Trade and Employment From Myths to Facts - International Labour ...

Trade and Employment: From Myths to Facts
response, the expanding sector substitutes capital for labour and, in the process, the
marginal productivity of labour increases. Workers have more capital to work with and
thus firms can pay higher wages. Again, note that this occurs in both sectors. Rising
world demand has increased wages at the expense of profits, but the latter do not
fall to zero because of factor substitution.
3.3.2.2 Elasticities of substitution matter yet again
It follows logically then, that the effect of trade on employment is crucially dependent
on the possibilities of substitution. The elasticity of substitution is thus an important
number to nail down empirically and must be done for each sector separately. The
Cobb-Douglas production function, the workhorse of economic analysis for more
than a century, is arguably of only limited use here. The elasticity of substitution is
defined rather complexly as the percentage change in the capital-labour ratio with
respect to the percentage change in the ratio of the cost of labour to the cost of
capital. For the Cobb-Douglas case, it can be shown analytically that the elasticity
is always equal to one for the constant returns to scale case. 20
Box 3-3: Why elasticities of substitution matter
The elasticity of technical substitution is an important number to accurately estimate
in simulations assessing the employment effects of trade. To see this, consider the
following example. As trade starts to boom, the import-competing sector begins to
contract, disgorging workers onto the labour market. In the expanding sector, labour
demand increases, but there is a problem. Because of the low elasticity of substitution
in the expanding sector, the capital per worker does not increase much, and therefore
neither does the marginal productivity. Thus, real wages cannot rise and the incentives
for labour to move, search out these newly emerging opportunities and obtain the
skills necessary for the new job are all dampened. It is quite likely that skills will
need some upgrading, since the expansion of the export sector will have attracted
foreign capital with more advanced technology and higher demands on its workers.
Retooling, as the sector expands, raises its elasticity of substitution and with it the
marginal productivity of labour. Not as much labour is required, but those who do
find jobs are well remunerated, at least comparatively. Slaughter (2001), for example,
notes that changes in the elasticity of labour demand over time arise more from technological
progress rather than trade itself.
After the Cobb-Douglas, the most popular production functions are constant
elasticity of substitution (CES) production functions and translog, which closely approximates
well-defined cost functions. These mathematical struc tures have elasticities
of substitution that are different from one and can be estimated econometrically.
All can be modified to use more than two factors so that, for example, the analysis
20 For a Cobb-Douglas function of the form Q = ΑΚ α L β , the elasticity of substitution is 1/(α +
β), where Q is output, Α is scaling parameter and α and β are the elasticities of Q with respect
to capital and labour L .
80