Trade and Employment 2007 ILO

TRADE AND EMPLOYMENT
ILO - WTO
CHALLENGES FOR POLICY RESEARCH
This study is the outcome of collaborative research between

the Secretariat of the World Trade Organization (WTO) and the
TRADE AND EMPLOYMENT CHALLENGES FOR POLICY RESEARCH

International Labour Office (ILO). It addresses an issue that is
of concern to both organizations: the relationship between
trade and employment.
On the basis of an overview of the existing academic

literature, the study provides an impartial view of what can be
said, and with what degree of confidence, on the relationship
between trade and employment, an often contentious issue
of public debate. Its focus is on the connections between
trade policies, and labour and social policies and it will
be useful for all those who are interested in this debate:
academics and policy-makers, workers and employers, trade
and labour specialists.
WTO ISBN 978-92-870-3380-2 A joint study of the International Labour Office

ILO ISBN 978-92-2-119551-1
and the Secretariat of the World Trade Organization
Printed by the WTO Secretariat - 813.07

TRADE AND EMPLOYMENT
CHALLENGES FOR POLICY RESEARCH
A joint study of the International Labour Office

Prepared by
Marion Jansen Eddy Lee

Economic Research and Statistics Division International Institute for Labour Studies
World Trade Organization International Labour Office
TRADE AND EMPLOYMENT: CHALLENGES FOR POLICY RESEARCH
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WTO ISBN 978-92-870-3380-2

ILO ISBN 978-92-2-119551-1
Also available in French and Spanish:

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Printed by WTO Secretariat, Switzerland, 2007

TRADE AND EMPLOYMENT: CHALLENGES FOR POLICY RESEARCH III
ACKNOWLEDGEMENTS
The authors thank Hilda Addison and Monica Takyi-Appiah for

research assistance and Peter Auer, Duncan Campbell, Michael Finger,
Ajit Ghose, Rizwanul Islam, Arne Klau, David Kucera, Karen McCusker,
José Manuel Salazar-Xirinachs, Ritash Sarna and Rolph Van der Hoeven
for comments on earlier versions of this study. Any remaining errors
are the fault of the authors.
IV TRADE AND EMPLOYMENT: CHALLENGES FOR POLICY RESEARCH
Foreword
This study is the outcome of collaborative research between the

Secretariat of the World Trade Organization (WTO) and the International
Labour Office (ILO). It addresses an issue that is of important concern
to both organizations, that is, the relationship between trade and
employment.
The multilateral trading system has the potential to contribute

to increasing global welfare and to promote better employment
outcomes. The challenge all our Members face is to find ways of
realizing this potential as fully as possible. A first step in that direction
is to improve our understanding of how trade and labour markets
interact and affect the lives of millions around the world.
We consider this joint study undertaken by the ILO and the

Secretariat of the WTO a useful and timely initiative that will promote
greater understanding and assist governments in making decisions in
an increasingly complex and fast-changing environment. In joining
the expertise of the two Secretariats, this technical study aims to
provide a broad and impartial view of what can be said – and with
what degree of confidence – about the relationship between trade and
employment, and the way in which trade policies and labour market
policies affect this relationship. The study also identifies questions that
are not always well understood in the literature, and on which more
research would be useful.
We are therefore pleased to present this study as an encouraging

illustration of how useful collaboration can be developed between the
two Secretariats on issues of common interest.
Pascal Lamy Juan Somavia

WTO Director-General ILO Director-General
VI TRADE AND EMPLOYMENT: CHALLENGES FOR POLICY RESEARCH
TRADE AND EMPLOYMENT: CHALLENGES FOR POLICY RESEARCH VII
EXECUTIVE SUMMARY 1
A. Introduction 13
B. Trade flows and employment:

the current context 14
C. Trade and employment: theory and evidence 19
1. Trade and income levels 20
2. Trade, job destruction, job creation and unemployment:

what theory tells us 24
3. The evidence: trade and (un)employment 30
D. Trade and inequality 38
1. Trade and inequality: what theory tells us 40
(a) Trade and the relative demand for different types

of labour 40
(b) Trade, FDI and the possibility to substitute

domestic workers by foreign workers 42
2. The evidence: trade and wage inequality 45
3. The evidence: trade and income inequality 50
4. The evidence: trade, FDI and the possibility to substitute

domestic workers by foreign workers 52
(a) Does globalization affect labour demand elasticities? 52

VIII TRADE AND EMPLOYMENT: CHALLENGES FOR POLICY RESEARCH
(b) Globalization, insecurity and the bargaining

power of workers 54
E. The role of policy-makers 55
1. Labour market institutions 56
(a) Insuring workers against adverse professional events 57
(b) Facilitating transition following trade reform 60
(i) Social protection and the potential role

of the international community 61
(ii) Active labour market policies 63
(c) Freedom of association and collective bargaining 65
(d) Trade reform and the informal economy

in developing countries 69
2. Redistribution policies 73
3. Education policies 76
4. Other policy areas 80
(a) Supply response in developing countries 80
(b) The role of financial markets for efficiency and stability 83
(c) The pace of trade liberalization 84
F. Conclusions 85
REFERENCES 91
Trade and employment

challenges for policy research

Executive summary
Objective
This study is the product of a collaborative effort by the Secretariat

of the World Trade Organization (WTO) and the International Labour
Office (ILO), aimed at providing an impartial view of what can be said,
and with what degree of confidence, on the relationship between
trade and employment, an often contentious issue of public debate. It
attempts to do this through a review of the academic literature,
both theoretical and empirical. A huge amount of research has
been undertaken on this subject and within this there are numerous
excellent literature surveys. This study intends to distinguish itself
from the existing surveys by focusing on the connections between
trade policies, and labour and social policies.
Basic issues
Economists have long recognized that trade would lead to a

division of labour advantageous to everybody involved. Indeed, by
reshuffling resources in accordance with the principles of comparative
advantage, they can be used more appropriately and effectively for
production, thus creating the so-called gains from trade. Highly
productive producers will be able to expand as they start selling their
goods or services abroad. Producers and consumers will be able to
take advantage of cheaper imports and of a larger product and quality

choice. The latter, however, implies that some domestic production
will be replaced by imports.
In other words, trade liberalization is expected to trigger a

restructuring of economic activity that takes the form of company
closures and job losses in some parts of the economy and start-
ups of new firms, investment in increased production and vacancy
announcements in other parts of the economy. Trade liberalization
is therefore associated with both job destruction and job creation.
In the short run the resulting net employment effects may be
positive or negative depending on country specific factors such
as the functioning of the labour and product markets. In the long
run, however, the efficiency gains caused by trade liberalization are
expected to lead to positive overall employment effects, in terms of
quantity of jobs, wages earned or a combination of both. Average
wage increases may, however, hide distributional changes that affect
some workers negatively.
Where trade liberalization affects parts of the labour force

negatively, labour and social policies are required in order to
redistribute some of the gains from trade from winners to losers.
This study tries to identify situations in which such government
intervention may be helpful, and individuals and groups that should
be targeted. It also discusses the possible effects of different types of
labour and social policies in the relevant situations. In this discussion
it is pointed out that labour and social policies may have unintended
efficiency effects. Indeed, to the extent that such policies may have a
negative effect on the above-mentioned “reshuffling” process that is
necessary in order to reap the benefits from trade, policy-makers may
be confronted with a trade-off, although not necessarily a very steep
one.
Recent developments
Traditionally, economists expected that the reshuffling process

triggered by trade liberalization would take place across sectors.
Roughly speaking, it was expected that labour-intensive industries
would shrink in developed countries, while skill and/or capital intensive
industries would expand. The opposite phenomenon was expected to
happen in developing countries. In developed countries jobs would
therefore be destroyed in labour-intensive industries and capital
employed in those industries would have to be re-employed. The
long-run distributional consequences of trade would imply increased
inequality between capital and labour or between skilled and unskilled
labour in the developed world. In contrast, inequality was expected to
decrease in the developing world.
Empirical evidence initially appeared to confirm these

predictions. In particular, decreases in inequality were observed in a
number of East Asian economies that liberalized trade. At the same
time, increases in the wage differential between high-skilled and low-
skilled labour – the so-called skill premium – were observed in a number
of developed countries. In other developed countries where labour
market policies, such as minimum wages, limited the extent of wage
adjustments, increases in low-skilled unemployment were observed.
But three important phenomena emerged that were not in line

with traditional trade theory, and a large body of theoretical and
empirical literature has tried to respond to this discrepancy between
traditional predictions and observed realities.
1. First, most industrialized countries trade above all with other

industrialized countries. Traditional trade theory was only of very
limited use in predicting employment effects resulting from this type
of trade. Recent contributions to the theoretical trade literature have

therefore looked at the question of whether trade among similar
countries, i.e. intra-industry trade, may have an impact on the demand
for high-skilled and low-skilled labour and some of these studies have
combined trade with technological change. This literature comes
to the conclusion that trade among similar countries can raise wage
inequality within countries and also within sectors.
Another branch of literature has examined the relationship

between openness and the sensitivity of labour demand to wage
changes. In this context it has been argued that in an open economy
employers would be more likely to threaten to lay off workers when
they demand higher wages than in a closed economy, for instance,
because they face stiffer price competition than before. Economists
refer to this increased sensitiveness as an increase in the price
elasticity of labour demand. This line of argumentation has two
important implications. First, trade between industrialized and
developing countries will affect the elasticity of labour, but the
same is true for trade among industrialized countries. Second, the
price elasticity of demand can be affected by the mere possibility of
trade. For instance, the mere threat of sourcing inputs from another
country or of delocalization may weaken workers’ resistance to wage
reductions.
This literature may explain why surveys in industrialized countries

have revealed that workers in very different types of industries report
greater perceived job insecurity as countries liberalize. The theoretical
literature confirms that trade, in particular if combined with Foreign
Direct Investment (FDI), has the potential to increase volatility in
labour markets. Surprisingly, though, statistics on labour market
reallocation do not reveal a systematic pattern of increased labour
market volatility. Work on how to reconcile the conflicting evidence on

workers’ perceptions of insecurity on the one hand, and labour market
statistics on the other, is ongoing in the research community.
2. Second, in contrast to expectations, increases in the skill

premium were also observed in developing economies during
periods of trade liberalization, notably in a number of Latin-American
economies. A large body of empirical literature has tried to explain
this phenomenon and finds that the timing of trade liberalization,
the tariff schedules in place before liberalization, and technological
change are some of the elements that explain why certain developing
countries have experienced increases in the skill premium after trade
liberalization. The relevant theoretical literature has focused on the
interaction between trade, FDI and technological change in order
to explain changes in wage inequality in developing countries. The
increasing importance of FDI has also led to renewed interest in the
functional distribution of income between capital and labour – as
opposed to the ratio between wages of high-skilled and low-skilled
workers – and in income inequality more generally.
3. Third, a lot of employment reshuffling was observed to

take place within sectors rather than across sectors as traditional
trade theory would predict. In response, a new generation of trade
models was developed that describes mechanisms according to
which trade liberalization encourages the expansion of the most
productive suppliers in all sectors, i.e. in sectors in which countries
are net exporters and in sectors in which they are net importers. As
a result, these models predict that in all sectors jobs are created by
those suppliers who are able to compete at the international level and
destroyed by those suppliers who are unable to compete. For policy-
makers this may be good news, as it is generally expected that it is
easier for workers to change firms within the same sector than to find
work in a different sector. Within-sector reallocation may, for instance,
imply lower retraining costs for workers and shorter search periods. On
the other hand, these new trade models imply that jobs are at risk in
all sectors. While traditional trade models would suggest that policy-
makers who wish to assist workers should focus on import-competing
sectors, more recent research suggests that such targeted intervention
is not justified. Indeed, recent literature emphasizes that it will be
increasingly difficult for policy-makers to predict which will be the jobs
at risk and which will be the jobs in demand in the near future.
A rich empirical literature has emerged from the analysis of these

different phenomena. One major difficulty that empirical studies
on the impact of trade on employment face is in distinguishing the
different possible causes of employment changes. Some of these
causes have a global character, like technological change, others are
country specific. Labour market policies, macroeconomic policies
or movements along the business cycle are only a few examples of
country specific factors that may affect an economy’s employment
level and structure. They may also affect the reaction of the labour
market to changes in trade policy. Not surprisingly, therefore, one of
the general conclusions that can be drawn from the literature is that
the employment effects of trade have differed significantly across
countries.
Implications for policy design
The present study goes on to discuss a number of policies from

three different angles: their potential to affect the link between trade,
growth and employment either positively or negatively, their effect on
redistribution, and their potential to provide security and insurance
against major adverse events in working life.
¡ Policies facilitating the transition following trade reform
Workers who lose their job following trade reform have to

look for a new job and potentially have to go through a period of
unemployment. They may be expected to relocate or to undergo
retraining. Two types of labour market policies targeting this situation
can be distinguished: passive income support during periods of
unemployment and so-called active labour market policies that
attempt to facilitate re-employment.
Most industrialized countries have more or less generous social

protection systems in place, but this is not the case in many low and
middle income countries. Active labour market policies are widely
used in industrialized countries where they are increasingly being
seen as a preferable alternative to passive income support for the
unemployed. Some industrialized countries even provide specific
trade adjustment assistance to workers.
The possibility of introducing social protection or active labour

market programmes of limited duration, and specifically targeting
those negatively affected by trade reform, has been discussed in the
literature and has recently been raised in the context of the debate
on aid for trade. Strengthening the capacity of developing countries
to design and implement such programmes could, indeed, enable
them to cope better with the social impact of economic reforms as
well as help to increase popular support for the reforms themselves.
There is, however, room for more research in order to improve our
understanding of how to design such programmes.
¡ Policies to provide security and insurance against adverse events
The policies for facilitating transition discussed above are part of the
general problem of providing security and insurance against adverse
events. Economists tend to agree that modern economies need to
constantly reallocate resources, including labour, from old to new
products, from inefficient to efficient firms. At the same time, workers
value security and insurance against major adverse professional
events, job loss in particular. In response to this demand for insurance,
economies have used different tools, like unemployment benefits and
job security legislation, to provide a buffer against the most negative
consequences of job loss. The discussion in this study shows that
there are reasons to believe that a trade-off exists between efficiency
and insurance, but that this trade-off does not need to be very steep
if insurance policies are designed appropriately. Getting the policy
mix right is a pressing issue. This is above all the case in developing
countries that face the additional challenge of channelling important
numbers of workers from the agricultural sector and the urban informal
economy as smoothly as possible into formal activities.
¡ Redistribution policies
It is also increasingly recognized that it is important for policy-

makers to ensure that the benefits of global economic integration are
sufficiently widely shared in order to maintain or obtain public support
for trade opening. This study provides a discussion of the literature
on redistribution policies in open economies and finds that there
is so far no agreement on how to design appropriate redistribution
policies in a globalizing world. The difficulty in designing an effective
redistribution policy arises from the fact that such policies are likely
to affect not only the distribution of income but also incentives in the
productive system. Redistributive transfer may affect the incentives
faced by those who receive them as well by those who pay for them
through, for instance, income or consumption taxes. An additional
complication may arise if the ability of governments to redistribute is
affected by the fact that some production factors are more mobile at
the global level than others.
Independent of their causes, increases in the skill premium

or income inequality represent a particularly serious challenge
for developing countries with limited experience in the design of
redistribution policies. The literature does not so far provide an answer
to the question of how to introduce appropriate policies in countries
that lack the necessary administrative and financial capacities.
¡ Education policies
Policies that provide wider access to education have been

identified in the literature as good pro-poor policies, as they stimulate
growth and reduce inequality at the same time. The present study also
emphasizes the increasingly important role of education policies in
determining how well countries cope with economic and technological
change. Education levels, for instance, determine countries’ absorptive
capacity, i.e. their capacity to adopt new technologies and maybe
develop them further. Education affects individuals’ capacity to deal
with change, an important aspect in a globalized world that expects
individuals to adapt constantly to new situations. At the same time
this study points out that it becomes increasingly hard to predict the
set of skills needed for future employment and that education systems
will therefore need to be increasingly flexible in order to respond to
economic changes. The practical implications of this, however, do
not appear to be entirely clear and further research on the issue of
economic change and education could be useful to provide guidance
to those responsible for education policy.
10 TRADE AND EMPLOYMENT: CHALLENGES FOR POLICY RESEARCH
¡ Other policies
How successful developing economies are in the creation of

more and/or better jobs, with attendant implications for poverty,
depends above all on the supply response of the economy to trade
liberalization. There appears to be a common understanding
of the possible bottlenecks for supply response in developing
countries. They include inadequate finance, physical infrastructure,
telecommunication, information and human capital. It has also been
argued that the pace of trade reform may affect countries’ supply
response. There appears to be an increasing awareness of the role the
international community can play in helping developing countries to
overcome supply constraints, that is reflected in the debate on aid for
trade. In this context it could be useful to improve our understanding
of how to effectively use aid for trade in order to optimize developing
countries’ supply response.
Main conclusion
The single main conclusion that emerges from this study is that
trade policies and labour and social policies do interact and that
greater policy coherence in the two domains can help to ensure that
trade reforms have significantly positive effects on both growth and
employment. From this perspective, research directed at supporting
the formulation of more effective and coherent policies would clearly
have a high pay-off to the international community.

TRADE AND EMPLOYMENT: CHALLENGES FOR POLICY RESEARCH 13

A. Introduction
The growing role of trade and foreign direct investment (FDI)

flows in the global economy has generated increasing interest
among policy-makers, the media and the general public in its impact
on employment and incomes across the world. In mainstream
economic theory it is presumed that these developments will, in spite
of possible problems of adjustment inherent in the process, eventually
yield net benefits in terms of employment and incomes in the global
economy. In contrast, discussions of the issue in the media often focus
on negative effects such as job losses resulting from increased import
competition and the displacement of local firms by FDI; the relocation
of jobs from high to low-wage economies, and claims that increasing
globalization has triggered a “race to the bottom” in terms of wages
and the quality of employment.
This study is the result of a collaborative effort by the ILO and the
Secretariat of the WTO and aims at providing an impartial view of what
can be said, and with what degree of confidence, on the relationship
between trade and employment. It attempts to do this through an
objective review of the academic literature, both theoretical and
empirical. A large amount of research has been undertaken on
this subject and within this there are numerous excellent literature
surveys. This study intends to distinguish itself from these existing

Surveys include Cline (1997), Slaughter (1998), Gaston and Nelson (2001), Acemoglu (2002), Ghose (2003),
Feenstra and Hanson (2004), Goldberg and Pavcnik (2004) and Hoekman and Winters (2005).
surveys by its focus on the link between trade policies on the one hand,
and labour and social policies on the other hand.
Trade policies have a significant impact on the level and structure of

employment, on wages and wage differentials, and on labour market
institutions and policies. At the same time, labour and social policies
influence the outcomes of trade policies in terms of the growth of
output and employment and the distribution of income. There appears
to be a need to disentangle the range of quite complex relationships
that exist between trade policy, growth, employment, job quality,
wages, poverty, inequality, and adjustment policies. This could serve
as a useful input to the policy-making process in both domains. It
may also act as a stimulus towards greater policy coherence that may
ultimately contribute to increasing the economic and social benefits of
trade liberalization and expansion.
B. Trade flows and employment: the current context
Trade has played an increasing role in the world economy over the
past decades as illustrated by the fact that the growth of real trade
exceeded that of world output. The ratio of world exports of goods
and services to GDP rose from 13.5 per cent in 1970 to 32 per cent in
2005 and all major geographic regions recorded an excess of trade
over output growth.
However, global trade expansion experienced several temporary

setbacks over these three decades, most notably during the Asian
financial crisis (1996-98) and the recession in the aftermath of the burst
of the information technology bubble in 2001. Nevertheless, global
trade expansion over the last decade (1995-2005) was nearly six per
cent per annum, almost two times stronger than global GDP growth.
The driving forces in this trade expansion over the last decades
include the deepening of the regional integration of Europe (European
Union) and North America (NAFTA), the shift to more outward oriented
trade policies in several large emerging markets (e.g. China and Mexico)
combined with unilateral liberalization measures in many other
developing countries and the multilateral liberalization in the Uruguay
Round. Other motors of the global trade expansion were the dynamic
growth of the information and telecommunication sector and the rise
in FDI flows since 1980.
FDI flows started to rise strongly from the first half of the 1980s
onward. Particularly buoyant FDI inflows were recorded into China
but other emerging markets in, for instance, East Asia and MERCOSUR
also attracted large FDI inflows. While in the early 1980s global annual
FDI flows hovered at around $55 billion they reached $200 billion in
1990-94 and after rising steadily peaked at $1300 billion in 2000 under
the impact of a merger and acquisition frenzy and high price stock
valuations. By 2003 global FDI flows contracted by half but recovered
partially in 2004 and 2005 when the flows again reached a level of $900
billion. The contribution of FDI to trade growth is particularly evident
in the case of China where foreign-invested enterprises account for
more than half of its merchandise exports.
According to estimates of the WTO Secretariat, the value of world

merchandise exports rose by 13 per cent and reached $10.2 trillion in
2005 thereby exceeding slightly the rise in the value of world services
exports. The major features of global trade developments in 2005

One of the Uruguay Round’s achievements was that the share of duty free lines in developed countries’
imports of industrial products rose from 20 to 43 per cent.

These values refer to averages of FDI in- and outflows (UNCTAD, 2005 and UNCTAD, 2006a).

WTO (2006).

The value of services exports amounted to $ 2.4 trillion in 2005 reflecting an increase of 10 per cent.
included the marked rise in oil and other commodity prices, which
benefited the exporters of primary commodities, and the continued
outstanding trade growth of China in manufactured goods and of
India in services trade. The combination of these three phenomena
has lifted the share of the developing countries in world merchandise
trade to 34 per cent, a new record level in the post WWII period. The
emergence of China as the third largest merchandise trader, with a
large trade surplus in manufactured goods, and the dynamic growth of
India’s software exports over the last five years has raised anxieties in
many parts of the world that, as China becomes the factory and India
the office for the world economy, the other regions would suffer from a
lack of employment growth.
In order to place these anxieties in perspective it will be useful to

recall a few basic facts on the global employment situation. The global
labour force in 2005 numbered 2.8 billion, of which 0.55 billion were in
OECD countries. Although trade and FDI are playing an increasing role
in the global economy, most jobs in the world have yet to be directly
affected by these developments. This is true of both industrialized
and developing countries. In the former, over 70 per cent of total
employment is in the service sector and, in spite of the recent growth in
trade in services, most of this sector consists of non-tradable activity. In
the latter, especially in low-income countries, the bulk of employment
is still in subsistence agriculture and the informal economy, both of
which are also, for the most part, non-tradable activities. For the
majority of the world’s working population it is, therefore, still the level
of development and the performance of the domestic economies in
which they work that determine their job and income prospects.
Viewed as a whole, there have also been few dramatic shifts

in the global employment situation, certainly neither a dramatic
improvement nor deterioration over the past two decades. In the

OECD countries the levels of unemployment increased significantly in
the 1970s and remained high for the next two decades. Since 1994,
however, “labour market performance in the OECD area as a whole has
improved; the unemployment rate has come down, the employment
rate has gone up and the participation rate has risen” (OECD, 2005).
A similarly reliable assessment for developing countries as a whole
is difficult to arrive at because of the lack of data but the estimates
that have been made in spite of this difficulty do not show a dramatic
change. The ILO’s Global Employment Trends (2006) shows slight
increases in the unemployment rates in most developing regions
and a slight decline in the Middle East and North Africa over the past
decade. There has also been little change in the overall levels of
underemployment and in the proportion of the working poor in total
employment.
Over the same period, however, there has been a significant

reduction in poverty and hence the proportion of working poor,
in China and, to a lesser extent, in India. This implies that there has
been a significant deterioration in the working poor and poverty
situation in other parts of the developing world, especially in sub-
Saharan Africa. This latter fact has given rise to several concerns over
the adequacy of employment growth in the global economy. A major
concern relates to the fact that many developing countries have yet
to share in the benefits of globalization in terms of higher rates of
growth of output and employment (WCSDG, 2004). A related concern
is that relatively stable unemployment and underemployment rates
may simply be masking the fact that there has been a deterioration
in the quality of employment. The argument is that while overall
job creation may be adequate, most new jobs have consisted of low
quality employment, for instance, in the informal economy. There is
consequently a growing recognition that it is important to find ways of

increasing the pace at which good jobs are being created in the global
economy.
Turning to the structure of global employment, this has continued

to shift but only gradually. The share of global employment in
agriculture has continued to fall. Nevertheless, in 2005 it still accounted
for 40 per cent of total employment, most of which is in the developing
countries. The share of industrial employment has remained constant
at 21 per cent; however given the growth in total employment over the
period, this represented an additional 95 million jobs in the industrial
sector, most of which were created in developing countries. The share
of employment in services increased throughout the world. This is a
continuation of a long-standing trend in the industrialized countries.
In the developing countries this is partly a reflection of the continued
growth of employment in the informal economy.
This aggregate picture of gradual change is not, however,

inconsistent with the fact that there have indeed been countries
and economic sectors that have experienced intense change in
employment conditions as a result of globalization. The limited
change in the aggregate employment picture is nonetheless a useful
reminder that the scale of these changes has been small in relation
to the whole. This is a reflection of the fact that the growth of trade
and investment flows has so far been highly concentrated, in terms of
a North-South divide as well as, within the South, in a small number
of developing countries. Nevertheless, in spite of this pattern of
concentration, the size of the impact of trade and investment flows on

These considerations have led to calls for greater priority to be given to the goal of full and productive
employment and decent work in both international and national policies. The most recent example of this is the
ECOSOC Ministerial Declaration in July 2006 on “Creating an environment at the national and international levels
conducive to generating full and productive employment and decent work for all, and its impact on sustainable
development”(www.un.org/docs/ecosoc).
employment in the global economy is likely to increase significantly

since the group of globalizing countries from the South now includes
China and India, the two most populous countries in the world. Both
have experienced very rapid growth as well as increasing integration
into the global economy.
C. Trade and employment: theory and evidence
Trade expands because individuals and companies around the

globe increasingly resort to importing and exporting goods and
services, presumably because they find it advantageous. Adam Smith
made reference to the propensity in human nature to “truck, barter, and
exchange one thing for another” that would lead to a division of labour
advantageous to everybody involved. Indeed, by reshuffling resources
in accordance with the principles of comparative advantage, they can
be used more appropriately and effectively for production. The result
is increased efficiency, reflected in lower prices of inputs and final
goods. In addition, consumers and producers benefit from a larger
choice of products and quality. For all these reasons, market opening
is expected to boost national incomes and possibly economic growth.
The “reshuffling” of production factors necessary to exploit

comparative advantage can in real life take the form of company
closures and job losses in some parts of the economy, with start-
ups of new firms, investment in increased production and vacancy
announcements in other parts of the economy. Trade liberalization
is therefore associated with both job destruction and job
creation. Whether the resulting net employment effects are positive
or negative in the short run mainly depends on country specific factors
like the functioning of the labour market. In the long run, however, the
efficiency gains caused by trade liberalization are expected to lead to
positive employment effects, either in terms of quantity or quality of

jobs or a combination of both.
The theoretical literature provides interesting insights into

the process of job destruction and job creation following trade
liberalization and illustrates how different country characteristics,
including labour market policies, can affect temporary and permanent
employment effects at the sectoral or country level. Due to a
combination of methodological and data problems, it has been more
difficult to provide robust empirical evidence for the relative impact
of trade liberalization and other domestic policies on employment
changes and economic growth. The empirical literature on trade and
the quality of employment, for instance, has focused on the income
effects of trade. Although there is broad agreement that the quality
of employment involves other aspects, like safety conditions in the
workplace or job stability, no appropriate data exist so far that would
allow economists to provide a systematic analysis of changes in job
quality according to this broader concept.
1. Trade and income levels
With respect to income, the theoretical literature mentioned before

predicts that trade liberalization raises average income levels, and
some contributions to the theoretical growth literature suggest that
trade also stimulates growth. A large number of multi-country case
studies and econometric studies using cross-country datasets have
tested the empirical validity of this trade-growth relationship but so far
there is no full agreement among economists concerning the precise
nature of this relationship.

See Baldwin (2003) for an overview of the openness and growth debate. Main contributions to this
literature are Dollar (1992), Harrison (1996), Rodriguez and Rodrik (2001) and Sachs and Warner (1995) and more
recently: Dollar and Kraay (2004), Loayaza, Fajnzylber and Calderón (2005) and Wacziarg and Welch (2003).
There are several reasons for this continuing disagreement.

Differences in the quality and detail of data being analysed are
one source of disagreement among economists. In particular, in
developing countries the lack of good data often makes it necessary to
have recourse to case studies. While many insights have been revealed
from such studies, some are reluctant to draw broad generalizations
from them because of their specificity and the bias that the personal
viewpoint of the authors may introduce in such studies. Another
source of disagreement is that some econometric studies analyse the
impact of trade on growth, while others emphasize instead the need to
focus on the impact of trade policies. Focusing on “openness”, typically
measured as the ratio between exports and/or imports on the one
hand and GDP on the other hand, ignores the fact that the reduction
of trade barriers does not necessarily lead to more trade. Indeed, a
disappointing supply response to policy reform has been observed
in numerous developing countries and lies at the origin of the recent
debate on aid for trade. Another problem with the use of this measure
is that countries whose incomes are high for reasons not related to
trade, may well be characterized by a high trade share. If this is the
case, the finding of a positive relationship between trade shares and
income per person using standard econometric approaches does not
allow for the conclusion that trade has a positive effect on growth.10
Notwithstanding the discussed data and methodological problems

encountered by those analysing the relationship between trade and
average income, and notwithstanding the persistent disagreement on
the importance of this relationship, there appears to be agreement that,

Baldwin (2003).

See also UNCTAD (2006b) and the discussion in section E.4.a of this study.
10
Such econometric work would suffer from a so-called endogeneity problem. See Lee et al. (2004) for a
recent paper that attempts to control for the effect of growth on openness. The results of this paper suggest that
openness has a positive effect on growth, although a small one. This result stands, despite the equally robust effect
of growth on openness.
on balance, general economic openness is much more favourable to

growth than a general inward-looking economic approach. Significant
uncertainty, however, exists in the profession as to the exact policy mix
which can maximize the growth effects of trade reform at a certain
time and under certain circumstances.
Another strand of literature that gives insights into the income

effects of trade reform is the so-called Computable General Equilibrium
(CGE) literature. CGE models are computer-based simulations, like
laboratory experiments, that show what today’s economy will look like
in the future as the result of a specified set of policy changes. Different
simulations have generated widely varying predictions as to the
dimensions of the economic gains for different trade liberalization
scenarios.11 One interesting exercise that has been performed with this
tool is the analysis of the geographical distribution of economic gains,
although again with differing outcomes. Some studies, for instance,
predict that agricultural liberalization in the context of the Doha Round
will lead to losses in sub-Saharan Africa, while other studies predict
gains for the region.12
In general, both strands of empirical literature analysing the

trade and income relationship have one major shortcoming that is of
relevance for this study: they look at overall or average income gains
for the economy and do not look at the effects of trade on subgroups
within the economy. In particular, the results of this literature do not
automatically allow for conclusions as to the effect of trade on the
average income of workers (as opposed to capital-owners, for instance),
of the poor or of the median family in the economy.
11
See Piermartini and Teh (2005) for an overview.
12
See Anderson and Martin (2006), Bouët et al. (2005), Decreux and Fontagné (2006) and Polaski (2006).
There are two exceptions to this general rule in the CGE

literature. Polaski (2006) uses a setup that allows for the analysis of the
returns to certain production factors and finds, for instance, that returns
to agricultural labour would increase in most developing countries as
the result of the so-called Hong Kong Scenario for trade liberalization,
while the model’s assumptions would lead to largely unchanged
wages for unskilled labour.13 The study by Anderson and Martin (2005)
provides explicit results for changes in the incidence of poverty and
predicts a reduction in poverty resulting from more or less ambitious
liberalization scenarios in the Doha Round.
A small number of cross-country econometric studies also provide

insights into the income effects of trade reform for subgroups in the
population. The study by Rama (2003) explicitly looks at the effects of
trade reform on wages and finds that wages grow faster in economies
that integrate with the rest of the world. The author concedes that
openness to trade can have a negative impact on wages in the short
run, but finds that it only takes a few years for this effect to change
sign. The impact of foreign direct investment is highly positive even
in the short run, highlighting the importance of a good investment
climate. Also Lopez (2004) differentiates between the short and long-
run impact of different policies, including the impact of open trade
regimes. He finds that trade openness raises inequality and stimulates
growth at the same time; he therefore refers to trade liberalization as
a win-lose policy. Improvements in infrastructure and in education
on the other hand reduce inequality and increase growth at the same
time; so does inflation reduction.
The empirical work by Dew-Becker and Gordon (2005) has

drawn the attention of policy-makers to the fact that the evolution
13
The study assumes an abundant supply of unskilled labour in the developing world.
of average income can deviate significantly from the evolution of

median income. In particular, they find that in the United States
over the entire period 1966-2001, as well as over 1997-2001, only the
top 10 per cent of the income distribution enjoyed a growth rate of
real wage and salary income equal to or above the average rate of
economy-wide productivity growth. This finding suggests that the
income distribution in the United States is becoming increasingly
unequal, an issue that will be discussed in more detail in section D of
this study. Suffice to say that changes to income distribution are likely
to become a significant matter of concern for policy-makers if they
negatively affect the incomes of median families, i.e. those families that
can be determinant for election outcomes.
2. Trade, job destruction, job creation and unemployment:

what theory tells us
Traditional trade models assumed that countries’ technological

capacities and/or relative endowments with production factors
like capital, land, skilled and unskilled labour would determine
the competitiveness of different sectors at the global level. As a
consequence each country would have a set of identifiable exporting
sectors and import-competing sectors. Exporting sectors would
expand production and their demand for labour, while import-
competing sectors would reduce production and possibly lay off
workers. But traditional trade models were not concerned with the
reshuffling process itself, i.e. the loss of jobs and the process involved
in finding a new one. It was assumed that all workers were employed
before trade liberalization and that adjustment to the reform would
take place instantaneously.14 Given this assumption that laid-off

workers would automatically move into new jobs, the issue of trade-
related unemployment did not arise.
However, this assumption of full employment did not imply

that there were no other effects of trade liberalization on
workers. Although it did not affect the quantity of jobs, trade
liberalization affected the quality of jobs. Since it was assumed that
exporting and import-competing sectors employ different types of
workers or employ them in different proportions, trade liberalization
would in the long run affect the relative demand for different types of
workers; and this change in relative demand would result in relative
income changes. In other words, traditional trade models would not
allow for the conclusion that trade affects the level of employment
or unemployment. They would rather lead us to expect that some
workers may be better or worse off in the long run because of changes
in their wages. In particular, economists predicted that trade between
industrialized and developing countries would lead to decreases in the
(relative) wages of low-skilled workers in industrialized economies and
increases in those wages in developing countries. On average, though,
individuals would be better off as a result of the overall economic
efficiency gains triggered by trade liberalization.
Trade reform can, however, have employment effects if the

economy was for some reason not characterized by full employment
before the reform, or if some domestic policy or labour market
characteristic hampers the adjustment process. For instance, in
economies with a highly elastic labour supply, e.g. a large latent
14
See Mussa (1978) for a traditional (Heckscher-Ohlin) model with adjustment costs. The model shows how
an economy moves from an autarky equilibrium to a trade equilibrium if adjustment takes time and is costly. One
of the possible outcomes is that the economy never manages to reach the trade equilibrium that would be optimal
in the absence of adjustment costs. It is worth noting that the “sticky” production factor in this model is capital and
not labour.
supply of labour in the rural areas before trade reform, exporters can
expand production by attracting workers from those rural areas at
existing wage rates. This situation is more likely to occur in developing
countries and in such cases trade liberalization would lead to increases
in formal employment levels rather than to changes in wages.
As for the interaction between labour market policies and trade

policies, the theoretical literature has analysed a number of different
setups that can explain a link between trade liberalization and
unemployment levels. Minimum wages, for instance, keep wages
above the equilibrium level for certain types of workers with the
result that supply exceeds demand for those workers and there
is unemployment. If those workers are mainly active in import-
competing sectors, then trade liberalization would further reduce
demand for those workers and unemployment would increase.15
If, for instance, in industrialized countries minimum wages for low-
skilled workers are higher than employers are willing to pay for their
services, trade with developing countries could result in increased
unemployment of low-skilled workers.
Other contributions to the theoretical literature have put more

complex labour market models on top of a trade model.16 So-called
efficiency wage models, for instance, assume that employers pay
wages above the market clearing level in order to increase their
productivity. Unemployment exists in the absence of trade, but
trade reform may smooth or exacerbate the unemployment problem
depending on its effect on the relative demand for different types of
workers. Something similar happens in labour market models with
search frictions, i.e. models in which laid-off workers and firms with
15
See Brecher (1974) for an early model on trade reform in the presence of minimum wages.
16
E.g. Matusz (1996) and Davidson, Martin and Matusz (1999).
vacancies need time to find an appropriate match. If such models

are combined with a trade model they give information on the net
unemployment effects of trade and also provide insights into the
effects on job destruction and job creation.17
The different models tend to have in common that changes in the

relative demand for labour triggered by trade reform can result in
increased unemployment of certain types of labour and decreased
unemployment of other types of labour. In other words, labour
market characteristics can explain why trade reform may result in
unemployment effects rather than wage effects, but the underlying
reason for these effects is the same in all cases: traditional trade
models predict a change in the relative demand for workers. Some
workers will be less in demand on the market than others, and
the former will be affected negatively in terms of remuneration
or in terms of their chances to find a job. It has, for instance, been
argued that labour market characteristics explain differences in
wage and employment trends in the United States and the European
Union. While wage inequality between skilled and low-skilled labour
has increased over time in the United States, unemployment rates of
low-skilled workers have increased in the European Union.
The discussion so far would justify policy-makers’ concern about

worker transition between sectors and about the distributional effects
of trade reform in the long run. More recent trade literature indicates
that adjustment processes may not only be observed between
sectors but that significant job reallocation may also take place within
sectors. In particular, the traditional approach has been challenged by
two types of new trade models: the sometimes called “new-new trade
models” that introduce firm heterogeneity and fixed-market entry
17
See Jansen and Turrini (2004).
costs into a trade framework, and a recent model of “task trade” used
to evaluate the implications of offshoring.18
The new-new trade literature emerged in response to a number of

empirical findings from the literature analysing plant level data that
were at odds with the predictions of traditional trade models. Bernard
and Jensen (1999) found that exporters in an industry tend to be more
productive than other plants in the same industry. In a later paper
they elaborate on this point and explain that the positive correlation
between exporting and productivity levels appears to come from
the fact that high productivity plants are more likely to enter foreign
markets.19 The productivity path for a plant switching from being a
non-exporter to an exporter shows a rise in productivity levels before
and during entry, and a flat trajectory thereafter. Their results show that
employment and output growth rates are much higher for exporters,
and employment growth continues to increase after entry into foreign
markets. From 1983 to 1992, more than 40 per cent of total factor
productivity growth in the US manufacturing sector resulted from
changing output shares across plants. Almost all of these re-allocative
effects resulted from the fact that high-productivity exporters grew
faster than lower-productivity non-exporters. Trade thus appears to
promote welfare by facilitating the growth of high-productivity plants,
not by increasing productivity growth at those plants.
The new theoretical trade literature reflecting these mechanisms

has also implications for the employment effects of trade reform. In
particular, it predicts that trade reform will trigger job creation and job
destruction in all sectors, as both net-exporting and net-importing
sectors will be characterized by expanding high-productivity firms
18
See Melitz (2003) and Helpman et al. (2003) for early papers of the “new-new trade theory” type and
Grossman and Rossi-Hansberg (2006) on offshoring.
19
Bernard and Jensen (2004).
and low-productivity firms that shrink or close down.20 The latter firms
tend to be relatively small firms that do not manage to enter foreign
markets and produce only for domestic consumers. For policy-
makers this implies that a lot of reshuffling of jobs takes place within
sectors.21 This may be good news, as it is generally expected that it is
more difficult for workers to move across sectors than to change firms
within the same sector. A move across sectors may, for instance, imply
higher retraining costs for workers and longer search periods. On
the other hand the fact that adjustment occurs in all sectors implies
that a wider range of jobs are at risk. While traditional trade models
would suggest that policy-makers who wish to assist workers focus
on so-called comparative disadvantages sectors, i.e. those that can be
identified as import-competing sectors, more recent research suggests
that such targeted intervention is not justified. Instead, this literature
may explain why surveys in industrialized countries have revealed that
workers in very different types of industries report greater perceived
job insecurity as countries liberalize.22
Also the recent offshoring literature suggests that job destruction

and creation will not take place according to a well established sectoral
pattern.23 In addition this literature suggests that the cleavage of the
labour market will not take place according to skill levels. Instead
the key distinction lies in the tradability of services. Those tasks that
can be provided at a distance are likely to be offshored. It has been
argued that such jobs can be characterized by four features: IT
20
See in particular Bernard et al. (forthcoming).
21
Wacziarg and Wallack (2004) focus on the pattern of reallocation of labour following trade
liberalization. They examine the impact of trade liberalization episodes on movements of labour across sectors
for 25 countries, mainly developing and transition economies, and find weakly negative effects of liberalization on
the extent of intersectoral labour shifts at the economy-wide 1-digit level of disaggregation. They find increased
sectoral change after liberalization at the more disaggregated 3-digit level within manufacturing, although the
estimated effects are statistically weak and small in magnitude. They also find that the effects of liberalization on
labour shifts differ across individual countries, in a way related to the scope and depth of reforms.
22
See Scheve and Slaughter (2004).
23
Grossman and Rossi-Hansberg (2006).
intensity, output that is IT transmittable, tasks that are codifiable,

and that require little face-to-face interaction.24 Such tasks may
include high-skilled jobs like security analysts or low-skilled jobs like
switchboard operators and are not necessarily sector specific. All in
all the impression that arises from the most recent trade and offshoring
literature is that it will be increasingly difficult for policy-makers to
predict the direction and nature of employment changes.25
3. The evidence: trade and (un)employment
The economic literature has produced a large number of empirical

studies analysing the employment effects of trade. Different
approaches have been taken to examine this question and so far
no clear message emerges from the literature. The only general
conclusion that may be justified is that employment effects depend
on a large number of country-specific factors. A major shortcoming
of the existing literature is that most studies of trade and employment
refer to manufacturing employment, with little indication of whether
their results can be generalized to agriculture or services, or indeed
anywhere outside the formal sector.26
One major difficulty the relevant studies face consists in

distinguishing the different possible causes of employment changes.
Labour market policies, macroeconomic policies or movements along
the business cycle are only a few examples of factors that may affect an
economy’s employment level. For instance, in their study on the impact
of the Canada-US Free Trade Agreement, Gaston and Trefler (1997), made
a distinction between the employment effects of the trade agreement
and those of a general recession affecting both trading partners in the
24
Van Welsum and Reif (2005) and Van Welsum and Vickory (2006).
25
Baldwin (2006).
26
Hoekman and Winters (2005).
same period. Similarly, other factors such as the job-search behaviour

of workers also affect unemployment rates. Rama (2003), for instance,
points out that temporary increases in unemployment following
trade reform have been observed in many developing countries,
even among successful developing country globalizers that could be
considered as “models” in their own regions. However, he suggests
that only a fraction of the unemployed concerned are out of a job
due to globalization. Instead, unemployment is to a significant extent
affected by so-called queuing for “privileged jobs”, especially in the
public sector, a common phenomenon among the educated urban
youth. Notwithstanding those temporary surges in unemployment
rates, Rama (2003) finds that unemployment rates do not appear to be
systematically higher in more open economies.
The use of different methodologies and datasets can have a

significant impact on the results economists obtain. For example,
the studies by Gaston and Trefler (1997) and Trefler (2001) both
analyse the employment effects in Canadian manufacturing following
the free trade agreement between Canada and the United States.
Gaston and Trefler (1997) find that tariff cuts contributed to reduced
employment during the years following the agreement but that
they also contributed to dramatic productivity increases leading to
important long-run efficiency gains. In the first five years following the
implementation of the FTA, Canada lost 390,600 jobs in the tradable
sector.27 Gaston and Trefler (1997), however, show that those job
losses were mainly due to economic recessions in both the Canada
and the United States during the same period (recessions that were
not caused by the FTA). In fact, as a result of the recession, exports
and imports contracted over most of the five years following trade
27
As a consequence, calls for the re-negotiation and abandonment of the agreement enjoyed popular
political support in Canada.
liberalization. After controlling for the recession, it appears that FTA-

mandated tariff cuts accounted for only 9-14 per cent of the jobs
lost over this period. In a more recent paper on the effects of the
Canada-US Free Trade Agreement, Trefler (2001) finds instead a bigger
role for the tariff cuts in the employment declines. According to his
estimates, close to 30 per cent of the observed employment losses in
manufacturing were a result of the FTA tariff cuts. In those industries
that experienced the largest tariff cuts, as much as two-thirds of the 25
per cent reduction in employment is estimated to have been caused
by the FTA. The fact that manufacturing employment has largely
rebounded since 1996 suggests that the adjustment process lasted
about seven years. During this adjustment process many workers
moved to high-end manufacturing jobs, while at the same time there
were dramatic productivity increases in low-end manufactures. Both
aspects reflect important long-run efficiency gains from trade.28
Another difficulty that empirical studies on the employment

effects of trade face is that it is not always straightforward to identify
periods of trade reform. This is particularly true of industrialized
countries that have tended to open up gradually over a relatively long
time period. Much work on developed countries has therefore focused
on the impact of exchange rate changes as opposed to trade reforms,
the former representing a significant source of changes in terms of
trade.29 One interesting finding of that literature is that changes in
the trend of real exchange rates and cyclical changes have different
effects on net employment. Using establishment panel data for the
US, Klein, Schuh and Tries (2003) find that changes in the trend of the
real exchange rate lead to a significant increase in job reallocation but
do not affect net employment as both job destruction and job creation
28
Note also that Trefler (2001) finds increases in workers’ annual earnings and that these increases are
significantly higher in those industries that cut tariff rates most.
29
increase. Instead, a cyclical variation affects job destruction and leaves

job creation unaffected. As a result, a cyclical appreciation of the
exchange rate reduces net employment.30
In industrialized countries there also appears to be concern

about the stability of employment. It is, indeed, a popular idea that
higher competition in goods markets, lower trade barriers and higher
integration of goods markets across countries, higher globalization and
outsourcing, are all leading to a more turbulent environment in terms
of job destruction and job creation. When the environment becomes
more turbulent, existing labour market institutions may become
dysfunctional and lead to substantially higher unemployment.31
Blanchard (2005), however, points out that data do not support this
idea. In the 1970s and 1980s the measures of reallocation – typically
based on the standard deviation of rates of change of employment,
either across sectors or across regions – showed no trend increase. The
evidence as of the early 1980s is well summarized in Johnson and Layard
(1986), who construct a table of standard deviations by industry or by
region for a number of countries. Half of the standard deviations are
higher in 1979 than in 1960, half are lower. In all cases, the changes are
small. But perhaps, the increase in reallocation is taking place mostly
within industries or regions, rather than across industries or across
regions. In that respect, measures of job flows based on plant-level
data are clearly preferable.32 The practical issue is that they typically
do not go back far enough in time. But to the extent that they do, they
also show little sign of increased turbulence.
30
Gourinchas (1999) finds that in France employment in traded-sector industries is very responsive to real
exchange rate movements. The results in the paper indicate that a modest 1 per cent real appreciation leads to
a decline in tradable employment of roughly 0.95 per cent, i.e. 35.000 jobs, over the course of the following two
years.
31
Jansen and Turrini (2004) show in a model with frictional employment that increased volatility does not
necessarily lead to higher unemployment.
32
For instance, along the lines of the work by Davis et al. (1996).
Although the existing evidence appears to indicate that labour

markets have not become more turbulent, Blanchard (2005) argues that
the argument is not settled. He points to two reasons, one empirical,
the other theoretical. The empirical reason is that other – admittedly
conceptually less appropriate – measures of turbulence send a different
message from job flows. For example, the measure of sales volatility
constructed by Diego Comin and Thomas Philippon (2005), based on
firm level data, shows a steady increase in volatility over time since
the late 1960s. The evidence on flat job flows and increasing sales
variability have yet to be reconciled. The theoretical reason is that one
can construct models in which turbulence is not necessarily reflected
in higher job flows, e.g. Ljunqvist and Sargent (1998, 2005). Increased
turbulence is reflected in an increase in the specificity of skills associated
with particular jobs. The implication is that an involuntary job change
is associated with a larger drop in the wage distribution facing a laid-off
worker than was the case in the past. In other words, turbulence does
not lead to more volatile job markets but to stronger negative effects
in the case of job loss. In such a scenario, if unemployment benefits
are linked to past wages, the unemployed may have high reservation
wages, and remain unemployed for a long time.
Studies on developing countries have tended to focus on the

extent of (un)employment effects of trade liberalization rather than on
changes in the volatility of labour markets. Many developing countries
have reformed their trade regimes strongly in the recent past, which
allows economists to analyse episodes of deep trade liberalization
where the source of the shock can be clearly identified in time.33
This greatly facilitates the attribution of effects to trade, making the
developing country-based literature more informative/robust in terms
of its conclusions.
33
A comprehensive, retrospective World Bank study of trade reforms

conducted in developing countries found that in eight out of nine
countries manufacturing employment was higher during, and one year
after, the liberalization period than before (Papageorgiou et al. 1990).34
Only in Chile did manufacturing employment decrease significantly
during and after trade liberalization.35 It has been argued, however,
that institutional factors rather than trade liberalization explain this
development. This view was confirmed by the analysis of Cox Edwards
and Edwards (1996), who find that the effects of working experience
and schooling outweigh the effects of trade liberalization on a Chilean
worker’s probability of becoming unemployed, as well as on the
duration of unemployment.
The results of the Papageorgiou et al. (1990) study have, however,

been challenged.36 Greenaway (1993) and Collier (1993) have
questioned its findings primarily on methodological grounds. More
recently, Agenor and Aizenman (1996) have pointed out that these
studies provide only limited evidence on changes in employment
in non-manufacturing production activities or changes in the
aggregate unemployment rate. A more recent World Bank study
on globalization (Dollar and Collier, 2001) takes a less sanguine view
of the employment effects of trade liberalization than the earlier
study. 37 While reiterating the benefits of trade liberalization for both
employment and wages over the long run, the study recognizes that
there are significant transitional problems that need to be faced. It
notes that “a series of case studies on the effects of trade liberalization
34
The study analyses thirteen liberalization periods in the following nine countries: Argentina (1967-70)
and (1976-80), Brazil (1965-73), Chile (1974-81), the Republic of Korea (1978-79), Peru (1979-80), Philippines (1960-
65) and (1970-74), Singapore (1968-73), Sri Lanka (1968-70) and (1977-79), Turkey (1970-73) and (1980-84).
35
Revenga (1995) also finds negative employment effects for the case of trade liberalization in Mexico
during the period 1984-90. Yet, due to the study’s focus on firm-level employment instead of total employment its
results can only be taken as indirect evidence of the possible existence of adjustment costs in the case of Mexico.
36
See the discussion in Lee (2005).
37
Lee (2005).
shows a considerable dispersion of the net impact on employment.”

More significantly, it highlights the problems that “small declines in
employment hide substantial job churning” and that “some of the
important losers from globalization will be formal sector workers in
protected industries.” Also the overview of a number of country case
studies in Box 1 confirms that employment effects differ significantly
across countries.
Box 1: A selection of country case studies on the employment

effects of trade reform
Milner and Wright (1998) investigated labour market responses

to trade liberalization in Mauritius. They show that manufacturing
employment increased significantly in the period following the
1983 trade liberalization. Though employment increases in the
long run exceeded those that occurred immediately after the
trade liberalization, the short-run impacts on employment were
significant and positive. Rama (1994), in contrast, finds a negative
effect of trade liberalization on employment in his analysis of
trade policy reform in Uruguay in the late 1970s and early 1980s.
Further evidence on developing countries is given by Harrison and
Revenga (1995) in a study cited by Matusz and Tarr (1999). They
find evidence of increases in manufacturing employment following
trade liberalization periods in Costa Rica, Peru and Uruguay.
Instead, in a number of transitional economies (Czechoslovakia,
Poland and Romania), employment fell during the transition
period. As the authors note, however, those countries were also
undergoing significant other reforms that went well beyond trade
liberalization.
Fu and Balasubramanyam (2005) use a panel data set for TVEs

(Township and Village Enterprises) in 29 provinces in China over
the time period 1987-1998, to analyse the effects of exports on
labour demand. They find a positive and significant impact of
exports on employment. A 1 per cent increase in export volume
raises employment by 0.17 per cent. The labour demand elasticity
of exports is similar to that of domestic production. This suggests
that exports simply draw upon existing surplus productive
capacity and labour and provide a vent for these surpluses. With
a total number of employees of 125.4 million for the year 1998 in
the township and village enterprises, a 1 per cent increase in total
exports would have created about 213,000 job opportunities in
the sector. During the 1998 to 2003 period, TVEs exports grew at a
15.5 per cent per year on average. For a country such as China with
a large volume of underemployment, this means about 3 million
job opportunities every year in the TVE sector fuelled by its fast
export growth.
Bentivogli and Pagano (1999) analysed the effects of trade with

the newly industrialized Asian economies on the labour markets
of Germany, France, Italy and the United Kingdom. The analysis
confirms that, despite the growing importance of this trade,
problems in the European labour market cannot be explained by
the increase in imports of manufactures from the Asian countries.
In particular the authors find that workers’ personal characteristics
(gender and education) are significantly more important than
exposure to import competition in explaining unemployment.
The distributional effects of employment changes caused by trade

have been analysed in a recent study of Madagascar, Nicita (2006).
Madagascar’s exports of textile and apparel products grew from
about US$45 million in 1990 to almost half a billion in 2001. Fueled
by an increase in exports, employment in Madagascar’s textile and
apparel industry grew at a rate of more than 20 per cent per year in
the late 1990s. The industry had an average earning premium of about
40 per cent over the average income of the workers in the informal
economy. Yet Nicita’s (2006) findings point to a strong variation in the
distribution of the benefits from export growth with skilled workers
and urban areas benefiting most. From a poverty perspective, export-
led growth in the textile and apparel sector had only a small effect on
overall poverty, according to the author. Nicita’s (2006) study points
to two reasons for this. First, a large majority of the poor are unable to
enjoy the new employment opportunities, given their lack of the skills
sought by the expanding textile and apparel export industry. Second,
most of the poor reside in rural areas where the employment effect is
small.
D. Trade and inequality
Economists have always been aware of the fact that the gains from
trade are likely not to be distributed evenly within the population.
Indeed, traditional trade models predict that there will be winners and
losers from trade and that losers may even be worse off in absolute
terms. This may not be a problem if the losers are individuals at the
higher end of a country’s income scale, but it may be if the opposite
is the case. Inequality would then increase and depending on the
extent of the change, governments may want to consider designing
compensation mechanisms to redistribute some of the gains to those
who lose. In fact, such mechanisms may be necessary in order to pre-
empt resistance against trade reform.
It is therefore important to have a good understanding of the link

between trade and inequality and the trade literature has devoted a lot
of attention to this question. First of all it is important to understand
who are the losers: are they individuals at the high end or at the low end
of the income scale, are they wage earners or capital owners, are they
workers in the formal or in the informal economy? Observed increases
in the wage premium, i.e. the difference between the wages of skilled
workers and those of unskilled workers, appear to indicate that low-
skilled wage earners have been losing out in recent years. Increased
wage inequality and, more generally, income inequality appears to be
a common phenomenon around the globe.38 But other factors than
globalization may be driving such increases in skill premium, the first
suspect being technological change. Economists have therefore tried
to disentangle the two mechanisms, i.e. they have tried to distinguish
changes caused by technological change from those caused by trade
reform. The research discussed further on confirms that technological
change is the main driver of inequality, which may also explain why
increases in inequality have been observed in many developing
countries, a phenomenon at odds with the predictions of traditional
trade models.
Indeed, traditional trade models concentrate on explaining

trade patterns and flows between significantly different
countries. They have therefore been used to predict the outcomes
of trade liberalization between industrialized countries on the one
hand and developing countries on the other hand. But as a matter
of fact industrialized countries trade far more with other industrialized
countries than with poor countries. The question therefore arises,
whether and how this phenomenon relates to the one of increased
38
This does not mean that all individual countries are affected by it. Ghose (2003), for instance, reports
decreasing wage inequality in the Netherlands and in the United Kingdom for the period of 1980 to 1996.
skill premiums. Is it only trade with countries like China and India which
exercises downward pressure on low-skilled wages in Europe or does
trade with the United States have similar effects? And what about the
role of FDI and outsourcing in all this?
1. Trade and inequality: what theory tells us
(a) Trade and the relative demand for different types of labour
The classical link between trade and income inequality is based on

the Stolper-Samuelson Theorem developed in a model that assumed
full employment. According to this theorem inequality is most likely
to increase in industrialized countries as a consequence of trade with
developing countries, because the former are relatively well-endowed
with skilled labour.39 Along the same lines, we would expect to see
declining inequalities in developing countries. This would be the case
because developing countries are typically well endowed with low-
skilled labour relative to developed countries. When opening up to
trade, developing countries will therefore be more competitive in low-
skill-intensive-sectors and these sectors will expand. The increased
demand for low-skilled workers, who typically belong to the poorer
segments of the population, will lead to an increase of their wages
relative to the wages of skilled workers.40
39
According to the Stolper-Samuelson theorem, some wages may even go down in absolute terms.
40
Increased openness may also lead to changes in asset distribution that can be to the advantage or to
the detriment of the poor. Robinson (2000) illustrates this with the following example: “In the nineteenth century
as transportation costs fell and the European economies developed and created a large market for tropical crops,
Central American countries were ideally endowed to take advantage of the expanding world demand for coffee. In
Costa Rica this led the government to pass laws in 1828, 1832 and 1840 allowing peasants to farm and gain title
to frontier lands. This led to the creation of the famous class of Costa Rican yeoman farmers. In Guatemala the
profitability of coffee instead induced a mass land grab by political elites in the 1870s that led to the creation of large
coffee estates and the re-introduction of colonial forced labour laws which lasted until the democratic interlude
after 1945. As a result, land inequality is higher in Guatemala than in Costa Rica today, as is income inequality.”
The focus on the Stolper-Samuelson Theorem may be somewhat

misplaced in the case of industrialized countries as the majority of their
trade is with other industrialized countries rather than developing
countries. Trade among industrialized countries often takes place
within the same industries, i.e. Japan exports cars to the EU and vice
versa. This so-called intra-industry trade therefore would not create
the changes in relative demand for different production factors
predicted by the Stolper-Samuelson Theorem. Recent contributions
to the theoretical trade literature, like Manasse and Turrini (2001), have
therefore looked at the question whether intra-industry trade may
have an impact on the demand for high-skilled and low-skilled labour
and come to the conclusion that intra-industry trade, i.e. trade among
similar countries, can raise wage inequality within countries and also
within sectors. Duranton (1999) comes to a similar conclusion in a
model that combines intra-industry trade with technological change.
In his model trade and technological progress will go hand in hand
and together lead to increased wage inequality.
The role of technological change has also been examined in

conjunction with trade of the “traditional” North-South type, i.e.
trade between industrialized and developing countries by Zhu and
Trefler (2005). In this model technological change takes the form of
catch-up in the South. The model shows that technological catch-
up causes production of the least skill-intensive Northern goods to
migrate South where they become the most skill-intensive Southern
goods. Thus, the demand for skills and hence wage inequality rise
in both regions. As a result inequality rises in both North and South
according to a mechanism similar to the one described by Feenstra and
Hanson (1997).41 Southern skill upgrading is also correlated with the
41
Feenstra and Hanson (1997) analysed FDI flows from the US to Mexico and found that it was related to
activities that would be considered low-skill intensive in the US but relatively high-skill intensive in Mexico. As a
result the relative demand for skills increased in both countries.
trade-weighted average of Southern catch-up. The paper therefore

provides some insight into the complex evolution of Southern
inequality and its relationship to changing trade patterns.
(b) Trade, FDI and the possibility to substitute domestic

workers by foreign workers
Recent literature has emphasized a second effect trade may have

on labour demand. In addition to changing the level of demand
for certain types of labour, trade may affect the sensitivity of labour
demand to wage changes. It is argued that in an open economy
employers would be more likely to threaten to lay off workers when
they demand higher wages than in a closed economy. There are a
number of reasons why this may be the case. Companies acting in an
open economy face stiffer price competition than companies acting
in a closed economy. More competitive product markets mean that a
given increase in wages and thus costs translates into larger declines
in output and thus demand for all factors.42 Economists refer to this
increased sensitiveness as an increase in the price elasticity of labour
demand. This increased elasticity reflects the fact that employers
and the final consumers can substitute foreign workers for domestic
workers more easily.
Labour demand elasticity may also increase as a consequence of

increases in FDI.43 Suppose that a firm is vertically integrated with a
number of production stages. Stages can move abroad either within
firms as multinationals establish foreign affiliates or arm’s length
relationships by importing the output of those stages from other
firms. Globalization of production thus gives firms access to foreign
42
Rodrik (1997), Scheve and Slaughter (2004).
43
Scheve and Slaughter (2004).
factors of production as well as domestic ones, either directly through

foreign affiliates or indirectly through intermediate inputs. This
expands the set of factors firms can substitute towards, in response to
higher domestic wages, beyond just domestic non-labour factors to
include foreign factors as well. Thus, greater FDI raises labour demand
elasticities.44
Ethier (2005) presents a model where globalization explains

both the emergence of the skill premium and the presence of skill-
biased technological change. His model assumes that outsourcing
and unskilled labour are highly substitutable and that equipment
and skilled labour are complementary, that production methods
are flexible, and that the country undertaking outsourcing has a
significantly different structure from that providing it. In this setup,
a decrease in the cost of outsourcing will increase the skill premium
in both countries. Increased globalization is also associated with
increased fragmentation of production and more fragmentation is
associated with a more elastic demand for unskilled labour. The model
thus predicts a combination of outcomes that have been discussed in
the literature and that have been prominent in the public debate.
There are two important differences between the mechanisms

driving shifts in the demand for low-skilled labour discussed in the
previous section and those driving the changes in the elasticity of
demand discussed here. The first difference is that a shift in demand
will mainly take place in the case of inter-industry trade, i.e. when
countries with very different labour endowments trade. In contrast,
price elasticity of demand can also change when similar countries
trade, as a low-wage worker in one European country competes with a
44
This does not necessarily imply that workers abroad are “exploited.” The authors point out that several
studies have documented that establishments owned by MNEs pay higher wages than do domestically-owned
establishments.
low-wage worker in another European country. The second difference

is that for the demand to shift, trade actually has to take place, whereas
the price elasticity can be affected by the mere possibility of trade.
An increase in the price elasticity of the demand for labour could

affect the position of (low-skilled) workers through a variety of
channels.45 It may lead to lower labour standards or benefits, higher
labour market volatility, a lower bargaining power of workers and/
or increased difficulties for governments to carry out redistribution
policies.
With respect to the first effect, Rodrik (1997) elaborates that the
costs for increased labour standards or benefits are usually shared
by workers and employers. How these costs are shared depends on
the price elasticity of the supply and demand curve for labour. An
increase in the elasticity of labour demand will raise the share of the
costs that will have to be borne by workers. In other words, it becomes
more difficult for workers to make employers share in the cost of these
benefits/standards and in order to maintain benefits/standards workers
may have to accept lower wages.
Changes in the demand elasticity for labour can be linked to labour

market volatility because an increase in the elasticity of labour demand
results in larger shifts in labour demand in response to any type of
economic shock. In other words, for the same level of economic
volatility, wages and employment become more volatile. This makes
workers feel more insecure and may also lead to increases in the skill
premium if it is the case that low-skilled workers go through longer
spells of unemployment and/or have to accept bigger wage losses
after displacement.46
45
Rodrik (1997).
46
Scheve and Slaughter (2004), Rodrik (1997).
The third argument relates to the bargaining power of workers.

If domestic workers can be more easily replaced by foreign workers due
to increased trade, the bargaining power of workers declines.47 This
erosion of bargaining power may explain the loss of union membership
in the United States and in many European countries in the recent
past.48 The fourth impact, that of changes in the elasticity of labour
demand on the governments’ ability to redistribute, has been analysed
in Spector (2001). The paper argues that trade liberalization reduces
the ability of government to manipulate wages. In other words,
trade liberalization eliminates one of the redistributive tools available
in a closed economy and Spector (2001) shows that this can make it
impossible to maintain everyone’s welfare at the level reached before
the opening of borders.
2. The evidence: trade and wage inequality
Much of the empirical work on trade and wage inequality for

industrialized countries focuses on the relative importance of trade
liberalization and technological change for changes in skill inequality
in developed countries. The estimated impact of trade on the rise
in skill differentials differs widely across the various studies. At the
one extreme the studies of Berman, Bound and Griliches (1994) and
Lawrence and Slaughter (1993) attribute a small or no role to trade, but
an overwhelming role to technological change.49 On the other extreme
47
Robinson (2000) has argued that the military regimes in Chile and Argentina in the 1970s saw the power of
their domestic opponents increase through trade liberalization, as the unions were strong in the import substitution
sector.
48
See Jansen (2003).
49
Bhagwati (2000), instead, suggests that the effect of trade with poor countries on wage inequality in
industrialized countries has been positive and has moderated the adverse impact on real wages in the North from
other causes, like technical change. He argues that capital accumulation and technical change in the 1980s and
early 1990s offset the effects of trade liberalization and resulted in a reduction of the relative supply of labour
intensive goods. The net result of these forces would be an increase in Northern prices for labour-intensive
manufactures, a phenomenon that has indeed been observed in the period mentioned. The changes exogenously
emanating form the South thus push goods prices in the wrong direction and cannot be responsible for the decline
of the real wages in the North.
Wood (1994) attributes 70 per cent of the causation to trade. Cline

(1997) provides a comprehensive overview of the existing literature
and concludes: “A reasonable estimate based solely on the literature
reviewed in this chapter would be that international influences
contributed to about 20 per cent of the rising wage inequality in the
1980s.” Cline’s (1997) own empirical analysis generates different results:
“ … about one-third of the net increase in the skilled/unskilled wage
ratio from 1973-93 in the US was attributable to trade and an additional
one-ninth was attributable to immigration.”
More recent research into the causes of increasing wage inequality

in industrialized countries attributes only a minor role to trade. To
gauge the effect of international trade on the rising US skill premium,
Haskel and Slaughter (2003) analyse the sector bias of price changes
induced by changes in US tariffs and transportation costs. It is found
that in both the 1970s and 1980s cuts in tariffs and transportation cost
levels were concentrated in unskilled-intensive sectors. Despite this
suggestive evidence, the authors estimate that price changes induced
by tariffs or transportation costs produced a rise in inequality that was
mostly statistically insignificant. Thus, they do not find strong evidence
that falling tariffs and transport costs, working through price changes,
produced rises in inequality.
It is notoriously difficult to identify trade effects on wages in

transition economies, given that those economies have been
subject to so many changes at the same time. One of the few studies
analysing a transition economy is the paper by Goh and Javorcik
(2004), that examines the impact of Poland’s trade liberalization
1994-2001 on the industry wage structure. The liberalization was
undertaken in preparation for Poland’s accession to the European
Union and was more pronounced in industries with larger shares of
unskilled labour. The analysis indicates that a decrease in an industry
tariff was associated with higher wages being earned by workers

employed in the industry, when controlling for worker characteristics
and geographic variables. The finding is consistent with liberalization
increasing competitive pressures, forcing firms to restructure and to
improve their productivity, which in turn translates into higher profits
being shared with workers. It could also be potentially attributed
to trade liberalization lowering the costs of imported inputs, which
enhances firm profitability. The result holds when skilled workers are
excluded from the sample, thus suggesting that reductions in trade
barriers benefited the unskilled in terms of an increase in wages.
Empirical research into the link between trade and wage inequality
in developing economies has produced mixed results. In particular
there seems to be a difference between the effect trade has had on
wage inequality in Asian countries as compared to Latin America. Most
of the empirical evidence from East Asia confirms the predictions of
traditional trade models, as the gap in wages between skilled and
unskilled workers narrowed in the decade following trade liberalization
(the 1960s in the Republic of Korea and Chinese Taipei, and the 1970s in
Singapore).50 Wage differentials also decreased in Malaysia (between
1973 and 1989), but evidence on the Philippines is more ambiguous.51
In Latin America, evidence suggests that trade liberalization has

coincided with an increase in both income and wage inequality.52
Argentina undertook trade liberalization between 1976 to 1982 and
again from 1989 to 1993. The Gini coefficient rose from 36 in 1975 to 42
in 1981 and 47 in 1989 implying an increase in income inequality.53 The
50
Wood (1997).
51
ibid.
52
Data on income inequality are taken from Slaughter (2000). Information on skill differentials is taken from
Wood (1997). The findings of Robbins (1996) go in the same direction.
53
The Gini coefficient is a measure of income inequality in an economy. The higher the value of the
coefficient, the more unequal is the distribution of income.
skill differentials in wages increased in the first period but narrowed in

the second period. Chile liberalized between 1975 to 1979 and the Gini
coefficient rose from 46 in 1971 to 53 in 1980. The wage gap between
different skill levels also increased. Costa Rica liberalized from 1987 to
1993, the Gini coefficient increased from 42 in 1986 to 46 in 1989, and
the wage gap also increased. Finally, during Mexico’s liberalization
episode from 1985 to 1988 the Gini coefficient rose – from 50 in 1984
to 54 in 1989. To the extent that poor workers in developing countries
have a limited educational attainment, they would not be the main
beneficiaries from globalization if openness goes hand in hand with an
increase in the skill premium.54
Several explanations have been put forward for the differences in

outcome between East Asia and Latin America. One line of argument
focuses on the fact that Latin America opened its markets later than
the East Asian economies (Wood, 1997). As a result, the entry of China
and other large low-income Asian countries into the world market for
labour-intensive manufactures in the 1980s shifted the comparative
advantage of middle-income Latin American countries into goods
of medium skill intensity.55 Increased openness in middle-income
countries thus reduced the relative demand for unskilled workers by
causing sectors of low-skill intensity to contract. This would explain
why relative wages of unskilled workers decreased.
Another explanation for rising inequality in some developing

countries is that liberalization introduces new skill-intensive activities
into developing countries. For example, there is evidence that
liberalization in Mexico induced larger FDI inflows from the United
54
Rama (2003).
55
It has also been argued that most Latin American economies are abundant in natural resources rather
than low-skilled labour. This would also explain why wage inequality did not decrease in Latin America.
States.56 These FDI flows reflected the shift of low-skill intensive

activities from the United States to Mexico.57 Yet, Mexico’s relative
demand for skilled workers within industries in manufacturing rose
along with FDI inflows into those industries, which led to increases
in Mexican wage inequality.58 The explanation for this phenomenon
is that jobs which were low-skill intensive in the United States were
relatively skill-intensive in a country like Mexico.
The tariff schedule in place before trade liberalization will also

affect the impact trade has on wage inequality. If protection was
higher in the low-skill intensive sectors, then trade liberalization may
actually lead to shrinkage of these sectors. As a consequence, wage
inequality would increase. It has been suggested in the literature that
this phenomenon has been observed in Mexico and Morocco.59
Attanasio et al. (2003) find evidence for a link between trade, skill-
biased technological change and increases in wage inequality in line
with the theoretical literature discussed before. They investigate
the effects of the drastic tariff reductions of the 1980s and 1990s in
Colombia on the wage distribution. They identify three main channels
through which the wage distribution was affected: increasing
returns to college education, changes in industry wages that hurt
sectors with initially lower wages and a higher fraction of unskilled
workers, and shifts of the labour force towards the informal economy
that typically pays lower wages and offers no benefits. Their results
suggest that trade policy affected each of the three channels. The
56
Feenstra and Hanson (1997).
57
See also the previous discussion of the paper by Zhu and Trefler (2005).
58
Currie and Harrison (1997) focus on another explanation for rising inequality in developing countries
when liberalization occurs. They argue that the wage impact of liberalization depends crucially on the nature
of product market competition. If increased product market competition reduces the relative price of low-skill
intensive products, trade could have perverse wage-inequality effects. Currie and Harrison argue that this pro-
competitive effect of liberalization mattered in Morocco.
59
Hanson and Harrison (1999) and Currie and Harrison (1997) as quoted in Slaughter (2000).
increase in the skill premium was primarily driven by skilled-biased

technological change; however, the authors suggest that this
change may have been in part motivated by the increased foreign
competition to which the trade reform exposed domestic producers.
With respect to industry wages, they find that wage premiums
decreased by more in sectors that experienced larger tariff cuts.
Finally, they find some evidence that the increased size of the informal
economy was related to increased foreign competition as sectors
with larger tariff cuts and more trade exposure experienced a greater
increase in informality, though this effect was concentrated in the years
prior to the labour market reform. However, the authors conclude that
increasing returns to education, and changes in industry premiums and
informality alone cannot fully explain the increase in wage inequality
observed over this period, suggesting that overall the effect of the
trade reforms on the wage distribution may have been small.
3. The evidence: trade and income inequality
Labour income represents only a fraction of total income and

studies on wage inequality therefore only provide limited information
on changes in income inequality. Developments in the agricultural
sector, which still plays a predominant role in many developing countries,
are not reflected in data on manufacturing wages. Also, wage data do
not give any information on possible additional revenues of workers,
for instance, through investments in shares. More importantly, changes
in the returns to capital are not captured by the evolution of wage
inequality. This is an important shortcoming in a time where concerns
increase about the divergence between capital and wage income.60
60
On capital-wage inequality, see this quote by Rogoff (2005): “The simple truth is that corporations
represent capital, and capital – in the form of factories, equipment, machines, money, and even houses – has
been the single biggest winner in the modern era of globalization. Corporate profits are bursting at the seams
of investors’ expectations in virtually every corner of the world. Even in moribund economies like Germany and
Italy, where employment security is vanishing, corporations are swimming in cash. This phenomenon comes as no
surprise to economists. Add two billion Indian and Chinese workers to the global labor force, and the value of other
means of production – particularly capital and commodities (for example, gold and oil) – is bound to go up. And so
it has, with capitalists everywhere gaining an ever larger share of the economic pie.”
A number of empirical papers that have analysed the impact

of trade reform on income inequality have yielded divergent
results. Dollar and Kraay (2002) find that trade openness affects
income distribution positively. A similar result is obtained by Behrman,
Birdsall and Szekely (2001) for a set of Latin American countries.
However, Sanchez-Paramo and Schady (2003) find the opposite result
in six Latin American countries, where trade volumes would negatively
affect inequality. Spilimbergo et al. (1999) and Barro (2000) also find
that trade openness would be associated with higher inequality,
whereas Edwards (1997) does not find any significant effect of trade
on income distribution. This literature does not appear to allow for
any general conclusions as to the link between trade liberalization and
income distribution and the impression arises that this link is country
and situation specific.
The recent market opening in China represents an interesting case

study for economists and a number of studies have looked at the
impact of trade on income inequality in this particular country.
Together they provide interesting insights into what may be driving
changes in income inequality related to market opening. Two
different studies estimated that increased openness was accompanied
by increases in the Gini coefficient in China from 38.2 in 1988 (28.8 in 1981)
to 45.2 (38.8) in 1995.61 Yet another recent paper finds that across China,
those cities that have had a greater increase in the trade-to-GDP ratio
have also tended to witness a reduction, rather than an increase, in
income inequality.62 Woo and Ren (2002) point out that trade has
benefited the coastal provinces in China most, widening the income gap
between the coastal and inland provinces. Yet, they argue, the gap was
not the result of the rich getting richer and the poor getting poorer.
Instead, all provinces appear to have gained from economic opening.
61
Cited in Wei and Wu (2001).
62
Wei and Wu (2001).
Recent research has also examined the issue of whether trade

and other variables have simultaneous effects on income inequality
and growth. Lopez (2004) finds that improvements in education and
infrastructure, and lower inflation, increase growth while reducing
inequality i.e. these policies lead to both growth and progressive
distributional change. Thus policies in these areas support both higher
growth and lower inequality, and have a positive effect on poverty
reduction. On the other hand, they find that financial development,
trade openness, and decreases in the size of government are associated
with increases in growth and in inequality. Such policies are therefore
referred to by the author as win-lose policies, as they stimulate growth
but increase inequality at the same time. In particular, the paper
argues that in the short run, the positive impact of these policies
on growth would not be enough to offset their negative impact
on inequality. As a result, in the absence of pro-poor policies that
accompany those reforms, or additional feedback effects from growth
(such as improvements in education or infrastructure), poverty could
actually increase in the short run. Lundberg and Squire (2003) come
to similar conclusions with respect to the positive impact of open trade
regimes on both growth and inequality.
4. The evidence: trade, FDI and the possibility to substitute

domestic workers by foreign workers
(a) Does globalization affect labour demand elasticities?
Various contributions to the empirical literature have examined

whether the demand for labour has become more sensitive to wage
changes as a result of trade. So far, direct evidence on the effect of trade
liberalization on labour demand elasticity is mixed. Slaughter (2001)
tries to determine whether international trade has been increasing
the own-price elasticity of demand for US labour in recent decades.
He finds that over time demand for production labour has become
more elastic in manufacturing, and in five of eight industries within
manufacturing. The elasticity fluctuated around -0.5 until the mid-
1970s, but then moved steadily to around -1.0 by 1991. Non-production
labour demand has not become more elastic in manufacturing overall
or in any of the industries within manufacturing. Almost all estimates
range somewhere between -0.5 and -0.8, and if anything, demand
seems to have become less elastic over time. Slaughter (2001) also
tries to identify determinants of changes in the price elasticity of labour
demand and his findings provide only mixed support for the hypothesis
that trade contributed to increases in these elasticities.63
Hasan, Mitra and Ramaswamy (2003) looked at how major trade

reforms initiated in India in 1991 affected labour-demand elasticities
in the manufacturing sector.64 Their findings suggest that labour-
demand elasticities increase with reductions in protection.65
The paper also finds that after reforms, productivity and
output volatility resulted in larger wage and employment
volatility. Fajnzylber and Maloney (2005) question the theoretical
link between liberalization and labour-demand elasticities and
find confirmation in their empirical results. Using dynamic panel
techniques to estimate labour-demand relations for manufacturing
establishments in Chile, Colombia and Mexico across periods of trade
63
For production labour, many trade variables have the predicted effect for specifications containing as
regressors only these variables, or them plus industry-fixed effects. However, these predicted effects generally
disappear when time controls are included. For non-production labour, things are somewhat better. Four possible
trade variables – narrow and broad outsourcing, the foreign-affiliate share of US multinational corporations’ assets,
and net exports as a share of shipments – have the predicted sign at least to the 90 per cent level of significance
even when both industry and time controls are included. For both labour types, time itself is a very strong predictor
of elasticity patterns.
64
Their data are disaggregated by state and industry and are for the period 1980-97. Given the variation
across industries and over time in protection levels, and the variation across states in labour market institutions, the
authors are able to decompose the effect of protection and labour regulations on labour demand elasticities and at
the same time look at the interactions between the two. See the discussion in Section E.1 of this study.
65
Unlike Slaughter (2001), the authors do not find time, independent of protection, to dominate their
results.
policy reform their findings do not strongly support the hypothesis

that trade liberalization has a direct impact on own-wage elasticities.
(b) Globalization, insecurity and the bargaining power of

workers
Increases in the price elasticity of labour demand can lead to a

number of changes in the working environment. They may, for
instance, lead to a reduction in the bargaining power of workers and
to increases in the volatility of labour market outcomes. A number
of recent empirical studies have focused on this indirect evidence of
changes in the elasticity of labour demand. Slaughter (forthcoming)
finds a statistically and economically significant correlation between
falling union coverage in the US and increases in inward FDI
transactions. Since the affiliates of foreign multinationals investing
in the US actually have higher unionization rates than US-based firms,
this correlation cannot reflect a compositional shift towards these
affiliates. Rather, it is more likely to reflect changes in the bargaining
power of workers in US companies consistent with the theoretical
relationship between FDI and labour demand elasticity.
An increase in the elasticities of labour demand can also affect

perceptions of economic insecurity. Scheve and Slaughter (2004)
analyse panel data from the United Kingdom over the 1990s and
find that industries’ level of FDI activity is positively correlated with
individual perceptions of economic insecurity of workers employed in
these industries. To be more precise, they find that individuals more
exposed to FDI activity are more likely to report greater insecurity
and also that changes in exposure for a single individual, controlling
for previous levels of insecurity, are correlated with changes in worker
insecurity.66 The authors regard the individual-level panel results as

the first valid evidence consistent with a causal relationship between
globalization and worker insecurity.
A number of scholars have argued that increases in economic

insecurity from globalization may generate demands for more
generous social insurance that compensates workers for a riskier
environment (e.g. Rodrik, 1997; Burgoon, 2001; Hayes, Ehrlich and
Peinhardt, 2002; Boix, 2002). At the same time many scholars have
also suggested that globalization limits the capacities of governments
to provide such compensation (e.g. Rodrik, 1997; Desai, 1999; Besley,
Griffith and Klemm, 2001). Thus, individuals may be concerned about
globalization because they believe it reduces the insurance provided
by the state for all labour market risks, including those heightened by
global integration.
E. The role of policy-makers
The discussion so far has shown that the employment and income
effects of trade liberalization, and of globalization more generally, have
differed significantly across countries. This is not entirely surprising as
countries differ immensely, for instance, in their climatic conditions,
their cultural heritage, political structure and domestic institutions
like the legal system and labour market institutions. This section
attempts to shed some light on how domestic institutions can affect
the relationship between trade and employment. In particular, it
tries to provide some insights into possible trade-offs between the
intended effects of policies or institutions and their unintended side
effects. The domestic institutions and policies discussed in this
66
I.e. the positive relationship holds in yearly cross-sections, in a panel accounting for individual-specific
effects, and in a dynamic panel model also accounting for individual-specific effects.
section tend to pursue one or a combination of three policy goals:

they aim at reducing inequality, at providing insurance against
adverse professional events and/or at enhancing the functioning of
markets. The negative side effects typically take the form of efficiency
losses as policy interventions may change incentives in one way or
another and therefore introduce distortions into the economy.
1. Labour market institutions
Labour market institutions are part of the governance structure

of both industrialized and developing countries. They typically
consist of:
i) labour legislation (and a corollary administrative structure) to

ensure basic rights at work; to regulate the terms of employment
contracts covering aspects such as minimum wages, employment
security, working time and conditions of work; and to provide social
benefits such as health care and pensions,
ii) institutions for collective bargaining and for social dialogue: that
is, consultations between government, trade unions and employer
organizations on labour market issues,
iii) government agencies responsible for the formulation and

implementation of policies relating to the functioning of labour
markets and to skill development, and active measures to promote a
higher level of employment.
There are significant differences among countries in the extent of

coverage and in the specific form these institutions take. Nevertheless,
there is an international consensus on the basic principles and rights
(spelled out in the ILO’s Declaration on Fundamental Principles and
Rights at Work of 1998). These principles and rights include freedom of

association, the right to collective bargaining, and non-discrimination.
In addition, there is also a broad international recognition of the value
of social dialogue.
The coverage and nature of labour market institutions and

policies have an influence on the economic and employment
outcomes associated with trade and related economic liberalization
programmes. For example, they affect the social impact of adjustment;
the incentive for workers to seek, and for employers to create, new jobs;
and the extent of wage inequality. It is thus important to review the
literature on how various aspects of labour market institutions affect
the outcomes from trade liberalization.
(a) Insuring workers against adverse professional events
Modern economies need to constantly reallocate resources,

including labour, from old to new products, from bad to good firms.67
At the same time, workers value security and insurance against major
adverse professional events, job loss in particular. In response to
this, economies have used different tools to provide a buffer against
the most negative consequences of job loss. These tools include:
job-security regulation that makes it harder for employers to lay off
workers and unemployment benefits that provide workers with a
certain level of income during periods of unemployment. However,
both types of policies, may negatively affect the reallocation
process, i.e. the process of creative destruction inherent to the
growth process and also to the adjustment process following
trade liberalization. The question therefore arises, whether and to
what extent a trade-off between efficiency and insurance exists.
67
Blanchard (2005).
Concerns have been expressed as to the potential impact of job-

security regulation on the speed of adjustment to trade and related
economic reforms.68 The literature on the impact of labour market
regulation on the many different economic, political and sociological
variables associated to labour markets and their participants is
extensive and contentious. However, the proposition that job security
provisions may reduce restructuring is a point of agreement. Job
security provisions increase the cost of reducing employment and
therefore lead to fewer dismissals when firms are faced with negative
shocks. Conversely, when faced with a positive shock, the optimal
employment response takes into account the fact that workers
may have to be fired in the future, and the employment response is
smaller. The overall effect is a reduction in the speed of adjustment to
shocks.
The paper by Caballero et al. (2004) analyses this relationship

empirically and analyses how cross-country differences in job security
regulation affect the speed of adjustment. Its methodology builds
on the simple partial-adjustment idea that larger adjustment costs
are reflected in slower employment adjustments to shocks.69 The
authors find that job-security regulation clearly hampers the creative-
destruction process, especially in countries where regulations are likely
to be enforced. Moving from the 20th to the 80th percentile in job
security, in countries with strong rule of law, cuts the annual speed
of adjustment to shocks by a third while shaving off about 1 per cent
from annual productivity growth. The same movement has negligible
effects in countries with weak rule of law.
Bolaky and Freund (2004) go a step further and argue that slow
adjustment caused by rigid regulation can reduce the growth effects
68
These concerns are not limited to developing countries.
69
Note that this paper is not specific to trade shocks.
of trade liberalization. They examine the effect of openness on

growth using cross-country regressions with data from more than
100 countries. Results from level regressions imply that increased
openness is, if anything, associated with a lower standard of living in
heavily-regulated economies.70 The logic is simple: if the structure
of economic activity is rigid, then trade only has a modest impact on
the allocation of resources across and within industries. Moreover, to
the extent that the production structure does not change, excessive
regulation may encourage increased production of the wrong goods
– those the country is not relatively efficient to produce.
However, other contributions to the literature have cast doubt on

the linkage between job security policy and adjustment to shocks.
Wacziarg and Wallack (2004) try to account for the impact of job
security policy on structural change following trade liberalization
and find contradictory evidence when using different samples. Their
results therefore do not allow for any general conclusions. It is also
important to remember the initial aim of job security policy, i.e. that of
reducing insecurity for workers. Hasan, Mitra and Ramaswamy (2003)
find that the response of labour-demand elasticities to protection is
conditioned by the nature of labour institutions: Indian states with
more flexible labour markets see larger increases in labour-demand
elasticities in response to reductions in protection. This finding
indicates that there may indeed be a trade-off between efficiency and
insurance.
70
The authors’ index of regulation is composed of data on labour regulations and business entry regulations
drawn from the “Doing Business” dataset of the World Bank. Their labour regulation index consists of the logarithm
of an employment laws index, where the latter reflects how regulated the labour market is and is constructed
through an examination of detailed provisions in the labour laws of each country. The employment laws index
is an average of three indices covering flexibility of hiring, conditions of employment and flexibility of firing. The
authors also use an index of entry regulations, using data on the number of procedures and time it takes to start a
business in each country.
Blanchard (2005) asserts that a trade-off between efficiency and

insurance exists, but emphasizes that the experience of some successful
European countries suggests it need not be very steep. Sapir (2006)
comes to a similar conclusion when comparing four different European
social models in their potential to generate high employment rates
– efficiency according to his definition – and to keep the risk of poverty
low – equity in his terminology. He concludes that the Nordic model
manages to be both efficient and equitable.71
Much of the impact of job-security legislation appears to depend

on the way it is designed. Blanchard (2005) argues that it is important
to protect workers, not jobs. This means employment protection, but
in the form of financial costs to firms to make them internalize the social
costs of unemployment, including unemployment insurance, rather
than through a complex administrative and judicial process. This
means dealing with the need to decrease the cost of low-skilled labour
through lower social contributions paid by firms at the low wage end,
and the need to make work attractive to low-skilled workers through
a negative income tax rather than a minimum wage. The idea of a
negative income tax, i.e. an income subsidy, has also been discussed in
the context of redistribution policies and will be raised again later on
in this study.
(b) Facilitating transition following trade reform
Trade liberalization leads to a reshuffling of economic activities as

the result of which economies are expected to be better off. But the
transition period may involve some hardship, in particular for workers
whose jobs are threatened by trade liberalization. Those workers
may have to look for a new job and potentially have to go through a
71
In this paper the group of Nordic countries includes Denmark, Finland, Sweden and the Netherlands.
period of unemployment. They may be expected to relocate or to re-

educate. Two types of labour market policies targeting this transition
process can be distinguished: (passive) income support during periods
of unemployment and so-called active labour market policies that
attempt to facilitate re-employment.
(i) Social protection and the potential role of the international

community
Financial markets typically fail to help the jobless both

in industrialized and developing countries. But while many
industrialized countries have developed social protection systems to
assist individuals concerned, developing countries are typically unable
to afford adequate protection. For the poor in such countries, “even
switching from one unskilled informal sector job to another could
cause severe hardship.”72
Numerous industrialized countries, in particular in the European

Union, are characterized by rather generous social protection
systems. But these systems differ significantly when it comes to the
detail. Often, income support during unemployment is calculated
as a percentage of the most recent salary while employed. These
percentages differ significantly across countries, but in general
this approach implies that high-skilled workers are also better off
during unemployment than low-skilled workers. Different rules
also exist as to the length of unemployment benefits and as to
the level of income support to workers that remain unemployed
for many years. The economic literature has pointed at the need
to design systems such that the unemployed continue to have
incentives to look for new jobs. In this context, Blanchard (2005)
72
Winters (2000).
argues that it is important to provide generous unemployment

insurance, but that it ought to be conditional on the willingness
of the unemployed to train for and accept jobs if available. In
industrialized countries numerous examples exist of adjustment
programmes directed at specific regions or sectors. The US Trade
Adjustment Assistance programme specifically targets workers who
have lost their jobs as a result of changes in trade flows and
the European Union recently decided to introduce a similar
programmes.73
Social protection in low-income countries is typically confined to

the minority of workers who are in the formal sector. This is because
it is difficult to introduce systems of social insurance for workers in the
informal and agricultural sectors who are outside the fiscal system;
levels of poverty are also high in these sectors. The major challenge
faced by low-income countries is thus that of devising and extending
alternative means of providing social protection to the informal
economy. Such alternative measures, which have been experimented
with in some countries, have included local self-help initiatives to
provide insurance against illness and loss of income; active labour
market policies such as employment guarantee schemes based on
labour-intensive rural and urban public works programmes; and
various forms of micro-credit programmes to promote productive self-
employment. While such measures have played a useful role in specific
local contexts they all face the problem of “scaling up” – increasing
their coverage to all those who are in need.
73
There is no agreement in the literature as to the success of specific trade adjustment programmes
in facilitating adjustment. In the United States it has been suggested that the Trade Adjustment Assistance
programme should enlarge its scope and provide compensation to displaced workers for permanent income
losses. In other words, it has been suggested to use the programme also as a redistributive tool. See also the
discussion on redistribution in this study.
In middle-income countries where formal employment is more

significant there is often more scope for providing social protection
to workers who are adversely affected by trade and related economic
reforms. However, very few of these countries have systems of
unemployment insurance even though such schemes are financially
and organizationally feasible. Progress in these areas would clearly
strengthen the capacity of these countries to cope with the economic
and social impact of trade liberalization and other economic reforms.
To the extent that the introduction of wide-ranging social

protection systems in low and middle income countries takes
time, the literature has discussed the possibility of introducing
programmes of limited duration, targeting those negatively affected
by trade reform. Although there does not seem to be a clear
understanding of how precisely such programmes should be
designed, one can envisage that they could constitute an element
of so-called “aid for trade” packages financed by the international
community.
(ii) Active labour market policies
Active labour market policies are intended to facilitate the re-

integration of the unemployed into the labour market as well as
the reallocation of labour necessitated by structural change or
geographical, occupational, and skill mismatches. They include
measures such as retraining schemes for displaced workers, job-search
assistance, direct employment creation programmes such as public
works schemes, credit and training programmes to promote self-
employment74; and employment subsidies to promote the hiring of
74
The German “Überbrückungsgeld”, for instance, refers to a state-supported credit programme for
unemployed who wish to start their own company.
vulnerable groups such as low-skilled workers and new entrants to the

labour force.
Active labour market policies may also be a useful tool to facilitate

adjustment to changes in the structure of production brought about
by trade liberalization. Measures to provide retraining for displaced
workers and job search assistance to facilitate labour mobility
will be important in this connection.75 Evidence on the effect of
retraining programmes on unemployment duration and wage levels
in the context of trade liberalization is scarce and comes to mixed
results.76 Rama (1999) indicates that it may be important for retraining
to focus on the acquirement of new skills rather than on the updating
of previous skills. The work by Falvey et al. (2006) highlights that the
appropriate policy may differ across countries, depending on their
level of income and on the skill and age composition of the working
population. Their results suggest that trade-adjustment-assistance
should focus on older-unskilled workers in skilled-abundant countries
and younger-skilled workers in unskilled-labour-abundant countries.
Active labour market policies are widely used in industrialized

countries where they are increasingly being seen as a preferable
alternative to passive income support to the unemployed. Coupled
with measures to increase the incentive (and obligation) to seek work,
such measures can help to raise the employment rate, especially in a
context of positive overall employment growth. Hybrid systems of
income support and active labour policies have also been suggested.
Heitger and Stehn (2003), for instance, propose the reinterpretation of
the unemployment insurance system as an employability insurance
system. Under such a system, individuals who are laid off could take
75
See Lee (2005).
76
Bacchetta and Jansen (2003).
their insurance entitlement and use it to finance the investment in

human capital necessary to regain employability. In some countries,
such as the United States, active labour market policies have also been
specially targeted at workers who have been adversely affected by
trade liberalization.
While many developing countries do implement elements of

active labour market policies such as public employment services,
skill development programmes, and various direct employment
creation schemes, the scale of such interventions and the resources
devoted to them is typically limited. The programmes are also often
poorly designed and managed. Strengthening the capacity of these
countries to design and implement such programmes, especially ones
that are targeted at workers adversely affected by trade and related
liberalization, will clearly enable them to cope better with the social
impact of economic reforms as well as help to increase popular support
for the reforms themselves.
(c) Freedom of association and collective bargaining
Freedom of association and the right to bargain collectively are

the foundational elements of rights at work. Although, as mentioned
earlier, there is an international consensus on the importance of
respecting these rights there has nevertheless been a debate on their
economic effects in developing countries. Some developing countries
have expressed concerns that the full exercise of these rights could
have a negative impact on their economic competitiveness. This
concern derives from the view that a high level of unionization and
collective bargaining could lead to an excessive rise in labour costs that
erodes their comparative advantage, based on low wages, as well as
lead to labour market rigidities that retard required adjustments in the
structure of employment.
However, as will be seen below, there has been little empirical

support for this view in the economic literature. It is also important
to point out that the focus on the economic effects of fundamental
worker rights in the context of trade competitiveness overlooks other
important dimensions of these rights. Apart from being a part of
universally recognized Human Rights, they have clearly positive effects
through enabling social dialogue between workers, employers and
governments; this is invaluable for promoting broad social support
for economic reforms as well as a more equitable distribution of the
burdens and benefits from trade liberalization.
A number of recent studies have analysed whether labour market

characteristics affect economies’ responses to trade liberalization.
Kucera and Sarna (2006) use a bilateral trade gravity model to evaluate
the effects of freedom of association and collective bargaining (FACB)
rights and democracy on exports, evaluating exports by labour
intensity for the 1993 to 1999 period. The model includes data for up
to 162 countries and employs a number of indicators of FACB rights and
democracy, including those constructed by the authors based on the
coding of textual sources, the OECD FACB indices, the Freedom House
civil liberties and political rights (democracy) indices. The paper finds
robust relationships between stronger FACB rights and higher total
manufacturing exports as well as between stronger democracy and
higher total exports, total manufacturing exports and labour-intensive
manufacturing exports. The paper finds no robust relationship
between FACB rights and labour-intensive manufacturing exports.
These results suggest that FACB rights do not harm the export potential
of developing countries and may even stimulate it.
This may explain why Neumayer and de Soysa (2006) do not find
evidence of a race to the bottom in FACB rights. Using the measure
for FACB rights constructed by Kucera and Sarna, the authors find that
countries that are more open to trade have fewer rights violations
than more closed ones. This effect holds in a global sample as
well as in a developing country sub-sample and holds also when
potential feedback effects are controlled for via instrumental variable
regressions. The extent of an economy’s “penetration” by FDI has no
statistically significant impact on the violation of rights. The authors
conclude that while globalization might not be beneficial for outcome-
related labour standards, it is likely to promote the process-related
standard of a right to free association and collective bargaining.
Other empirical papers analyse how union activity affects the

employment and wage response to trade reform and the overall
adjustment path following reform. Griffith et al. (2006) use time-
varying information on product market reforms to test theoretical
predictions that higher levels of competition increase employment
and real wages. They also examine whether the increase is larger for
employment and smaller for real wages when workers’ bargaining
power is higher. Empirically, the paper shows that the significant
product market deregulation experienced in the 1990s by some
OECD countries was associated with an increase in competition as
measured by average firm profitability. Such exogenous increases
in competition were further associated with increases in aggregate
employment and the real wage. They estimate that in countries with
higher levels of collective bargaining coverage and/or union density the
increase in employment is more pronounced, and the increase in real
wages less so.
Forteza and Rama (2001) compare the impact of different labour

market characteristics on an economy’s propensity to adjust.77 In
77
The study looks at adjustment to “economic reform programmes” financed by World Bank adjustment
credits and loans.
addition to minimum wages and non-wage costs, the authors include

the level of unionization and the size of government employment in
their measures for labour market rigidity. The results of their empirical
analysis show that countries where organized labour is potentially
influential are more likely to experience recessions immediately
before adjustment and slower recovery afterwards, whereas growth
performance is not affected by the level of minimum wages and
non-wage costs. They argue that the resistance of organized labour
to reform may have induced policy-makers to redesign original
reform packages and introduce conflicting elements, with the result
that reforms become less effective. Spector’s paper (2004) can help
to understand the reasons for resistance to reforms. The paper
focuses on product market deregulation and shows that widespread
opposition to product market deregulation does not necessarily
reflect workers’ myopia. It may instead constitute a rational attempt
to protect the rents that workers as a whole extract at the expense
of firms’ shareholders. Indeed, more intense competition may cause
wages to fall in the long run, even when general equilibrium effects and
the long-run adjustment of the capital stock are taken into account.78
If both labour and product markets are very regulated, the beginning
of the deregulation process is therefore a very difficult political step.
Since the distributional effect of product market deregulation may
prevent the building up of sufficient political support, Spector (2004)
argues that it may be necessary to complement deregulation with
fiscal redistribution.
78
Note that Spector’s model does not fit the evidence by Griffith et al. (2006) discussed above.
(d) Trade reform and the informal economy in developing

countries
A key differentiating feature of the structure of employment

in developing countries is the fact that a high proportion of total
employment is in the informal economy. This has important
implications for the impact of trade liberalization on employment,
inequality, and poverty in these countries. A fundamental issue is how
trade liberalization affects output, employment, and incomes in the
informal economy. A priori reasoning suggests that this effect can be
both positive and negative.
The informal sector takes on a substantial proportion of the

economies of many developing countries, some as high as 70-80 per
cent and reaching 90 per cent in India when the agricultural economy
is considered as a major section of the informal sector (Marjit and
Maiti, 2005). The informal economy is estimated at 50-60 per cent in
Colombia (Goldberg and Pavcnik, 2003) while non-registered workers
accounted for 40 per cent of the Brazilian workforce in 1999 (Soares,
2005). On a broader scale, Charmes (1998) notes that the share of
the non-agricultural workforce ranged from over 55 per cent in Latin
America to 45-85 per cent in different parts of Asia and to nearly 80 per
cent in Africa.79
Dual labour markets are an important feature of developing

countries and if trade is to be considered as an important development
tool in these economies, it must in the very least have a positive impact
on the informal sector. Pertinent issues of concern to policy-makers
and activists alike usually border on the transforming relationship
between the formal and informal economy as a country goes through
79
See also Carr and Chen (2002). This paper also looks at gender impacts of globalization.
phases of trade liberalization. Does the increased competition that

comes with trade liberalization reduce formal sector employment and
wages in developing countries while expanding the informal economy
and reducing wage levels there simultaneously? Or does trade
liberalization bridge the gap between formal and informal economy
wages, thereby reducing inequality? If the answer to the latter question
is in the affirmative, the direction of this bridge should be of concern:
whether previously high wage earners are worse off or low wage
earners are better off with the introduction of trade liberalization.
Arguments in support of both directions of change can be found

in the literature. It has often been argued that globalization has
led to a rise in informality. This statement is based on the following
rationale. Trade reforms expose establishments in the formal sector to
increased foreign competition. In response, such establishments try to
reduce labour costs by cutting worker benefits, replacing permanent
workers with part-time labour, or subcontracting with establishments
in the informal economy, including home-based and self-employed
micro-entrepreneurs. Firms in the formal economy may also lay
off workers who subsequently seek employment in the informal
economy. On the other hand it has been argued that globalization
creates new opportunities in the form of new jobs for wage-workers
and new markets for the self-employed in particular in export oriented
activities. According to this argument globalization has a strong
potential to reduce the role of the informal economy.80
The nature of labour market institutions and policies in developing

countries is also often believed to have an influence on how trade
liberalization impacts on the informal economy as well as on the level
and structure of employment. In particular, it has been argued that the
80
Kapoor (2005).
extent of labour market regulation, especially employment protection,

will influence the distribution of employment between the formal and
informal economies in the aftermath of trade liberalization.
The existing empirical evidence on the relationship between trade

and the informal economy is still limited and inconclusive. This is not
surprising as the informal economy is largely undocumented, which
makes data collection very difficult. Some work in this area has,
however, been done on Brazil (Soares, 2005), Brazil and Colombia
(Goldberg and Pavcnik, 2003) and India (Marjit and Maiti, 2005).
Goldberg and Pavcnik (2003) examine the link between trade

liberalization and the incidence of informality in Brazil and Colombia.
Their results for Brazil show no relationship between trade policy
(tariffs in particular) and informality and this remains unchanged
with the inclusion of different control variables and using different
estimation methods. In contrast, trade variables are on average
significant for Colombia. Decreases in tariffs are associated with a
higher probability of informality. The authors attribute the different
impacts of trade reform on the informal economy between Brazil
and Colombia mainly to differences in labour market policies. In one
exercise they control for Colombia’s labour market reforms in 1990,
that significantly reduced the cost of firing a worker and increased
labour market turnover. Their results suggest that tariff declines are
associated with increases in the probability of informal employment
prior to labour reforms when the costs of firing formal workers were
high. In contrast, a tariff decline in an industry is associated with a
smaller increase and a potential overall decrease in the probability of
informal employment after the reform.
Soares (2005) seeks to identify links between trade liberalization

and the fall in the Brazilian wage differential and also examines
possible links between trade liberalization and the proportion of

non-registered workers. The author finds that import penetration
impacted negatively on wage differentials but had no effect on the
proportion of registered workers. Tariffs negatively affected the
proportion of registered workers without having any effect on wage
differences. In other words, industries most affected by a reduction
in effective tariffs also experienced increases in the proportion of
registered workers. Even if trade liberalization cut wage premia of
registered workers, it increased the proportion of registered workers
in some sectors.
Marjit and Maiti’s (2005) survey for India reports significant

organizational change regarding the linkages between formal and
informal production units in a period of increased openness to trade.
They document a decline in independent and cooperative units from
44.38 per cent to 41.85 per cent and 34.56 per cent to 12.64 per cent
in 2001 respectively. Tied units proved to be a dominant tendency.
These are units that have strong links with a “merchant capitalist” or
middleman mostly located in towns. Crafts persons in tied units make
products according to the design and on order from the merchant
capitalist. The artisans may possess the tools and the workshops,
but they are under tight control from the traders. Trade liberalization
brought with it expanding national and export markets for rural
artisans who hitherto depended mainly on small rural markets. With
the help of export merchants and marketing agencies, hornware
products are exported to Germany and Japan, hand loomed products
to Japan and brassware for regional markets. As export markets
expand, the informal rural industries exhibit increasing dynamics of
tying, technology adoption and growth.
From a policy perspective it appears important to undertake

more empirical studies to improve our understanding of how trade
liberalization affects the informal economy. This will enable policy-

makers to frame trade policies that aim at minimizing any possible
negative impacts of trade liberalization on the informal economy and/
or at strengthening its positive impacts. It may also help to design
accompanying policy interventions if these are useful to ensure that
the informal economy benefits more from trade liberalization.
2. Redistribution policies
It has been discussed before that traditional trade models

predicted that trade would lead to a rise of the wage premium in
countries relatively well endowed with skilled labour and a rise of the
capital-wage-ratio in countries relatively well endowed with capital. It
comes therefore as no surprise that economists have attempted to
analyse the effect of redistribution policies within these models. Using
a traditional, full employment model of trade Dixit and Norman
(1980, 1986) have argued that it is possible to use commodity taxes
to compensate the losers without exhausting the benefits from freer
trade. Brecher and Choudhri (1994) have raised concerns about this
result by showing that in the presence of unemployment this scheme
may not work. Instead, they show that in such a setting and under
reasonable conditions, fully compensating the losers may eat away all
of the gains from trade. Feenstra and Lewis (1994) have shown that
similar problems arise when factors of production are imperfectly
mobile.
In the past two decades many public finance economists have

focused their attention on the incidence and optimality of taxes
when factor markets become more integrated. One standard model
is built on the assumption that capital becomes more and more
mobile across countries or regions, while labour is rather less mobile
or even assumed to be immobile.81 Increasing mobility of capital has

important consequences for tax policy because a higher elasticity of
capital relative to labour would call for lower tax rates on capital on
efficiency grounds. This has at least partly undesirable distributional
consequences. In particular, it significantly restricts the possibilities
for governments to redistribute from capital to labour. Several
contributions to the literature have recommended international tax
coordination or even tax harmonization in order to reduce the strong
downward pressures on the taxation of capital income.82 International
tax coordination would allow countries to reap the benefits of capital
mobility, while compensating the losers of increased openness.
Other contributions to the literature have focused on the trade-off

between the aim to redistribute and the efficiency losses introduced by
redistribution policies. Davidson and Matusz (forthcoming) develop
a model that allows them to compare a variety of labour market
policies to determine the best way to compensate the groups that are
harmed by liberalization. They distinguish two groups of losers: the
movers (who bear the adjustment costs imposed on the economy
by liberalization in terms of re-training and unemployment) and the
stayers (those who remain trapped in the shrinking sector because
they find it too difficult to acquire the skills required for the expanding
sector, i.e. the exporting sector). They consider four policies to
compensate movers: wage subsidies, training subsidies, employment
subsidies and unemployment insurance. The authors explain that there
are two distortions associated with each compensation scheme. The
first comes from the policy itself since it distorts incentives. The need
to pay for the compensation scheme creates the second distortion.
They assume that any policy is financed by taxing earned income at
81
Janeba (2000).
82
Rodrik and van Ypersele (2001), Razin and Sadka (2004).
a constant rate. In their setup the employment subsidy differs from a

wage subsidy in that it is independent of the worker’s wage so that
all movers receive the same payment regardless of ability, i.e. both
the employment and the training subsidies do not vary with ability,
whereas both the wage subsidy and the unemployment benefit do. In
the context of their model the authors argue that the optimal way to
compensate the movers is with a targeted, temporary wage subsidy,
and the optimal way to reach the stayers is with a targeted, temporary
employment subsidy. They also find that the costs of compensating
the stayers is much higher than the costs of compensating the movers,
but that the total cost of compensation remains quite modest – it never
rises above 5 per cent of the net benefit from liberalization.
Increases in wage inequality and, more generally, income inequality

have been observed in numerous countries around the globe and
have triggered calls for changes in redistribution policy. In the United
States the discussion around redistribution policies has also been
related to trade reform, possibly reflecting a concern among policy-
makers that rising inequality may make it increasingly difficult to
introduce economic reforms, including trade reforms.83 Over the
past 15 years, at first quietly and then with more momentum since
2000, wage insurance has emerged in the United States as a potential
additional adjustment policy tool, particularly in the context of free
trade (Kletzer, 2004). As proposed in Kletzer and Litan (2001), eligible
workers would receive some fraction, perhaps half, of their weekly
earnings loss. The fraction could vary by age and tenure of the
worker. Payments begin only when a worker has a new (full-time) job
83
See, for instance, this quote from a speech by Federal Reserve Bank Chairman Ben Bernanke at the Federal
Reserve Bank of Kansas City’s Thirtieth Annual Economic Symposium (Jackson Hole, August 2006) : “The challenge
for policymakers is to ensure that the benefits of global economic integration are sufficiently widely shared – for
example, by helping displaced workers get the necessary training to take advantage of new opportunities-that
a consensus for welfare – enhancing change can be obtained. Building such a consensus may be far from easy,
at both the national and the global levels. However, the effort is well worth making, as the potential benefits of
increased global economic integration are large indeed.”
and could continue for up to two years following the initial job loss,
as long as the new job paid less than the old job. By “topping up”
earnings if the new job pays less than the old, and only for a specified
period, the programme offers re-employment incentives, in contrast
to the incentives introduced by unemployment insurance and training
subsidies. Taking into account these increased re-employment
incentives, the programme can also be seen from an active labour
market policy perspective, in the spirit of re-employment bonuses.84
To sum up, the debate on which level of redistribution to target and

how to redistribute effectively in a globalized world is an ongoing one.
Finding satisfactory answers does not appear to be straightforward
and will be particularly challenging for developing countries that
often lack any significant experience in this domain, and the necessary
financial and administrative capacities. Yet, there are indications that
the trade-off between equity and efficiency need not be steep and
that win-win strategies exist where policies that are good for equity
are also good for growth.85
3. Education policies
Education policies are likely to play an increasingly important role in

modern economies. The reasons are manifold and include:
• Education policies can act as a redistribution tool in a world where

the relative demand for skilled labour increases.
• Education levels determine countries' absorptive capacity, i.e.

their capacities to adopt new technologies and maybe develop them
84
Re-employment bonuses are lump-sum payments to unemployed workers who find jobs within a
specified limited timeframe.
85
See also Bigsten and Levin (2004) and Dağdeviren et al. (2004).
further. Education levels thus determine to which extent countries can

reap the benefits of innovation.86
• Education affects individuals' capacity to deal with change, an

important aspect in a globalized world that expects individuals to
constantly adapt to new situations.
• Education levels affect individuals' ability to be an active part in a

global society. Globalization has, for instance, raised the requirements
for effective communication in terms of linguistic skills, technological
skills and skills to deal with different institutions and cultures.
The distributional impact of education policies has been analysed

in Janeba (2000). He explores (theoretically) the role of government
policies in a situation where the wage gap between the high and
low-skilled is widening due to increasing foreign competition in the
manufacturing sector of low-skilled intensive goods. Specifically, he
tries to find the best way to deal with inequality in an open economy
– whether scarce government resources should be used to encourage
investment in education or to redistribute income in favour of those
who remain unskilled. A linear income tax, for instance, tends to
be progressive because of the uniform subsidy, thereby mitigating
the increasing wage gap between low-skilled and high-skilled
workers. Yet, at the same time, the policy reduces the incentive
to become a skilled worker in the first place. By, contrast, when the
government subsidizes investment in education, more people tend to
become skilled workers. The downside of this policy seems to be that
a regressive bias is built in because the existing tax money is used for
those who in the end are better off anyway.
86
Keller (1996) argues that access to foreign technologies alone does not increase growth rates of developing
countries and he shows that if a country’s absorptive capacity (measured by its stock of human capital) remains
unchanged, a switch to an outward orientation may not lead to a higher growth rate.
There is an increasing awareness among economists that

education policies are key to enabling economies to adjust to
economic change and to take advantage of its opportunities. The
idea that upgrading the skill level of countries’ workforce is one
answer to the challenges faced by modern economies has found
wide acceptance for quite a while now. But many countries, both in
the developed and in the developing world, appear to find it difficult
to skill the low-skilled. Another impression that arises increasingly
from the literature is that providing higher skills to more people is
not enough.
McIntosh and Steedman (2001) analyse the change in demand for

different skill levels in a number of European countries and propose
policy responses. Their research focuses on France, Germany, the
Netherlands, Portugal, Sweden and the United Kingdom and they
observe that the supply of low-skilled individuals continues to exceed
demand at the prevailing labour costs. They recommend that young
people should be encouraged to reach at least an ISCED 3 (upper
secondary) level. This will help with meeting future demands of the
workplace since many unskilled jobs now require better communication
and social skills. More generally, they recommend a balance between
formal education and personal and social skills.
Tickly (2001) examines the evolution of educational systems in

developing countries over the various phases of globalization. During
the colonial period educational systems were limited to equipping
indigenous labourers with basic skills required by the colonial
economic and administrative systems – a policy that has been blamed
for the marginalization of African economies. Tickly (2001) notes that
education in Africa remains profoundly linked to the politics of the
postcolonial state and would remain so in the foreseeable future while
Europe and the newly industrialized countries of the Pacific Rim have
gone through educational transformation. The paper argues that

there is need for more information on the skills needed for
development in the global era if education is to have a real, positive
impact on development.
Also Ridell (1996) emphasizes the need for a different approach

to education policies in modern integrated economies. While basic
literacy was necessary, and maybe enough during previous waves
of integration, he argues that recent waves of globalization require
very different human resources in order for developing countries to
compete. According to the author, this change in requirement for
skills stems from a shift in trade patterns: a shifting reliance on the
South for intermediate and finished products as opposed to primary
materials in previous waves of globalization. Hence there is the
need to adjust educational systems in the face of new production
systems. His concept of “educating for employment” emphasizes
the need for education to go beyond formal education and continue
with on-the-job training/education. Hence, his suggested action
plan for developing countries includes overcoming illiteracy by going
on with policies that enhance primary and secondary education. In
addition, policies enhancing flexibility in the labour force should be
implemented. These should include the development of analytical/
logical skills, communication skills, interpersonal skills as well as
openness to continual learning.
Economists have also emphasized the need for education systems

in industrialized countries to be flexible enough to adjust to the
changing demands for skilled labour. The issue has been raised in
the context of the recent offshoring literature discussed earlier in this
study. It has, in particular, been argued that it may in the future be more
important for children to learn how to learn than to learn any particular
set of skills, as they may have to adapt their skills continuously during
their working life.87 As Blinder (2006) puts it: “Simply providing more
education is probably a good thing on balance, especially if a more
educated labour force is a flexible labour force, one that can cope more
readily with non-routine tasks and occupational change. However
education is far from a panacea … . In the future, how children are
educated may prove to be more important than how much.”
It has been argued in the literature that market forces are

unlikely to generate the supply of skills that matches the demand for
skills. Instead, educational planning at government level appears to
be required in order to avoid significant mismatches. Riddel (1996)
recommends that educational planners should start from a framework
of global development and should be more concerned with longer-
term, dynamic issues rather than looking at the link between education
and development in a static nation state. They should focus on creative
alternatives that bridge new education with flexible production as well
as bridging the gap between firms and communities.
4. Other policy areas
A number of other policy areas have been emphasized in the

literature that are likely to have an impact on the employment
response to trade liberalization. Although it is beyond the scope of
this overview to discuss them in detail they are briefly introduced in
this section.
(a) Supply response in developing countries
How successful developing economies are in the creation of more

and/or better jobs, with attendant implications for poverty, depends
87
Baldwin (2006).
above all on the supply response of the economy to trade liberalization

and on the employment intensity of that supply response. The
reduction of tariffs and other trade barriers lowers transaction costs
and therefore makes trade more beneficial. But if other transaction
costs are very high trade may still not be sufficiently beneficial. Trade-
related transaction costs refer to a myriad of components, including:
communication costs with clients, domestic transport costs to bring
goods from the production site to the border, time and money spent
in ports on border procedures or to make products ready for shipment,
international transport costs and inspection and certification
costs. Many of these costs are higher in developing countries than
in industrialized countries and there are reasons to believe that they
have in numerous cases been responsible for disappointing supply
responses to economic reform in developing countries.88
The role of infrastructure has been emphasized in a number of

studies analysing the determinants of trade flows.89 Estimating a
gravity model of trade Nordås and Piermartini (2004) show that the
quality of infrastructure has a significant and relatively large impact
on bilateral trade flows, and among the individual infrastructure
indicators, port efficiency has the largest impact on bilateral
trade. Other studies confirm this. Clark et al. (2004) find that port
efficiency is an important determinant of ocean freight costs. They
estimate, for example, that maritime transport costs in Brazil or India
would fall by over 15 per cent if their port efficiency was at the level
of France or Sweden. Their findings also suggest that if a country like
Peru or Turkey were to improve seaport efficiency to a level similar to
Australia or Iceland, they would be able to increase trade by roughly
25 per cent. Limão and Venables (2001) find that own infrastructure
88
See also UNCTAD (2006b).
89
The importance of infrastructure is underlined by the before-mentioned study by Lopez (2004), who finds
that improvements in infrastructure are likely to lead to both growth and progressive distributional change.
explains 40 per cent of transport costs for coastal countries while own
and transit country infrastructure explains 60 per cent of transport
costs for landlocked countries.
These findings have important policy implications for least-

developed countries. If improvements in the quality of infrastructure
in these countries lag behind the development in more developed
countries, their share of world trade is likely to continue to
decline. Worse, it appears that time to market and hence the quality of
infrastructure matter more than before in sectors such as textiles and
clothing; a development that threatens to undermine least-developed
countries’ comparative advantage in important segments of these
sectors. Improvements in the quality of infrastructure can, however be
costly and in the short term beyond the means of the governments of
developing countries, in particular the least developed among them.
There appears to be an increasing awareness of the role the

international community can play in helping developing countries
to overcome supply constraints, that is reflected in the debate on
aid for trade. There also appears to be a common understanding
of the possible bottlenecks for supply response in developing
countries. They include inadequate finance, physical infrastructure,
telecommunication, information and human capital. But there does
not seem to be a clear understanding of how to use aid for trade in
order to overcome supply constraints.90 Examples exist of countries
that have successfully combined outward-orientation, sound
macroeconomic policies and financial assistance, and lessons could be
learned from these examples.91
90
See OECD (2006) for suggestions on “how to make aid for trade effective.”
91
See, for instance, IMF (1997) on the progress of the Irish economy as a result of outward-oriented policies,
financial discipline and EU assistance. The possible benefits of US assistance for capacity building in partner
countries has also been raised in the context of CAFTA (see Salazar-Xirinachs and Granados, 2004).
(b) The role of financial markets for efficiency and stability
Badly functioning financial markets can lead to significant supply

constraints in developing countries. Where credits are allocated
inefficiently, companies with export potential will not necessarily be
able to obtain the funding required to expand their production or
start new activities.92 Small companies more frequently suffer from
credit constraints than larger entities, both in industrialized and
developing countries. But in many developing countries, notably in
Africa, the majority of business is done by small or very small firms. As
a consequence, credit constraints for small companies can result in a
significant adjustment burden for the economy as a whole.
An efficient financial sector is in many respects important for

a country’s development prospects, but unfortunately it is not
something that can be introduced overnight. Companies have
in many cases adapted to the prevailing situation and finance
investment out of savings. In fact, in many developing countries
new firms are almost entirely financed from the founder’s own
savings, as credit constraints tend to be particularly stringent for
start-up finance.
In recent years, systems of microfinance institutions (MFIs) have

developed outside the formal sector in many developing countries to
offer financial services to a larger part of the population. For example,
in Tanzania, only about 6 per cent of the population had access to
the formal banking sector (4 per cent in rural areas) and the activities
of MFIs also reached around 6 per cent of the population in 2002.93
MFIs also play an important role in entrepreneurial activities in some
92
Bacchetta and Jansen (2003).
93
Basu et al. (2004).
developing countries. In Tanzania, for instance, MFIs held about 60

per cent and 11 per cent of total commercial bank deposits and credits,
respectively. The appropriate integration of the microfinance sector
into the regulatory system is therefore an important challenge for
many developing countries.
Opening up the financial sector to foreign competition can

contribute to increasing the sector’s efficiency and expanding its
activities. If accompanied by increased international capital flows,
increased financial openness may, however, also have distributional
consequences, as pointed out in Rama (2003). He contends that the
main threat to workers comes from international capital movements
and the financial crises they can prompt. These crises can lead to a
durable decline in the labour share of income. If they can be avoided,
the long-term wage gains from globalization should more than offset
the short-term losses, even assuming a very high time preference. The
potentially significant negative effects of financial liberalization on
employment and income have also been emphasized in Van der
Hoeven and Lübker (2006).
(c) The pace of trade liberalization
The design of trade policy may affect how the private sector reacts
to trade reforms. By announcing trade reform for a certain date in the
future, i.e. by allowing for implementation periods, governments give
economic actors a warning about upcoming changes. Companies thus
get a chance to accumulate profits and to rely on internal financing for
adjustment to foreign competition. Unfortunately, the literature gives
little guidance as to the appropriate length of such implementation
periods.
The possible role of adjustment periods has been analysed in Levy

and van Wijnbergen (1995). They argued in favour of gradual trade
liberalization together with a well-targeted adjustment programme
in the case of agriculture liberalization in the context of NAFTA in
Mexico. The adjustment programme they suggested was a programme
of investments in land improvements in order to transform a factor that
was to lose from trade reform (rain-fed land) into a factor that would
gain from trade reform (irrigated land). The authors of the study
argued that gradual trade liberalization would make it possible for the
transformed factors to reap the combined benefits of transformation
and trade without having to experience a period of losses.
The NAFTA agreement had provided for a transitional period of 15

years for the Mexican corn sector, but liberalization was accelerated
and the 1995 crisis made it impossible to allocate fiscal resources to
the transforming sector. According to one study (Nadal, 2000) corn
production has remained stable in Mexico after trade reform, despite
sharp drops in corn prices. In other words, trade reform does not seem
to have induced the expected reallocation of resources. The same study
argues that “the situation of rural farmers, especially corn producers,
is desperate, partly as a result of the NAFTA-induced changes in trade
and other government policies.”
F. Conclusions
The material presented so far illustrates that there are no simple

generalizations possible on the relationship between trade and
employment. The standard trade model focusing on inter-sectoral
trade among very different countries proves to be a rather inadequate
guide. There is a growing literature pointing to the importance of
new factors influencing the trade-employment relationship such as
the impact of FDI, the nature of trade (e.g. different types of intra-
industry trade among similar countries versus North-South trade),

the role of technological change and the impact of greater openness
on the elasticity of demand for labour. Differences in the initial
conditions of countries, in the nature of institutions and in how trade
policies are implemented also affect the relationship between trade
and employment. It is important to understand the role of these new
factors in forming an overall judgement on the relationship between
trade and employment as well as in the formulation of policy. The
review of the recent literature contained in the present study hopefully
establishes this point. At the same time, it has also indicated areas
where, in the light of this, the current state of knowledge is still limited
and where further research could make a useful contribution to the
formulation of better policies.
The review attempted in this study suggests that globalization

can be good for most workers in both industrialized and developing
countries, provided the appropriate economic policies are in place.
But it may not be good for all workers, and its distributional implications
should not be ignored. The overview indicates that the increase
in the relative demand for skilled labour is a global phenomenon
often resulting in increased skill premiums. Traditional trade theory
would have predicted that trade between industrialized countries
and developing countries leads to increased skill premiums in the
industrialized world. But research has shown that this so-called North-
South trade can only explain a small part of the observed changes in
relative wages. Trade among industrialized countries is also likely to
play a role, but it is above all skill-biased technological change that
appears to drive observed increases in the skill premium.
In the case of developing countries, the literature also points

to the significance of new factors such as FDI and the relocation of
production, skill-biased technical change, and the emergence of China
as a major producer of labour-intensive manufactures, in explaining

changes in wage inequality. Recent research also indicates that trade
and outsourcing are connected phenomena that both stimulate
the pace of technological change. To the extent that technological
change enhances growth, this process should be encouraged. But the
literature agrees that the process will increasingly shift relative demand
for labour towards skilled labour.
Independent of their causes, increases in the skill premium, or

even income inequality, represent a serious challenge for developing
countries in which redistribution policies have traditionally been
absent or inadequate. The literature does not provide an answer
to the question of how to introduce appropriate policies in
countries that often lack the necessary administrative and financial
capacities. Further research in this area will clearly be useful to policy-
makers.
The discussion in this study on the links between trade reform on

the one hand and labour and social policies on the other hand has
also shown that there is no agreement on how to design appropriate
redistribution policies in a globalizing world. Any redistribution policy
changes incentives for those on the receiving end and thus carries
the potential to introduce distortions to market processes. The need
to pay for the redistribution policy, for instance through levying
income or consumption taxes, creates an additional distortion. The
design of effective redistribution schemes in a world where some
production factors are more mobile at the global level than others
thus also represents a serious challenge for relatively well-equipped
governments in industrialized countries. New research focussed
on this question would help policy-makers to meet their important
challenge.
Another policy tool that can have redistributive effects is education

policy. Policies that provide wider access to education have also
been identified in the literature as good pro-poor policies, as they
stimulate growth and reduce inequality at the same time. The present
study also emphasized the increasingly important role of education
policies in determining how well countries cope with economic and
technological change. At the same time, however, this study pointed
out that it becomes increasingly hard to predict the set of skills needed
for future employment and that education systems will therefore need
to be increasingly flexible in order to respond to economic changes. It
may also become increasingly important to teach how to study in order
to enable workers to adapt to changes in the demand for skills. The
practical implications of this, however, do not appear to be entirely clear
and further research on the issue of economic change and education
could be useful to provide guidance to those responsible for education
policy.
Other policies accompanying trade liberalization, especially the

absence or presence of pro-poor policies, have an important influence
on the impact of trade on inequality and the level of poverty. In
addition to the already-mentioned education policies, investment in
infrastructure has been identified in the literature as a good candidate
for pro-poor policies. The quality of infrastructure is also an important
determinant of countries’ supply response to trade liberalization.
Investments in infrastructure thus have the potential to help the poor
via multiple channels: they reduce inequality, have a direct positive
impact on growth and an indirect positive impact on growth via their
effect on trade flows.
On an issue that is important for many developing countries,

namely the impact of trade liberalization on the informal economy,
the theoretical literature points to the possibility of both positive
and negative impacts. The net outcome depends on which of these

predominate. The empirical evidence is however very limited and
shows mixed results. Further research on this issue should therefore
be a priority.
The pace of trade liberalization also influences outcomes. Gradual

liberalization combined with well-targeted adjustment programmes
are likely to lower adjustment costs and increase benefits. The need
for trade adjustment programmes seems more pressing in developing
countries than in industrialized countries, where existing social
protection arrangements, e.g. in the form of unemployment benefits,
take care of those affected by job loss. While the introduction of wide-
ranging social protection schemes in developing countries is desirable,
it may not be feasible in the short run. The introduction of adjustment
programmes of limited duration, targeting those negatively affected
by trade reform, may be an interesting alternative. Although numerous
examples of adjustment programmes directed at regions or sectors
exist in industrialized countries, our knowledge of the efficient design
of such programmes in the context of developing countries is still
incomplete and needs to be strengthened through further research.
Another theme that has been discussed in this study is the rising
perception of insecurity among workers, as revealed in worker surveys.
The theoretical literature confirms that trade, in particular if combined
with FDI, has the potential to increase volatility in labour markets.
Surprisingly, statistics on labour market reallocation do not reveal a
systematic pattern of increased labour market volatility. Research on
how to reconcile the conflicting evidence on workers’ perceptions of
insecurity on the one hand and labour market statistics on the other
hand is ongoing.
Notwithstanding the evidence from labour market statistics,

economists tend to agree that modern economies need to constantly
reallocate resources, including labour, from old to new products,
from bad to good firms. At the same time, workers value security
and insurance against major adverse professional events, job loss in
particular. In response to this demand for insurance, economies have
used different tools to provide a buffer against the most negative
consequences of job loss. The discussion in this study has shown
there are reasons to believe that a trade-off exists between efficiency
and insurance, but that this trade-off does not need to be very steep
if insurance policies are designed appropriately. Again, getting the
policy mix right is a pressing issue and further research can support the
attainment of this objective. This is above all the case in developing
countries that face the additional challenge of channelling important
numbers of workers in the informal economy as smoothly as possible
into formal activities.
The main conclusion that emerges from this study is that trade
policies and labour and social policies do interact and that greater
policy coherence in the two domains can have significantly positive
impacts on the growth effects of trade reforms and thus ultimately on
their potential to improve the quality of jobs around the world. From
this perspective, research directed at supporting the formulation of
more effective and coherent policies would clearly have a high pay-off
to the international community.
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TRADE AND EMPLOYMENT

This study is the outcome of collaborative research between

TRADE AND EMPLOYMENT CHALLENGES FOR POLICY RESEARCH

On the basis of an overview of the existing academic

WTO ISBN 978-92-870-3380-2 A joint study of the International Labour Office

Printed by the WTO Secretariat - 813.07

A joint study of the International Labour Office

Marion Jansen Eddy Lee

Copyright © 2007 International Labour Organization and World Trade Organization.

WTO ISBN 978-92-870-3380-2

Also available in French and Spanish:

Printed by WTO Secretariat, Switzerland, 2007

The authors thank Hilda Addison and Monica Takyi-Appiah for

This study is the outcome of collaborative research between the

The multilateral trading system has the potential to contribute

We consider this joint study undertaken by the ILO and the

We are therefore pleased to present this study as an encouraging

Pascal Lamy Juan Somavia

B. Trade flows and employment:

C. Trade and employment: theory and evidence  19

1. Trade and income levels  20

2. Trade, job destruction, job creation and unemployment:

3. The evidence: trade and (un)employment  30

D. Trade and inequality  38

1. Trade and inequality: what theory tells us  40

(a) Trade and the relative demand for different types

(b) Trade, FDI and the possibility to substitute

2. The evidence: trade and wage inequality  45

3. The evidence: trade and income inequality  50

4. The evidence: trade, FDI and the possibility to substitute

(a) Does globalization affect labour demand elasticities?  52

(b) Globalization, insecurity and the bargaining

E. The role of policy-makers 55

1. Labour market institutions 56

(a) Insuring workers against adverse professional events  57

(b) Facilitating transition following trade reform  60

(i) Social protection and the potential role

(ii) Active labour market policies 63

(c) Freedom of association and collective bargaining 65

(d) Trade reform and the informal economy

4. Other policy areas 80

(a) Supply response in developing countries 80

(b) The role of financial markets for efficiency and stability 83

(c) The pace of trade liberalization 84

Trade and employment

A joint study of the International Labour Office

This study is the product of a collaborative effort by the Secretariat

Economists have long recognized that trade would lead to a

take advantage of cheaper imports and of a larger product and quality

In other words, trade liberalization is expected to trigger a

Where trade liberalization affects parts of the labour force

Traditionally, economists expected that the reshuffling process

Empirical evidence initially appeared to confirm these

But three important phenomena emerged that were not in line

1. First, most industrialized countries trade above all with other

of trade. Recent contributions to the theoretical trade literature have

Another branch of literature has examined the relationship

This literature may explain why surveys in industrialized countries

market volatility. Work on how to reconcile the conflicting evidence on

WTO ISBN 978-92-870-3380-2 A joint study of the International Labour Office

C. Trade and employment: theory and evidence 19

1. Trade and income levels 20

3. The evidence: trade and (un)employment 30

D. Trade and inequality 38

1. Trade and inequality: what theory tells us 40

2. The evidence: trade and wage inequality 45

3. The evidence: trade and income inequality 50

(a) Does globalization affect labour demand elasticities? 52

(a) Insuring workers against adverse professional events 57

(b) Facilitating transition following trade reform 60