Can Free Trade Reduce Your Paycheck?

by Frederico Gil Sander

Free trade is often seen as a threat to the well being of America's low skilled workers. Many fear that free trade will lower wages and lead to an exodus of jobs. In reality, free trade has less to do with the decline in the wages than most people think.

In his suggestively titled 1993 book,1 Ross Perot condemned the North American Free Trade Agreement (NAFTA) on the basis that free trade with a poorer country such as Mexico would produce a “giant sucking sound” as American wages and jobs go down the drain (or across the border). Three years after NAFTA has gone into effect, Perot's alarmist predictions seem to have been vastly exaggerated. The debate whether free trade has a significant negative effect on the wages of unskilled workers, however, is yet to be settled.

The general feeling that free trade has had a negative effect on the wages of unskilled workers stems from the confluence of several trends. Before 1973, the real earnings of workers rose by 1.9% annually2, while between 1980 and 1994, real average annual earnings for high school dropouts fell by 18%.3 At the same time, imports were going up: in 1960 manufactured imports represented 6.5% of manufacturing value added; by 1990 this figure increased to 30.7%.4 Moreover, a significant part of this increase in imports came from low-wage countries. From 1960 to 1990 the proportion of manufacturing value added from low wage countries doubled.5

The above statistics are uncontestable facts. Do we have any reason to believe that they are in any way related? Perot and many others seem to think so. If we have free trade with Mexico, won't firms have to lower wages because of competition from lower-wage Mexican firms? Or won't they threaten to move to Mexico in order to get wage concessions from their workers? As the aftermath of NAFTA has shown, the story is more complicated.

The multifactor productivity in the United States, after growing rapidly since the mid 1930s, has leveled off and shows no signs of picking up again.

The primary effect of free trade is to lower the prices of the traded goods. People will not buy foreign goods unless they are of equal or lower price than the domestic equivalent. This simple fact leads to the prediction that the wages of domestic workers producing commodities which are imported should decline.
To understand the consequences of lower commodity prices on wage levels, consider the case of textiles. Opening the textile market to foreign competition lowers the price of textiles, which in turn makes producing fabrics less attractive to US firms. Some firm owners will find it more profitable to sell their factories and buy, say, a vacation resort. As a consequence, the former employees of the closed factories will be displaced. The resort industry uses proportionally more capital (the resort itself, etc.) than workers, and the capital added (the money from the textile machine sales) requires fewer workers to operate compared to the number of workers required to operate the same amount of capital in the textile industry. Therefore, some workers will be unemployed, which creates a pressure for wages to go down.
Since the United States has a relatively abundant supply of skilled workers, it tends to be better at producing (and exporting) goods produced by skilled workers. By the same logic, it imports mainly goods made by unskilled workers. If imports from low wage, low skill countries increase, one would expect the prices of domestic goods that are similar to the imported goods to fall. Through the mechanism outlined above, one would expect the wages of unskilled American workers to fall.
There is some evidence that import prices have tended to be correlated with wages.6 Evidence for a shift from low to high skilled employment, however, is more mixed. Krugman and Lawrence7 find that employment has increased more rapidly in skill intensive industries, but that the ratio of skilled to unskilled employment within industries has not declined for most US industries as would be expected.

Free trade between countries is equivalent to free movement of people and capital. For example, when there are no tariffs, an entrepreneur is indifferent between becoming an importer of foreign goods or going abroad to produce the goods. Therefore, the effects of free trade on the wage level are similar to that of increased immigration.
Consider again the example of the textile industry. Wages for textile workers in California are higher than those of their Mexican counterparts. Now imagine the borders are open and Mexican workers may freely compete for the American textile jobs. Since the wages in the US are higher than in Mexico, those workers will migrate to the US until the wages are equalized.
This idea is similar to the popular argument for a “race to the bottom,” whereby it is capital that migrates seeking ever lower wages and higher returns. In the latter argument, however, wages somehow converge to the least common denominator.
Why, then, have we not seen any wage equalization across countries if capital can move relatively freely and US trade barriers are currently quite low?8 The answer lies in the fact that labor is not the same across countries, and even some jobs regarded as “low skilled” require some basic skills (being able to read instructions, for example). Hence, some firms choose not to relocate to lower wage countries because the lower wage reflects lower productivity rather than profit opportunities. Yet, as one has seen for over a decade now, when lower wages do reflect profit opportunities, firms such as Nike and many others do not hesitate to move abroad.

It was suggested earlier that free trade has a negative and significant effect on the wages of unskilled American workers. Even if this is the case, is it a good reason to reject free trade? The answer to that question is clearly 'no.'
It was also shown here that the factor which has the most significant impact on wages of American workers is productivity. Lifting trade barriers is not a solution to the productivity problem; indeed, it can make the problem worse by removing competitive incentives. In order to increase productivity and wages, the best policies to follow are investments in education and R&D, not tariffs.
Although the move into free trade does put downward pressure on the wages of unskilled workers by lowering the price of the goods they produce, promoting convergence of wages across countries and reducing union rents, the costs of protection far outweigh benefits. In particular, protection does not address the intrinsic, yet more difficult, productivity issues. In order to address that problem, the U.S. should estbalish a more effective education system, not trade barriers.

Endnotes: 1. Perot, R. Ross and Choate, Pat. Save Your Job, Save our Country - Why NAFTA must be stopped - Now!. Hyperion Books, New York, 1993. 2. Lawrence, R.Z. and Slaughter, M.J. “International Trade and American Wages in the 1980s: Giant Sucking Sound or Small Hiccup?” Brookings Papers on Economic Activity: Microeconomics, 2:1993. 3. Council of Economic Advisors. Economic Report of the President transmitted to the Congress - 1996. GPO, Washington D.C., 1996. 4. Sachs, J.D. and Shatz, H.J. “Trade and Jobs in U.S. Manufacturing.” Brookings Papers on Economic Activity, 1:1994, p.1-65. 5. Sachs and Shatz, op. cit. 6. See Sachs and Shatz, op. cit., Krugman, P. and Lawrence, R. “Trade, Jobs and Wages.” Scientific America, April 1994, pp.44-49. 7. Krugman and Lawrence, op. cit. 8. Lucas, R.E. Jr., “Why Doesn’t Capital Flow from Rich to Poor Countries?” American Economic Review, 80 (May), pp. 92-96. 9. Krugman and Lawrence, op. cit. 10. Leamer, E. “Trade, Wages and Revolving Door Ideas.” NBER Working Paper Series. no. 4716

Frederico Gil Sander, PC’98, is an economics and international studies major at Yale College.