This article investigates the impact of labor market regulations in a setting with incomplete compliance. It takes as its starting point the limited evidence regarding the distortionary costs of labor market regulations and argues that there may exist natural limits to the efficiency losses engendered by such regulations. The article reviews some stylized facts regarding labor market behavior, presents an analytical model that may explain such behavior, and provides a checklist for assessing the distortionary impact of regulations such as minimum wages.Does labor market regulation in developing countries result in significant efficiency losses? In his survey paper, Freeman (1993: 139) expressed surprise that "Studies designed to support the distortionist view of labor markets in developing countries failed to make a stronger empirical case than they did."There are several possible explanations for this result. First, the regulations may not be binding at the market equilibrium. Second, even if the regulations are binding, the relevant elasticities of supply and demand may be so low that the impact of the regulations on efficiency is small. And third, even if the regulations are binding and the elasticities are sizable, compliance may be low. On this point, Freeman (1993: 128) notes that "If extensive unemployment results, the minimum will often be unenforceable because both workers and employers will have incentives to collude to avoid the law and save jobs." In this article we focus on the third reason and argue that the following proposition holds: the likelihood of noncompliance will be greatest when the regulations are binding and the relevant elasticities are sizable. That is, if the distortionary costs of regulations are not rendered insignificant by the first two reasons, then the returns to noncompliance will be high and, other things being equal, employers will either evade or avoid the regulations, thereby minimizing their impact on efficiency. Lyn Squire and Sethaput Suthiwart-Narueput are with the Policy Research Department at the World Bank. This article was originally prepared as a background paper for World Development Report 199S: Workers in an Integrating World. The authors gratefully acknowledge Ahmed Galal, Dipak Mazumdar, Branko Milanovic, Martin Rama, participants at a World Development Report seminar at the World Bank, three anonymous referees for comments, and Marcel Fratzscher for research assistance. The authors also thank Martin Rama, Klaus Schmidt-Hebbel, Luis Serven, and various officials at labor departments in Ecuador, Egypt, Kenya, and the United States for their help in a small survey of labor enforcement practices.
Following the Stolper-Samuelson type of logic, the general impression is that freeing up trade, whether preferentially as in the North American Free Trade Agreement (NAFTA) or on a nondiscriminatory basis as in the Uruguay Round, must lower real wages in one set of countries and raise them in the other set of countries. An increase in the real wage in all countries as a result of freeing up of trade either relies on gains via an improvement in the terms of trade or requires special assumptions such as increasing returns, complete specialization or asymmetries in production technology. This paper shows that even within a standard threecountry, three-good, small-union model, preferential trade liberalization can lead to increased real wages in both partner countries without necessarily relying on terms-of-trade improvements, increasing returns, complete specialization, or asymmetries in production technology.The issue of trade and wages has assumed center stage in many economic policy debates. In the USA, the decline in the real wages of unskilled workers during the 1980s led to strong opposition to the North American Free Trade Agreement (NAFTA) by labor unions. There appeared to be a general sympathy for the argument that as NAFTA raises the real wages in Mexico, it will lower them in the USA.Empirical evidence on trade as a cause of the decline in real wages of unskilled workers is at best mixed. Studies by Borjas et al. (1992) and Murphy and Welch (1991) found support in favor of a connection, while those by Grossman (1986Grossman ( , 1987 and Revenga (1992) disputed it. Bhagwati and Dehejia (1994) subjected the thesis that trade is an important cause of the decline in unskilled wages to a systematic critique. They questioned both the empirical evidence and theoretical rationale behind the thesis.This note offers a simple model to analyze the impact of preferential trade arrangements (PTAs) on real wages. Unlike a large volume of the literature which equates NAFTA with free trade, we explicitly recognize that the agreement involves discriminatory liberalization. Assuming a production structure which is commonly employed in trade models, we demonstrate that preferential trade liberalization can potentially raise real wages not only in the country exporting labor-intensive manufactures but also in the country importing them. Typically, a result like this requires the assumption of increasing returns, differences in technology or asymmetries in the structure of production (see Bhagwati and Dehejia). We resort to none of these assumptions. Our innovation is simply to combine the Meade (1956) model of preferential trading with Krueger's (1977) trade model which is itself a combination of the Heckscher-Ohlin and Ricardo-Viner models.
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