, B, ) A w North and the South is then given by = cw (, q, PB, ) A w θ q ah ( ) ( θ ) + n wal( ) n, where the cost advantage is not only q ah ( ) + w al ( ) determined by the relative wage rates but also by the relative diversity of business services. In a detailed survey of literature, Cline (997) documents that wage inequality in developed countries is more modest than in developing countries. One reason behind the scene might be due to the relative abundance in educational investment in developed countries in comparison to developing countries. As a result, the relative supply of skilled labor in the North is more abundant than in the South, leading to a lower skill premium in the North. Therefore, let s follow a presumption in Feenstra and Hanson s (996) model q q that takes <. w w q q With n> n, A > A, < but w> w, we can argue that there exist a w w such that the North has a cost advantage in the range of [,], and the South has a cost advantage in the remaining range [0, ), where represents the marginal manufacturing sector. While the derivation is similar to that in Feenstra and Hanson s (996) model, I spare the related derivation. In this current model, let us assume that in an initial equilibrium we have cwqp (,,, ) > cw (, q, P, ) because of political barriers against trade. As a B B

636 Chu-Ping Lo result, the marginal manufacturing sector is located in the North rather than in the South even though the South has comparative advantage in producing the intermediate component. However, the sector will be relocated to the South when the trade barrier is removed with the adoption of a free trade policy. This outsourcing activity reduces the general production cost and the price of manufacturing final goods, thus improving the welfare of the North as a whole. 2.4 Equilibrium Workers are mobile across all sectors, but not across national borders. The total demand for unskilled labor in the manufacturing sector is q ( a ) L ( E ) L m θ = d w wal( ) + qah( ). (0) Similarly, total demand for skilled labor is q ( a ) H ( E ) H m θ = d w wal( ) + qah( ). () In equilibrium, the labor market clears when ( ) b m p L ( ) L( ) S ( a ) L ( E ) L= L + L + L = a b n S + a p X + θ d wal( ) + qah( ), ( a ) H ( E ) and H = Hb + Hm + Hp = nah( b) + ah( p) + θ d wal( ) + qah( ). (2) With a given n, the relative demand for skilled to unskilled labor in the North is defined as: ( a ) ( ) na b a p E d H H( ) + H( ) + θ q H wal( ) qah( ), + = ( ) L ( ) L( ) ( ) L( ) S θ L + H. w L a E a b n S + a p X + d wa ( ) qa ( ) (3) When a free trade policy leads to a larger, we can calculate the relative demand for skilled labor in the North. Taking the logarithmic derivative of (3)

Would a North-South Free Trade Agreement Hurt Unskilled Labor in the North? 637 with respect to, we get: ln L H ah ( ) ( ) E = H L al( ) wal( ) qah( ) + al ( b) X S + n S + al ( p) > 0, (4) H H ah ( ) where > because the sectors located in the North are more skilled- L al ( ) labor intensive compared with the marginal sector. Note that, an increase in international outsourcing reduces the price of manufacturing final goods. Implied in (), due to the substitution effect, a lower price in the manufactured final good X would encourage more consumption of personal services, such that S > 0. ln Therefore, we then have > 0 as shown in (4). That is, wage inequality increases with an increase in international outsourcing activity. However, with > > 0, (4) also implies that the rising wage inequality due to international outsourcing could be mitigated by an increase in business varieties (i.e., 2 ln < 0 ). n 3 Labor Redeployment and Wage Inequality As implied in Feenstra and Hanson s (996) model, the relocation of the marginal manufacturing sector from the North to the South raises the relative demand for skilled versus unskilled workers and an increase in wage inequality. Fully differentiating (2) with respect to, we obtain the labor demand for skilled and unskilled labor, respectively: dh n Eθ( ) ah ( ) = a ( ) 0, H b d wal( ) qah( ) > + dl n = a ( ) ( )( ) L b n S a L b Sn (5) d Eθ ( ) al ( ) 0. < wal( ) + qah( )

638 Chu-Ping Lo dn To ensure the inequality in (5) holds, we must have > 0. That is, business d service variety in the North increases with an increase in its international outsourcing to the South. As implied in (2), the real wage of unskilled labor in the North with respect to the personal service good is unchanged with an increase in the international outsourcing activities. However, as implied in (5), (6), (8), and (9), the real wage of unskilled labor in the North with respect to manufacturing goods is ( θ ) w wn = θ PM al ( b) 0 B e ( )ln[ wal( ) + qah ( )] d+ ( )[ w al( ) + q ah ( )] d θ ρ θ ρ. (6) Taking the logarithm of (7) with respect to, we obtain dwp ( M) ( dn d ) wal( ) + qah( ) = ( θ) ( ) ln θρ d n w al( ) + q ah( ). (7) With the fact that the North is wealthier and more equal than the South, such as q q w> w, q> q and w > >, we should observe that (7) is decreases with w because the second term in (7) increases in. That is, in line with Feenstra and Hanson (996), when is sufficiently small, (7) shows that the real wage of unskilled labor in the North might increase with the international outsourcing activities. dn However, as implied in (5), we have > 0, implying that growth of business d service varieties matters for the welfare of unskilled labor. (7) further suggests that if growth of the business service varieties is sufficiently large (high ( dn d ) dwp ( ), we might observe M ) > 0. That is, the real wage of unskilled n d labor in the North does not necessarily increase with an increase in international outsourcing activities if the country is more prosperous in business services. When the North is more favorable to generating business service varieties to the extent that growth of business service varieties is sufficiently high, we might observe that international outsourcing increases the real wage of unskilled labor dwp ( ) (i.e., M > 0 ), even when international outsourcing activities is d

Would a North-South Free Trade Agreement Hurt Unskilled Labor in the North? 639 significantly large. This is the main implication in this paper. 4 Concluding Remarks I have presented a simple model to demonstrate that business services matter in the welfare of unskilled labor in a country. In this model, specialied business services facilitate manufacturing production, creating additional welfare gains in the presence of positive production externalities. The favorable policies contribute to the development of a larger bundle of specialied business services, generating more welfare gains to not only skilled but also unskilled labor. Thus, a country s unskilled labor is not necessarily worse off with open trade if the country is prosperous in business service provisions. This model suggests that a country benefits by applying favorable policies for the expansion of its business service sector rather than resorting to protectionism. Take Hong Kong as an example. On one hand, a large bundle of various professional business service providers locate in Hong Kong. On the other hand, comparing the calculation in Hsieh and Woo (2005) for Hong Kong with the calculation by Hummels, Ishii, and Yi (200) for Mexico, it is feasible to conclude that Hong Kong engaged in no less, if not more, international outsourcing activities than Mexico did from the 980s to the 990s while both exceeded 30 percent in the ratio of outsourcing trade to total trade. However, wage inequality in Hong Kong only increased slightly, while that of Mexico increased by almost fifty percent within the same period (Chiquiar, 2005). Another example is Singapore. Singapore has created a business-friendly environment and engendered a positive atmosphere that has encouraged the development and expansion of large multinational corporations, and small start-up firms, especially in the business services industry. In particular, in order to meet global competition, Singapore has liberalied its immigration policy to attract and retain foreign professional and managerial workers. In 2006, skilled workers and professionals accounted for 3.4 percent of Singapore s total nonresident population; the majority of which was from China and India (Yeoh, 2007). 5 It turns out that the financial and business services subsector in 5 Instead, since the 970s, Singapore s immigration policy towards unskilled and low-skilled migrants is unfriendly. Unskilled workers are managed through a series of measures, including a work permit system, the dependency ceiling, and the foreign-worker levy. These unskilled workers are not allowed to bring their spouse and children with them, and they are also not allowed to marry Singaporeans. Unlike unskilled workers, high-skilled workers are allowed to bring their family members.

640 Chu-Ping Lo Singapore experienced the highest employment growth rate within the service industry in the 990s, which accounts for the bulk of new jobs created since 99 while the manufacturing industry shed ten percent of its workers. The business services industry in Singapore boasts a higher percentage of skilled workers compared to the manufacturing industry. By contrast, the personal services subsector in Singapore, as the share of total service output, declined from 40 percent in 960 to 20 percent in 996. 6 As implied by Feenstra and Hanson s (996) model, while the share of inflow FI in Singapore s GP rose from 5.7 percent in the 960s to 28. percent in the 980s (Lim and Fong, 99) and as Singapore ranks as the fifth largest source of FI in China (Zhang, 2005), wage inequality in Singapore should have widened as in the U.S. or Mexico. 7 Conversely, wage inequality in Singapore has been narrowing between 966 and 990, with the exception of the period from 98 to 986 (Fig. 6.3 in Wood, 994). I argue that both Singapore and Hong Kong s business service industries are much more prosperous than Mexico s, 8 which helps to explain why Mexico saw a substantial worsening in wage inequality in the late 990s, while Singapore and Hong Kong experienced either a reduction or only a slight increase. Trade liberaliation will definitely drive the manufacturers in developed countries to engage in more international outsourcing activities in developing countries. However, it is not necessary for developed countries to experience a worsening wage inequality and a lower welfare for unskilled labor. Both Singapore and Hong Kong set a good example to other countries. In the case of having a free trade agreement, rather than resort to protectionism, it will be better to create an environment favorable to the expansion of specialied business services. Acknowledgements This research is supported by the National Science Council of Taiwan (NSC 99-240-H-002-062-). 6 See Singapore s Services Sector in Perspective: Trends and Outlook by the Monetary Authority of Singapore (998). 7 The China-Singapore Free Trade Agreement (CSFTA) took effect on Jan, 2009. 8 Although the welcome-foreign-talent scheme has no direct equivalent in Singapore, Hong Kong is trying similar ways to lure talents, and for similar reasons. For example, Hong Kong allowed non-residents settle there without first getting a job and most of the successful applicants are from China (Chong, 2008).

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