U.S. Department of Labor 

Employment and Training Administration Occasional Paper 2005-11 

 

The Labor Market Effects of 

Globalization and Trade Adjustment 

Assistance 

George E. Johnson 

University of Michigan 

This report has been funded, either wholly or in part, with Federal funds from the U.S. 

Department of Labor, Employment and Training Administration under Contract Number 

AF-12985-000-03-30. The contents of this publication do not necessarily reflect the 

views or policies of the Department of Labor, nor does mention of trade names, 

commercial products, or organizations imply endorsement of same by the U.S. 

Government. 
U.S. Department of Labor 

Employment and Training Administration 

Table of Contents 

1.0 Introduction ........................................................................................................... 1 

1.1 Overview ........................................................................................................... 1 

1.2 Some Background Facts About the Labor Market in the U.S. ........................... 3 

1.3 Some Background Facts About Trade Flows in the U.S. .................................. 4 

1.4 The Determination of Unemployment and Employment in the U.S. .................. 6 

2.0 Trade Theory and Empirical Evidence .................................................................. 9 

2.1 Wage Determination in the Closed Economy .................................................... 9 

2.2 Wage Determination in the Open Economy .................................................... 12 

2.3 The Major Welfare Implications of the Open Economy Model ........................ 17 

2.4 Estimation of the Effect of Changes in International Prices on Relative Wages.. 

 ........................................................................................................................ 19 

2.5 Departures From the “Pure” Open Model ....................................................... 21 

2.6 Trade and Economic Growth .......................................................................... 23 

2.7 Outsourcing ..................................................................................................... 25 

2.8 Future Trends in the Sensitivity of the U.S. Labor Market to the Rest of the 

World ........................................................................................................................ 28 

3.0 Short-Run Adjustment and Trade Adjustment Assistance .................................. 29 

3.1 The Simple Adjustment Model ........................................................................ 29 

3.2 Trade Adjustment Assistance Programs ......................................................... 31 

3.3 Individual Job Displacement Effects ............................................................... 32 

3.4 Wage Insurance .............................................................................................. 34 

4.0 Recommendations for Future Research and Information Gathering by DOL ..... 35 

Endnotes ....................................................................................................................... 37 

Appendix A: A Simple Ricardian Model with Two Skills and Four Goods ..................... 42 

Appendix B: The Effects of the Outsourcing of Jobs on Employment, Average Real 

Wages, and the Distribution of Earnings in the Short, Medium, and Long Runs ........... 50 
U.S. Department of Labor 

Employment and Training Administration 1 

1.0 Introduction 

1.1 Overview 

 This report deals with the effects of increasing globalization on the labor market in the 

United States. To many authors the term “globalization” is somewhat imprecise (Dore 2001), for 

it seems to apply as much to the homogenization of cultures (what is often called variants of 

“Americanization”). For purposes of this report, however, globalization is taken to reflect 

the extent to which the U.S. economy is integrated into the world economy. Within this 

definition, there is no question that globalization has increased over the past half century. 

Further, it seems likely—but is not a certainty—that economic integration will continue to 

increase over the next several decades. Such a prediction is conditional on further decreases in 

transportation and communication costs and a continuation of a relatively stable international 

political climate and favorable attitudes within the U.S. and other relevant countries toward 

trade. 

 Section 1.3 of the report reviews some of the key facts about the increase in the 

importance of traded goods—both imports and exports—in the U.S. economy over the past 40 

years. The interesting analytical questions concern the implications of globalization on the 

operation of the labor market. How much of the increase in earnings inequality during the past 

25 years (the facts about which are reviewed in section 1.2) is due to the factors that caused an 

increase in trade? Opinion of economists on the extent to which international forces have 

affected the U.S. labor market ranges from “a lot” (Wood 1994) to “surprisingly little” (Freeman 

2003). 

 Section 2.0 of the report examines different approaches to various aspects of the labor 

market effects of globalization in the medium and long runs in which an economy like that of the 

U.S. has time to reach full employment. Most labor economists and macroeconomists in this 

country think of the determination of wages and employment in a closed economy; i.e., an 

economy in which trade and foreign prices are not important. This was a fine assumption in, say, 

1950, but it is not very accurate for the current American economy. Nevertheless, because so 

many people think in these terms—and because there is still a great deal of relevance to the 

model—the closed economy labor market is sketched in section 2.1. At the other extreme is the 

standard textbook model in which trade is not only significant, but in which foreign economic 

conditions dominate in the determination of labor market variables within the U.S.—even if 

traded goods represent a relatively small fraction of total production. This model of the open 

economy labor market is discussed in section 2.2. It is interesting to note that the potential effects 

of many labor market policies (including many DOL programs) are very different in an open as 

compared to a closed economy setting. 

 One of the propositions of the normative economics of trade policy is that, under most 

specifications, the typical policy that promotes free trade between the U.S. and other countries 

has a negative effect on some group of workers, but a larger positive effect on the welfare of 

others such that, on average, U.S. citizens are better off. Section 2.3 discusses this conclusion 

with illustrative examples. An interesting conclusion of this section is that the aggregate gains of 
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Employment and Training Administration 2 

the “winners” from a liberalized trade policy tend to be only slightly larger than the aggregate 

losses of the “losers” due to the policy. Thus, the redistributive effects of a particular trade policy 

may be much more noticeable than the gains in average income. Given these results, it is not 

surprising that the consensus of the empirical literature on the effects of international openness 

on the rate of economic growth, which is reviewed in section 2.6, is that this effect is small and 

statistically insignificant. Another presumption of the trade literature is that, since the U.S. is 

relatively abundant in high- rather than low-skilled labor compared to the rest of the world, 

increased openness will benefit the upper tier of the skill distribution and hurt the lower tier. 

 There is a large amount of literature on the effects of the international forces that cause 

increased trade on the wage structure in the U.S., and this literature is reviewed in section 2.4. 

Using both price equations and factor content analysis, various studies conclude that a relatively 

small fraction of the huge increase in earnings inequality, the high-/low-skilled average relative 

wage, since the late 1970s is directly attributable to international factors. It appears from these 

studies that more important causes of increases in inequality are skill-biased technological 

change and, to a smaller extent, increased immigration of low-skilled workers. Nevertheless, the 

fact that the increase in earnings inequality coincided with the increase in imports and exports in 

the U.S. gives the perception that there is a causal relation. 

 The conclusion that the major labor market developments were not caused by 

globalization leads economists to be somewhat skeptical about the applicability of the pure 

textbook version of the open economy model discussed in section 2.2. Among the assumptions 

necessary for this model to apply are that consumers within the U.S. treat foreign and domestic 

versions of most products as perfect substitutes and that the U.S. is active in a wide range of both 

low-skilled intensive industries as well as high-skilled intensive industries. Many recent papers 

in international economics disagree with one or both of these assumptions, and the resulting 

model yields a set of predictions about the behavior of labor markets that are between those of 

the closed and open models. This “intermediate” case is discussed at length in section 2.5. In this 

author’s view, there is no question that the correct model is indeed a weighted average of the two 

extreme models. The important question involves how close the true model of the labor market is 

to one extreme versus the other. 

 In section 2.7, the rather smaller literature on the outsourcing (or “offshoring”) of parts of 

production processes to foreign countries is discussed. This has—in part because the latest focus 

of outsourcing has been on white collar and high-tech jobs rather than, as was the case in the 

1980s and 1990s, on blue collar jobs—become controversial in recent years. In principle, the 

effects of outsourcing are little different from the effects of trade in goods. If the outsourcing is 

concentrated on low-skilled intensive production processes, it has much the same effects on U.S. 

GDP (Gross Domestic Product) and wages as an increase in imports of low-skill intensive 

products (like textiles), but the lower prices on these goods have, in the aggregate, a beneficial 

effect on wages. Some economists have argued that because earlier outsourcing concentrated on 

low-skilled jobs, the conclusions about the impact of trade based on industry import and export 

data are seriously underestimated. In other words, international factors actually accounted for a 

much higher fraction of the increase in earnings inequality than was concluded by the studies 

discussed in section 2.4. This is a possibility, but the data on outsourcing and trade in services 

are simply not yet good enough to resolve this issue. 
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 The more an economy is open to international trade, both in terms of import policy and 

institutional and technological arrangements, the closer the operation of the labor market is to the 

textbook open economy model rather then the closed economy model. Section 2.8 reviews what 

is known about this in the U.S. with a view toward determining how things will look at various 

points in the future. The answer to this is (as with the questions associated with section 1.3) 

partly conditional on political events that are essentially unforeseeable. However, barring certain 

catastrophic shocks, it is likely that the U.S. economy will become more integrated with those of 

other regions. Recent trends in the outsourcing of services underscore the prediction in this 

regard. 

 Section 3.0 of this report examines various aspects of the short-run adjustment of the 

economy to trade shocks. Section 3.1 sets out a simple model in which the effects over time of an 

adverse trade “shock” on three different groups of members of a labor type that are adversely 

affected by the development. These include: (a) those in the affected industry who lose their jobs 

due to the shock, (b) those in the affected industry who retain their jobs, and (c) all other workers 

in that labor type. In the medium run; i.e., after 2 or 3 years, a shock that affects this labor type 

negatively causes the wages of groups (a), (b), and (c) to fall. In the short run, however, the 

workers who lose their jobs directly due to the shock, group (a), incur the costs of adjustment, 

both in terms of lost earnings due to unemployment and the retraining and/or movement 

expenses associated with changing industries. In addition, group (a) workers, especially those 

with high levels of job tenure, tend to lose job specific human capital, thus causing further longrun losses upon reemployment. This literature is reviewed in section 3.3. 

 Trade adjustment assistance (TAA) programs, which attempt to provide income support 

and transition assistance to group (a) workers, are discussed in section 3.2. Since TAA does not 

provide any sort of compensation to the other losers from a particular trade development 

(workers from groups (b) and (c) in the preceding paragraph), the policy cannot by definition 

meet the requirement that the “winners” from a change in trade policy fully compensate the 

“losers”—the focus of attention in section 2.4. Resources allocated to TAA, however, can affect 

the speed of adjustment of the labor market after the change in trade policy or some other 

international development, and TAA can be usefully evaluated in terms of its contribution to 

economic efficiency. 

 An interesting variant of TAA is the concept of “wage insurance,” in which group (a) 

workers who are subsequently reemployed at lower wage rates receive a fraction of their lost 

earnings in the form of compensation from the government. This is discussed in section 3.4. 

Although restricted to group (a) workers over the age of 50, wage insurance was added to TAA 

in the U.S. in the 2002 legislated changes to the program. 

 Section 4.0 of the report discusses ongoing research and data needs with respect to 

globalization and the labor market in the U.S. 

1.2 Some Background Facts About the Labor Market in the U.S. 

A great deal of the attention of labor market analysts during the past 15 years has focused 

on issues dealing with what has happened to the average level and the structure of real wages. 

Some of these developments are summarized in table 1. First, column (c) shows the ratio of the 
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average weekly wages for males of college graduates to those of high school graduates. The most 

notable feature of this number is that, like most other measures of returns to skill and income 

inequality,1 it rose so rapidly during the 1980s. The growth in the educational earnings 

differential has continued since 1989, but at a slower rate. 

Table 1. U.S. Basic Labor Market Data 

Selected Years: 1960–2003 

Year 

Relative 

supply skill* 

(a) 

Avg. growth 

rel. supply 

(b) 

Relative 

wage skill** 

(c)

Avg. real 

wage*** 

(d)

Avg. growth 

real wage 

(e) 

1960 .120 1.35 1.00 

1973 .325 7.7 1.40 1.30 2.0 

1979 .434 4.9 1.34 1.30 0.0 

1989 .609 3.4 1.58 1.24 -0.5 

2000 .718 1.5 1.69 1.35 0.7 

2003 .745 1.2 --- 1.39 1.1 

 *From data in table 13, Borjas, Freeman, and Katz (1997), last two years updated by author. 

 **From figure 5, Card and DiNardo (2002), first and last years calculated by author. 

***Average hourly earnings of production workers in private employment adjusted by the consumption deflator. 

Second, column (d) reports an index of the average real hourly earnings of production 

workers in the private nonagricultural industries. This was rising at an average rate of 2.0 percent 

per year from 1960 to 1973 (a little above its average growth rate for roughly a century before 

1960) when it stopped growing until the mid-1990s. Since 1995, the average real wage rate has 

started to increase as it used to before 1974, although it is too soon to tell whether or not real 

wage growth will reach and, more importantly, sustain its pre-1973 trend value. 

 The third interesting stylized fact in table 1 is the fact that the relative supply of skilled 

workers in the U.S. has been rising at a very rapid rate for many years. Column (a) reports 

estimates of the ratio of the employment of “college equivalents” to the employment of “high 

school equivalents.”2

 This has grown consistently since 1960 (and, of course, back to the 19th

century), but its rate of growth, column (b), has diminished steadily over the past half century.3

From the point of view of closed economy economic analysis, the fact that the relative wage of 

skilled workers rose for the 25 years after the early 1970s in the face of a large increase in the 

relative supply of skilled workers was considered by labor economists to be somewhat 

paradoxical—things tend to fall in price when they become more, not less, abundant. 

1.3 Some Background Facts About Trade Flows in the U.S. 

 By any relevant measure, traded goods have steadily become a larger part of the U.S. 

economy since World War II. Table 2 presents the most basic macroeconomic data involving the 

international sector—the percentage ratio of exports and imports to GDP and the difference 

between these two numbers, the net exports as a percentage of GDP. The sum of the 

exports/GDP and imports/GDP ratios is sometimes used as an indicator of the importance of 

trade to the economy, and this roughly tripled between 1960 and 2003. 
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Table 2. U.S. Basic Macro Trade Data as a Fraction of GDP 

Selected Years: 1960–2003

Year Net exports 

(a) 

Exports 

(b) 

Imports 

(c) 

Openness 

(d) 

1960 0.5 4.8 4.3 9.1 

1973 -1.5 5.1 6.6 11.7 

1979 -0.9 6.2 7.1 13.3 

1989 -1.2 8.0 9.2 17.2 

2000 -3.5 11.3 14.8 26.1 

2003 -3.8 10.9 14.8 25.7 

One reaches similar qualitative conclusions about the data on trade confined to trade 

involving merchandise alone (Donnelly 2001), merchandise trade with low-wage countries 

(Borjas, Freeman, and Katz (1997)), and in terms of imports of intermediate inputs as a fraction 

of value added in manufacturing (Feenstra 1978). The U.S. has, over the past 50 years, simply 

become much more open to trade with other countries than it used to be. 

 Net exports have been consistently negative since the 1970s, and usually of a large 

magnitude relative to GDP since the 1980s. This foreign trade deficit is often interpreted by 

politicians and journalists to be caused by the increase in U.S. imports and/or rejection by 

foreign economies of exports from the U.S.4 The position of orthodox economists, however, is 

that under conditions such as faced by the U.S. and other industrialized countries since the 

1970s, net exports are determined by the difference between GDP and the sum of domestic 

demand for goods and services, consumption plus investment plus government spending. Given 

flexible real and nominal exchange rates, GDP is determined only by monetary policy and the 

exogenous variables of the domestic product market.5

 The role of a positive trade deficit 

(negative net exports) is to finance the difference between total domestic demand and total GDP. 

Net exports (along with the predetermined value of GDP and domestic and foreign tastes for 

imports) determine the values of exports and imports, not vice versa. Any attempt to cut the 

foreign trade deficit (raise net exports) by restricting imports would simply increase the real and 

nominal value of the dollar and lower both exports and imports by the same amount. 

 Since government spending and investment as fractions of GDP have not been 

particularly large during the last 20 years, it follows from the preceding that the large increase in 

the foreign trade deficit since the beginning of the 1980s is simply the result of consumption 

being too high. The reason that consumption was too high is a combination of taxes being set too 

low and perceived wealth effects from the dramatic rise in stock market prices (why save for the 

future when your 401k will triple in value as the Dow goes to 30,000?).6

 That exports and imports have become increasingly important in the U.S. economy over 

the past half century is not subject to question, and obviously, the effects of international factors 

on the U.S. labor market have grown accordingly. The interesting questions in this regard 

concern what will happen to the relative importance of trade in the future. Will the U.S. continue 
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to experience increases in exports and imports over the next several decades? Will international 

factors become even more important to the U.S. labor market? 

 A forecast of a summary index of openness such as exports/GDP plus imports/GDP, 

which is given in column (d) of table 2, based on an extrapolation of the value of that variable 

since the end of World War II would clearly yield an affirmative answer to this question. 

However, there are several reasons to be somewhat skeptical of a naive forecast of this sort. The 

first reason for skepticism is that a forecast of increasing trade volume in the future is conditional 

on a continuation of both international political stability and of political attitudes within major 

national blocs that are favorable to relatively unrestricted trade. The steady increase during the 

19th century in trade volume as a percent of GDP for the U.S. and other industrialized countries 

came to an abrupt end with the onset of World War I, at which point trade volumes fell 

drastically (Johnson and Slaughter 2001). Because of protectionist policies during the 1920s, the 

Great Depression of the 1930s, and World War II, trade volume as a percent of GDP did not 

reach its 1913 level until the mid-1950s. Based on data up to 1913, a forecast based on a simple 

extrapolation would have predicted a continuing increase in trade/GDP over the next 40 years. It 

is, accordingly, possible that 2004 is a point similar to 1913; i.e., that unforeseeable events will 

cancel out the forces that have historically caused trade volume to increase. 

A second reason for being skeptical of predicting a continuing increase in the degree of 

openness of the U.S. economy is that we may be approaching the limit of the extent to which 

merchandise can be profitably traded. Rodrik (1997 and 2000) makes the case rather 

convincingly that, at least at some point in the relatively near future, further increases in 

international economic integration will require an expansion of political jurisdictions. This 

means that the U.S. and other countries would have to give up a large amount of control to some 

supra-national agency over policies that affect trade between nations—just as individual states in 

the U.S. have little control over inter-state commerce. Rodrik thinks that this is likely in the long 

run, but he indicates that he would not be surprised if there were several backward movements 

(like bouts of protectionist legislation) over the next 20 years. 

 Although, as will be pointed out in section 2.0, there is a fair amount of disagreement 

among economists about how the observed expansion of trade (or, more precisely, the factors 

that caused the expansion of trade) over the past 30 years has affected labor market outcomes in 

the U.S. An important element in the answer to questions concerning the future effects of 

international developments on the U.S. labor market is the extent to which international 

economic integration continues to grow. This author’s estimate is that there will be an expansion 

of trade and globalization over the next several decades, but the forecast error of this prediction 

is, for the two reasons given above, rather large.7

 

1.4 The Determination of Unemployment and Employment in the U.S. 

In all economic models of labor markets in an economy with trade, there is a common 

result that the various international “shocks” that can hit the economy shift the demand curves 

for different types of labor in different ways. These demand shifts can affect the real and relative 

price of labor types, the data underlying table 1, and they can, in principle, also affect 

employment and unemployment levels of the different types of labor. 
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es 

icultural jobs in 2002. 

 This author’s view is that—during the post World War II era, at least until 2000 and most 

likely beyond 2004—aggregate employment and unemployment in the U.S. tend to be unaffected 

by shocks after about 3 years. This applies to all sorts of shocks—energy price, technological, 

and aggregate demand as well as those dealing with foreign prices. The motivation for this is the 

results of a regression for the postwar period of quarterly unemployment rate in the U.S. related 

to lagged values of unemployment and a dummy variable for a cyclical turning point into (but 

not out of) a contraction and its value lagged twice,8

 as well as time trends to capture movements 

over time in the equilibrium aggregate unemployment rate. The occurrence of a turning point to a 

downturn—whatever the shock that caused it—is followed, on average, by a rise in the 

unemployment rate until between the fourth and sixth quarter after the shock. After this rise in 

the unemployment rate, there is a slow decline in the rate back to its equilibrium value such that 

after 3 years most of the initial rise in the unemployment rate is over.9

Within this framework there is no long-run effect of a shock on unemployment and, 

given that there is, at most, a very small effect on the long-run value of labor supply, there is 

very little long-run effect of the shock on employment. This conclusion applies to whatever were 

the shocks that caused the recession and this reasoning is applied to the long-run (i.e., after a 

couple of years) effect of international shocks on employment. 

 This is not to minimize the costs of adjustment to individuals due to international shocks 

which will be discussed in section 3.0 of this report. However, the major effects of increasing 

trade on the U.S. labor market would appear to be the average value and distribution of wages—

the sorts of variables represented in table 1—rather than on employment levels. 

 At the same time, there is considerable attention paid in the popular press about the 

possibility that there have been major employment effects over the past couple of years due to an 

alleged increase in outsourcing of jobs in American firms. There has been much discussion of the 

“jobless recovery” from the recession that began in 2001,10 and this is the major reason this 

author hesitates to apply the “rapid adjustment model” (described above) to a prediction of the 

current adjustment of the economy. 

 To see how things might be different in the current economy, a standard employment 

adjustment function on annual data for the period 1957 through 2001 was estimated.11 The 

model was then used to predict the rates of growth of employment in 2002 and 2003, the figur

for which are reported in table 3. Using the Bureau of Labor Statistics (BLS) establishment 

survey data on nonagricultural employment, one would have predicted no change in 

employment, but employment actually fell by 1.1 percent. For 2003, with a recovery—however 

weak—in output growth, one would have expected employment to rise by 1.3 percent, but it 

actually fell by 1.3 percent. Thus, employment growth was 1.1 percent lower (with a forecast 

error of 0.3 percent) than it “should” have been in 2002 and 1.6 percent (0.4) higher in 2003. 

This implies a shortfall of about 3.5 million nonagr
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Table 3. Actual and Predicted Employment Growth in 2002 and 2003 

Using Alternative Data Sets

Year 

Establishment survey 

Actual Predicted Residual

2002 -1.1 0.0 -1.1 

2003 -0.3 1.3 -1.6 

Household survey 

Actual Predicted Residual

2002 -0.4 0.1 -0.5 

2003 1.0 1.0 0.0 

 The establishment data suggest the presence of a jobless recovery, and a common 

explanation of the phenomenon, is that the additional output is being produced in China, Mexico, 

and—to the chagrin of computer programmers—India. This would imply that “Okun’s law,” a 

historical relationship between changes in the unemployment rate and changes in GDP, has been 

repealed. Of greater relevance to this report, it might also suggest a greater impact than 

commonly believed for “trade” shocks on the U.S. labor market. However, the lower panels of 

table 3 report predicted values of a different employment variable, total civilian employment 

based on the Current Population Survey (CPS) household survey. Now, with the same 

employment function model, the difference between the predicted value of employment growth 

and its actual value is -0.5 percent, which is within two forecast errors in 2002 and essentially 

zero in 2003. This is a shortfall on only 700,000 jobs (and obviously not statistically different 

from zero). These results suggest a very different story about the potential problems being 

caused by the much publicized spate of outsourcing.12

 This author has attempted to determine why these two employment series give such 

drastically different pictures of employment growth during the early stages of the recovery from 

the recession of 2001. Again, employment from the establishment survey fell by 1.4 percent over 

the 2002-2003 period, but employment from the household survey increased by 0.6 percent 

during this time. First, during the 1957-2001 period the percentage changes in the two 

employment levels were highly correlated (r = +.94), so their divergence in the last 2 years is 

quite remarkable. Second, about 0.2 percentage points of the household survey employment 

number from 2001 to 2003 represents an increase in self-employment, which is not included in 

the establishment survey. Third, about 1.0 percentage points of the increase in employment from 

the household survey represents an increase in the fraction of workers who are employed on a 

part-time basis (0.8 for economic reasons and 0.2 voluntarily). To the extent that the 

establishment survey misses part timers, this may explain part of the reason why the two series 

tell such different stories. Another reason is that the establishment survey may be based on a 

sample that could have missed a lot of job creation in small businesses—if there was in the past 2 

years a major structural change from large to smaller firms. 
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Employment and Training Administration 9 

2.0 Trade Theory and Empirical Evidence 

2.1 Wage Determination in the Closed Economy 

We begin by examining the fairly long-run determination of employment and wages in an 

economy that is characterized by both full employment and the absence of any international 

trade. The second assumption—that the economy is closed—is obviously a temporary one, for 

the point of this report is to review the labor market effects of various international 

developments. This closed economy assumption leads to a set of conclusions in which wages by 

skill are determined by the relative supplies of different types of labor and the nature of 

consumer demand for different products. The open economy model that will be discussed in 

section 2.2 leads to very different conclusions about what affects the determination of wages. 

 It is convenient to think of the aggregate labor force as being composed of two types of 

workers, high-skilled (H workers) and low-skilled (L workers). This is a gross simplification of 

the labor market in the U.S. (or anywhere else), for different members of the labor force are in 

reality delineated by a plethora of characteristics such that there are many separable types of 

labor input, rather than just two kinds.13

 For reasons that will become clear in subsequent discussion involving the possible effects 

of international developments, it is necessary to think of the economy as being composed of, at 

least, four industries. These four industries include two relatively high-skilled intensive 

industries (like finance or higher education) and two relatively low-skilled industries (like food 

retailing or textile manufacturing). In subsequent sections, one of each of the high-skilled 

intensive and the low-skilled intensive industries will be assumed to be competitive in world 

markets and products in those industries are imported and/or exported. The other two industries, 

again one high-skilled intensive and the other low-skilled intensive, produce goods that are 

nontradable. In this section, however, there are no exports or imports, so all the output of each of 

the four industries is consumed domestically. 

 It is customary to assume that workers of each type of labor are mobile across the four 

industries. It is also usually assumed that the wage rate of each type of labor is the same in each 

of the four industries.14

 In addition to the two types of labor, output is assumed to depend on inputs of capital and 

other factors of production. The aggregate stock of capital is presumably allocated among the 

four industries such that the rate of return to capital is identical in each. 

 The outcome variables in which we are interested are: 

• The real wage rates of high-skilled labor (WH) and low-skilled labor (WL). 

• The distribution of wages, in this case the relative wage of high-skilled workers, rel = 

WH/WL.

• The average real wage rate (WA = hWH + (1-h)WL, where h is the fraction of total 

employees who are high skilled). 
• The prices of the four goods in the economy. 

• The employment distribution of each type of labor across the four industries. 

The equilibrium of the economy and, of particular interest to us, of the labor market 

depends on the state of consumer demand for the four goods, the overall efficiency of the 

production process in each industry, the supplies of each type of labor, the aggregate supply of 

capital, and the technology parameters in each industry. What can, in the context of the closed 

economy model, happen that can cause the above outcome variables to change? The 

“comparative statics” of the models are as follows:15

• Shifts in consumer demand: If there is a shift in consumer preferences away from 

consumption of one of the low-skilled intensive goods toward one of the high-skilled 

intensive goods, the prices of the two high-skill intensive goods rise and those of the 

two low-skill intensive goods fall. This causes WH to rise and WL to fall, so the highskilled/low-skilled relative wage (rel = WH/WL) increases. The effect on the average 

real wage rate (WA) is ambiguous. The effects of an opposite shift in consumer 

demand—from a high-skilled consumption good to a low-skilled consumption 

good—are the opposite. 

The effects of shifts in product demand on the equilibrium high-/low-skilled relative 

wage are demonstrated in figure 1. A change in product demand toward a high-skill 

intensive good shifts the relative demand curve for skilled labor to the right—from 

(H/L)d to (H/L)d’

. This causes the high-/low-skilled relative wage, rel, to rise from its 

initial value rel0 to rel2.

Figure 1. Determination of the Equilibrium 

High-Skilled/Low-Skilled Relative Wage 

in the Closed Economy Case 

 

 (H/L)s

 (H/L)s’

 rel 

 rel2 

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 rel1 

 

 rel0 

 (H/L)d’ 

 rel3 

 

 (H/L)d

 

 (H/L) 
• Increases in the quantities of high- and low-skilled labor: If, ceteris paribus, the 

supply of high-skilled labor (H) rises proportionally more than the supply of skilled 

labor (L), the output of the two high-skill industries will tend to rise and the relative 

prices of the goods of those industries will fall. Accordingly, WH will fall and WL will 

(most likely) rise, thus causing a decline in rel = WH/WL. The average wage (WA) will 

fall in the short run, but, depending on the conditions dictating the aggregate supply 

of capital, the decline in WA will be much smaller in the long run (when the capital 

stock adjusts to its new equilibrium). Geometrically, the increase in (H/L)s is 

represented by the rightward shift in the (vertical) relative supply function in figure 1. 

This causes rel to fall from its initial value rel0 to rel3.

16 

• Increases in industry efficiency: Now suppose that the production process in one of 

the high-skill intensive industries becomes more efficient.17 This means that the price 

of the output of that industry falls, and resources are drawn from other industries, 

especially the other high-skill intensive industry, to that industry. The value of both 

the high- and low-skilled real wage rates and the average real wage rate rise, but one 

cannot tell in advance whether WH rises proportionately more or less than WL rises; 

the sign of this effect depends on the values of the various elasticities of product 

demand, intra-labor type substitution, and capital/labor substitution. The reason for 

this ambiguity is that the increase in efficiency in a particular industry raises the 

productivity of workers in that industry, which raises their relative wages, and, 

through the associated increase in output, lowers the relative price of output in that 

industry which depresses relative wages. Thus, the relative demand curve in figure 1 

may shift to the right or to the left (or not at all) in response to a change in the relative 

productive efficiency of a particular industry. 

• Skill-biased technical change: This is the labor economist’s “conventional wisdom” 

about what happened to the U.S. labor market from the mid-1970s into the 1990s.18 

Because of the introduction of computer technology and a general increase in the 

relative productivity of educated workers, many jobs that used to be performed by 

low-skilled workers were shifted to high-skilled workers—in all industries.19 This 

causes, holding relative supplies constant, a rise in WH and a fall in WL. In terms of 

figure 1, the relative demand curve shifts to the right, which, absent other changes, 

would make the skill differential rise to rel2. During the 1980s and 1990s in the U.S., 

however, the relative supply of high-skilled labor increased significantly. The bottom 

line (of this conventional view) is that the combination of skill-biased technical 

change and large relative supply increase caused the value of the skill differential to 

increase from rel0 to rel1—instead of increasing to rel2, due solely to skill biased 

technical change, or decreasing to rel3, due solely to the increase in relative supply. 

This framework was employed by several investigators, e.g., Bound and Johnson 

(1992) and Katz and Murphy (1992), to explain the apparent anomaly of observed 

rises in the value of both rel and H/L in the U.S. during the 1980s. 

 It should be pointed out that the closed economy labor market model has two 

implications that are not present in the extreme form of the open economy model that will be 

U.S. Department of Labor 

Employment and Training Administration 11 
U.S. Department of Labor 

Employment and Training Administration 12 

examined subsequently. The first of these concerns is the potential effects of education and 

training on wage rates of the two types of labor. A training program, in principle, uses resources 

to transform some low-skilled workers into high-skill workers; i.e., H rises and L falls by the 

number of successful trainees.20 The long-run economic effects of a training program (or of an 

expansionary educational policy, like an increase in tuition subsidies) are, in the context of the 

closed economy model, the results for an increase in H, which was discussed above, and a 

decrease in L. The prices of the goods produced in the high-skill intensive sectors would fall 

relative to the prices of goods in the low-skill intensive sector. In terms of figure 1, the (H/L)s

curve moves to the right so that WH/WL falls. 

 This leads to one of the very few policy implications from the closed economy model 

concerning the effects of skill-biased technological change. If society does not like the increased 

wage inequality that results from a prolonged spell of skill-biased technical change, it can pursue 

policies, like training programs, that lower WH/WL by increasing the supply of high-skilled labor. 

The second implication of the closed economy model that is not present in the open economy 

version concerns the labor market effects of immigration. Suppose that there is a large 

immigration of low-skilled workers into the country. This is represented by an increase in L such 

that the (H/L)s

 curve in figure 1 shifts to the left. The effects of this immigration include an 

increase in WH and a decrease in WL, as well as declines in the prices of goods produced in the 

low-skilled intensive industries relative to those in the high-skilled intensive industries. 

The principal conclusions of the closed economy model of labor market equilibrium in 

the medium and long run are: 

• Wage rates for different labor market types are affected by demand changes and 

changes in relative supply. 

• Generalized shifts in production functions, usually associated with skill-biased 

technological change, can also change wage differentials. 

2.2 Wage Determination in the Open Economy 

We now lift the assumption that the economy is characterized by autarky; i.e., that 

there is no significant foreign trade in the economy. This, the textbook model of the equilibrium 

of the labor market under international trade, yields very different assumptions about the forces 

that are influential in the determination of the wages of different types of labor in the economy. 

Instead of assuming that the economy is closed, we assume that the products of two of 

the four industries in the economy, one high-skilled intensive and the other low-skilled intensive, 

can be purchased or sold abroad (that is, they are potentially tradable). The other two industries 

in the economy, again one high-skilled intensive and the other low-skilled intensive, produce 

goods that are nontradable. To keep the exposition as simple as possible, we will identify the 

industries as follows: 

Industry 1 High-Skilled Intensive Tradable Goods 

Industry 2 Low-Skilled Intensive Tradable Goods 
Industry 3 High-Skilled Intensive Nontradable Goods 

Industry 4 Low-Skilled Intensive Nontradable Goods 

 It is further assumed that: all production of each of the four goods takes place 

within the country;21 foreign and domestic versions of tradable goods 1 and 2 are perfectly 

substitutable;22 as in the discussion of the closed economy above, all factors within the country 

are, after the passage of the relevant amount of time, perfectly mobile between industries; and 

the economy is too small to have a significant effect on the values of world prices of tradable 

goods (“small country” assumption). We also continue to assume that wages for each labor type 

are more or less equal across industries—although this is not very important.23

There is a problem with applying the completely open economy to the United States 

because it accounts for about 23 percent of world GDP and a significant, although somewhat 

smaller, fraction of the consumption of tradable goods. The “small country” assumption is not 

strictly correct for policy discussions involving the U.S. The world is, after all, a closed 

economy, and the U.S. accounts for between a quarter and a fifth of that economy. Thus, any 

analytical results for the U.S. should be a weighted average of the results for the relevant open 

economy model and the closed economy model, with the weight for the open economy result 

being equal to one minus the proportion of tradable goods that directly involve the U.S. (perhaps 

0.80 = 1 – 1/5). 

 The resultant model of labor market equilibrium and predicted effects of changes in 

certain exogenous variables are very different in the open economy model than in the closed 

economy model.24 First, the determination of the wage rates for high- and low-skilled labor 

throughout the economy are determined entirely in the tradable goods sector. The reason for this 

is that, given the world prices (inclusive of transportation costs and tariffs) of the two tradable 

goods (P1 and P2), as well as the conditions of production in those industries, WH and WL must 

take unique values in order for the firms in those industries to remain sufficiently profitable and 

to stay in business.25 This implies that the value of the high-/low-skilled labor relative wage rate, 

rel = WH/WL, is determined solely by the internationally determined relative prices of goods 1 

and 2, P1/P2, and the relative productive efficiencies of those two industries. Other exogenous 

variables, such as relative supply of high-skilled labor, (H/L)s, and composition of domestic 

product demand, have no effect on real and relative wages in the open economy model.26

U.S. Department of Labor 

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Figure 2. Determination of the Equilibrium 

High-Skilled/Low-Skilled Relative Wage 

in the Open Economy Case 

 (H/L)s

 (H/L)s’

 rel 

 

U.S. Department of Labor 

Employment and Training Administration 14 

 

 (H/L)d’ 

 

 

 (H/L)d 

 

 

 

 (H/L) 

The relative labor demand function in the open economy case is therefore horizontal, as 

depicted by the (H/L)d

 curve in figure 2. This demand curve is shifted up or down as, 

respectively, the internationally determined value of the relative price of the high-skilled 

intensive good (P1/P2) rises or falls. It also shifts up when the average efficiency level of the 

high-skilled intensive industry increases relative to the low-skilled intensive industry. The 

horizontal relative demand curve is not shifted by changes in tastes or by generalized (i.e., across 

all industries) skill-biased technological change. 

 It is instructive to compare the effects of various exogenous changes in the contexts of 

the closed and the open economies: 

• Shifts in consumer demand: If there is a shift in domestic consumption demand away 

from one of the low-skilled intensive goods, either the traded good (industry 2) or the 

nontraded good (industry 4), toward one of the high-skilled intensive goods (either 

industry 1 or 3), there is, in an open economy setting, no change in the relative 

demand for skilled labor and, therefore, no change in the high-/low-skilled relative 

wage, rel = WH/WL. In the closed economy model, we saw that such a change in 

tastes causes rel to rise. What happens due to product demand shifts in the open 

economy model is that labor and other factors of production flow toward the 

industries in which they are needed in order to keep relative prices consistent with 

their international values. This is sometimes rather subtle. For example, suppose that 

there is a shift in consumer demand from industry 4 (the low-skilled intensive 

nontraded good) toward industry 1 (the high-skilled intensive traded good). The 
U.S. Department of Labor 

Employment and Training Administration 15 

primary effect of this change in tastes is a shift of resources from industry 4 to 

industry 2 (the low-skilled intensive traded good). Domestic consumption of good 1 

has increased, meaning that exports of that good have fallen (or imports of good 1 

have risen), so exports of good 2 have to rise (or imports of good 2 have to fall) in 

order to keep the economy in balance.27 

• Increases in the quantities of high- and low-skilled labor: In the closed economy, as 

we saw in the last section, and increase in H/L causes the value of rel to fall. In the 

open economy, on the other hand, if a certain number of Ls were suddenly 

transformed into Hs, resulting in an increase in H/L, there would be no change in 

relative price of labor. What would happen instead is that there would be a flow of 

resources out of industry 2 (the low-skilled intensive traded good) into industry 1 (the 

high-skilled intensive traded good) along with slight increases in the amount of 

resources in both nontraded goods industries.28 

• Increases in industry efficiency: In the closed economy an x percent increase in the 

efficiency of any one of the industries, either high-skilled or low-skilled intensive, 

causes the average level of real wages to rise but has an ambiguous effect on the high-

/low-skilled relative wage. In the open economy, however, because the prices of 

traded goods are determined internationally, an x percent increase in the overall 

efficiency of each industry has different effects depending on the industry in which 

the efficiency increase occurs. First, the average real wage in the economy, WA, rises 

by approximately the share of the contribution of that industry to GDP times the x 

percent efficiency increase regardless of which industry the improvement occurred. 

Second, an x percent increase in the efficiency of the production of either of the 

nontraded goods, industry 3 or 4, causes an increase in both WH and WL by the 

consumption share of the relevant nontraded good times x percent. Third, an increase 

in the overall efficiency of the production of the high-skilled intensive traded good, 

industry 1, causes an increase in the high-/low-skilled relative wage, for the 

horizontal relative demand function in figure 2 shifts up by at least x percent. The 

price of the high-skilled intensive nontraded good, industry 3, rises and the price of 

the low-skilled intensive non-traded good, industry 4, falls. WH rises as a result of the 

increase in efficiency, but the low-skilled real wage rate (WL) falls. The qualitative 

effects of an increase in the efficiency of industry 4 are, of course, analogous to the 

effects of the increase in the efficiency of industry 1; rel falls, WH falls, WL increases, 

and so forth. 

• Skill-biased technical change: In the closed economy model, the effect of skill-biased 

technical change in any of the sectors of the economy on the relative demand function 

for high-skilled labor is an unambiguous rightward shift. In the open economy case, 

however, it is not the skill bias of technological change that causes an increase in the 

relative demand for high-skilled labor but the sector bias.29 The standard labor 

economics explanation of the behavior of the U.S. labor market during the past 25+ 

years—that there was significant skill-biased technical change in most or all 

industries—would not necessarily yield an increase in rel in the context of an open 

economy. 
U.S. Department of Labor 

Employment and Training Administration 16 

• Changes in the relative prices of tradable goods: There are three reasons why P2 (the 

price of good 2 relative to the price of good 1) may decline. First, the cost of 

transporting foreign production of good 2 into the U.S. may fall due to technological 

or political improvements. Second, economies in other parts of the world may get 

better at producing good 2. The third reason, which has slightly different effects on 

the level and distribution of real income and will be discussed in the next section, is 

that tariffs imposed by the U.S. on imports of good 2 may be reduced. In terms of 

figure 2, the decline in P2 causes the vertical labor demand function to shift up such 

that rel = WH/WL rises. There is a transfer of resources out of industry 2 into 

industries 1 and 4. The real wage rate of high-skilled labor rises and that of lowskilled labor falls. The average real wage in the economy rises as a result of the 

decrease in P2 so long as the economy was initially a net importer of the low-skilled 

intensive good. 

It should be clear that the two policy implications of the closed economy model discussed 

in the preceding section do not hold in the open economy version of the model. First, the attempt 

to reduce increasing earnings inequality with training and education policies designed to increase 

the relative supply of skilled labor ((H/L)s

) will not have a long-run effect on rel because the 

relative demand function is horizontal. Instead, an increase in H/L supplied will, after a period of 

adjustment, only cause the product mix of production to change without changing any relative 

prices or wages in the economy. 

The second implication of the open economy case that is different from the closed 

economy case concerns the effects of immigration on relative labor earnings. In the closed 

economy case, a large increase in low-skilled labor through immigration depresses the real 

wages of domestic low-skilled workers and, because of the necessary complementarity between 

low- and high-skilled workers, increases the real earnings of high-skilled workers. As with the 

potential policy response to skill-biased technical change in the closed case, the best (in the sense 

of cost efficiency as well as fairness) thing to do in this case is to train some of the domestic Ls 

to be Hs. In an open economy setting, the increase in low-skilled immigration causes a change in 

product mix in the economy without changing the value of rel. Further, the use of training 

programs in order to reduce relative wages is futile in an open economy setting, for the increase 

in the relative supply of skilled workers has, in an open economy framework, no effect on 

relative wages. 

The principal conclusions of the open economy model of labor market equilibrium in the 

medium and long run are: 

• Wage rates for different labor market types are principally determined by the 

internationally determined values of the prices of tradable goods and the general 

productivity of industries in the tradable goods sector. 

• Unlike the closed economy case, wage rates for different labor market types are not 

affected by product demand changes and changes in relative labor supply. 
U.S. Department of Labor 

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• Generalized shifts in production functions, usually associated with skill-biased 

technological change, do not change wage differentials as they do in the closed 

economy case. 

2.3 The Major Welfare Implications of the Open Economy Model 

The principal policy implication of the standard economic approach to international trade 

is that tariff or nontariff barriers to trade lower average real wage rates. The “best” (average 

utility maximizing) policy for a country is free trade. There are some exceptions to this general 

rule,30 but the consensus among international economists is that it is best not to interfere with the 

free flow of goods. 

 A strong interpretation of trade adjustment assistance policy is to assure that the “losers” 

due to a trade liberalization policy or some sort of globalization development are compensated 

by the “winners” such that the former are no worse off as a result of whatever happened.31 It is 

interesting, therefore, to illustrate the quantitative magnitudes of the effects of changes in tariffs 

and of international economic conditions. Table 4 shows what happens to aggregate GDP, highskilled labor real earnings, and low-skilled labor real earnings as a result of a perfectly targeted 

tariff on imports.32

Table 4. Hypothetical Effects of Imposition of Tariff on Imports 

of Low-Skilled Intensive Goods on GDP, High-Skilled and Low-Skilled 

Labor Earnings, and the High-/Low-Skilled Relative Wage Rate

Tariff GDP 

High-skilled 

earnings 

Low-skilled 

earnings 

rel 

0.00 1.000 1.000 1.000 1.50 

0.05 0.99997 0.975 1.024 1.43 

0.10 0.9990 0.951 1.047 1.36 

0.15 0.9978 0.928 1.067 1.30 

0.20 0.9962 0.906 1.087 1.25 

0.25 0.9942 0.884 1.105 1.20 

0.30 0.9920 0.863 1.121 1.15 

The numbers in the table show the hypothetical value of these variables relative to their values at 

a zero tariff. For example, at a tariff rate of t = 0.05, the aggregate earnings of high-skilled 

workers is 97.5 percent of its value at t = 0; at t = 0.10 high-skilled earnings are 95.1 percent of 

their value at a zero tariff. 

 The major implication of table 4 is that the major effects of tariffs are in terms of the 

distribution of economic welfare rather than its aggregate value. For example, imposing a 30 

percent tariff on the imports of low-skilled goods lowers the net real earnings of high-skilled 

workers by about 14 percent and raises the earnings of low-skilled workers by about 12 percent, 

but it only lowers the average net real earnings of all workers by about one percent. Accordingly, 

reductions in tariffs on low-skilled goods, along the lines of the North American Free Trade 
U.S. Department of Labor 

Employment and Training Administration 18 

Agreement (NAFTA), would be expected to yield smaller efficiency gains than their effects on 

income distribution.33

 A similar conclusion—that developments with respect to trade affect the distribution of 

real income more than its level—applies to the effect of a change in international relative prices. 

Table 5 reports the hypothetical effects on real GDP, its distribution among high- and low-skilled 

workers, and the high-/low-skilled relative wage (rel) of an exogenous decrease in the 

internationally determined relative price of the low-skilled intensive good.34

Table 5. Hypothetical Effects of Decreases in the 

International Price of Low-Skilled Intensive Tradable Goods on GDP and 

Its Distribution With and Without Tariff Increases 

P2

Without tariff increase With tariff increase 

GDP 

Highskilled 

earnings 

Lowskilled 

earnings rel t* GDP rel 

1.00 1.0000 1.000 1.000 1.50 0.000 1.0000 1.50 

0.95 1.0081 1.034 0.982 1.58 0.036 1.0079 1.52 

0.90 1.0173 1.071 0.964 1.67 0.075 1.0167 1.52 

0.85 1.0281 1.111 0.945 1.77 0.117 1.0267 1.58 

 0.818 1.0357 1.139 0.932 1.83 0.145 1.0335 1.60 

A 15 percent decrease in the international price of the low-skilled intensive good causes 

GDP to increase by about 3 percent, but this is the result of an 11 percent increase in the earnings 

of high-skilled workers and a decrease of 5.5 percent in the real earnings of low-skilled 

workers.35 The last three columns of the table calculate what would happen to aggregate welfare 

if a tariff on the importation of good 2 were imposed such that the net real wage rate of lowskilled workers was the same given the new value of P2 as it was initially with P2 = 1. This is an 

example in which policies are enacted such that the low-skilled population is “held harmless” of 

effects of globalization. This policy slightly lowers the increase in aggregate efficiency due to 

the fall in P2, but the increase in income inequality is, of course, substantially reduced. 

 This is not meant to advocate policies associated with the last two columns, for there are 

some serious objections to the use of tariff increases as a way of protecting groups of workers 

within the U.S. from international competition. First, except for temporary “emergencies,” it is 

illegal under World Trade Organization (WTO) rules. Second, raising tariffs in the U.S. invites 

other countries to impose tariffs on U.S. exports. Third, it is generally in the foreign policy 

interests of the U.S. to promote prosperity in poorer countries. Fourth, there are, in principle, less 

inefficient ways of compensating losers than tariffs (and, more so, nontariff barriers to trade). 

 
U.S. Department of Labor 

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The principal conclusion of this section is: 

• Increases in foreign productivity and liberalizations of trade policy will tend to 

increase average welfare, but they tend to have larger effects on relative wages.

2.4 Estimation of the Effect of Changes in International Prices on Relative Wages 

There are two major approaches in the literature on the estimation of the effect of 

changes in international prices on relative wages. The conclusion of both of these approaches is 

that—at least through the 1990s—a relatively small proportion of the increase in income 

inequality in the United States since 1979 is directly attributable to international developments. 

The first—and most direct—of these approaches is to use a regression analysis to relate 

the percentage change in the price of tradable goods to the factor shares of each factor of each 

good over a time period of relevance. Although there are some serious econometric issues (like 

the potential correlation of the omitted variable industry technology change with both the right 

hand side and the dependent variable), the estimates of these coefficients can, in principle, be 

used to determine the effect of international price changes on relative wages. 

 The results of estimation of these cross-sectional price equations have not been very 

encouraging. The most extensive recent study of this sort, Baldwin and Cain (2000), concludes 

that the thrust of their results for the 1979-1991 period “supports the conclusion that trade, by 

itself, cannot explain the increased wage inequality in favor of groups with more education.” 

The major reason for the lack of success of this approach in explaining movements in rel is 

contained in Leamer (1998), an economist who is more likely than most to accept an open 

economy explanation of events. Leamer reports that the relative price of producer prices for lowskilled labor fell significantly during the 1970s and rose during the 1980s. Given that the 

qualitative movement in rel during these both of these periods was very much in the opposite 

direction, one would have to look elsewhere for an explanation. 

One potential problem with the price equation approach is that it does not identify the 

source of price changes—in particular, those due to changes in tariffs and transportation costs 

versus those due to other factors like industry-specific productivity growth. Haskel and Slaughter 

(2003) attempt to sort this out for the U.S. by identifying the portion of imported good price 

changes between 1974 to 1979 and 1979 to 1988 that were due to reductions in tariffs and 

transportation costs. First, they find that these reductions were highest in the low-skilled 

intensive sectors of the economy. However, the estimated effect of these reductions on changes 

in relative wages in the U.S. was both small and statistically insignificant. 

 The second way of estimating the effect of trade developments on relative wages is factor 

content analysis (FCA). This approach (which seems to appeal slightly little more to labor 

economists than to trade economists) is based on the calculation of the amount of each type of 

labor that is used for exports and/or would be used in the production of goods that are now 

imported. The net additional demand across all tradable goods (positive for exports, negative for 

imports) for each type of labor is then subtracted from the aggregate supply of each type of labor, 
U.S. Department of Labor 

Employment and Training Administration 20 

and calculations can be made of the effects of changes in trade patterns on relative wages using 

the labor demand functions from a model based on the assumption of a closed economy.36

The approach is somewhat paradoxical in the following sense. Suppose that in a closed 

economy the supply of low-skilled workers rose by 10 percent because of immigration. After a 

period of adjustment, the prices of the low-skilled intensive goods and the wages of low-skilled 

workers would fall relative to the wages of high-skilled workers. In the open economy model, 

however, relative wages would not be changed after the period of adjustment; instead, the 

composition of product demand would change in response to changes in endowments such that 

there were more jobs in low-skilled intensive industries. 

 Now consider the effects of an increase in the efficiency in foreign countries of 

production of what are in the U.S. low-skilled intensive tradable goods. This causes the relative 

international price of these goods (e.g., toys) to fall and causes a shift of resources in the U.S. out 

of these industries and an expansion of the exports of high-skilled intensive goods. To determine 

the effect of this global “shock” on the U.S. wage structure, we could use FCA to calculate the 

implied change due to the event on the relative supply of high- versus low-skilled labor and then, 

with the closed economy relative demand elasticity, how much rel changes as a result of the 

change in international prices. If the synthetic relative supply change due to the increase in 

imports was a reduction in relative supply of 10 percent, the wage effect would be the same as a 

10 percent increase in real low-skilled supply due to immigration in the closed economy case. 

The use of FCA is an approximation, for it requires satisfaction of several assumptions,37

but it provides at least an approximation of the effects of trade. Borjas, Freeman, and Katz 

(1997) make calculations of the effects of increased U.S. trade with less developed countries 

(LDCs) on the change in the relative wage structure from 1980 to 1995. Of the increase in the 

college/high school relative wage of 21.0 percent during that interval, they estimate that 

increased trade with LDCs accounted for only about 0.7 to 1.3 percentage points (depending on 

the assumed wage elasticity of labor demand). A somewhat larger—but still relatively small—

fraction of the 11.5 percent increase in the wage differential between high school graduates and 

dropouts can be attributed to increased trade, between 0.6 and 1.2 percentage points. They 

interpreted the data as suggesting that increased immigration had a larger impact than increased 

trade. Baldwin and Cain (2000) used FCA to explain the 12.3 percent increase in the wage of 

workers with 13 plus years of schooling relative to those with lower levels of schooling over the 

interval 1977 to 1987. Their estimated attribution to trade developments was about 1/6th of the 

change in the differential—larger than Borjas, Freeman, and Katz, but still fairly small. 

 The principal conclusion of the recent literature on the effects of trade-related changes on 

relative wages since the 1970s in the U.S. is: 

• Trade developments have had an effect on wage differentials by skill in the U.S. since 

the 1970s, but this effect has been fairly small (1/10 to 1/5 of the observed changes). 
U.S. Department of Labor 

Employment and Training Administration 21 

2.5 Departures From the “Pure” Open Model 

The failure of the traditional open economy model to explain very much (hardly any) of 

the observed changes in relative wages raises questions about the degree to which the standard, 

textbook open economy model is relevant to the U.S. economy. In addition, there is abundant 

evidence that the relative demand function for skilled labor is downward-sloping rather than 

horizontal (that is, it looks, at least qualitatively, like figure 1 instead of figure 2). Contrary to the 

implications of the pure trade theory model, there is considerable evidence for the U.S. that 

domestic factor supplies have the negative ceteris paribus effect on domestic wage rates that is 

predicted by the closed economy model.38

 A key assumption of the open economy model is that the United States is active in both 

of the tradable goods industries, the high-skilled intensive industry, and the low-skilled intensive 

industry. We have seen that there is a reduction in resources devoted to industry 2 in response to 

an increase in H/L and a decrease in the world price of P2. As pointed out below, as 

transportation costs have fallen and a number of formerly relative primitive economies have 

organized industries producing good 2, the price of imported versions of good 2 is bound to fall. 

In addition, if there is an increased demand for low-skilled workers in nontradable services, an 

expansion of the relative importance in consumption of industry 4, there will be a further 

contraction of resources devoted to industry 2. 

 At a certain point, it is accordingly possible for industry 2 to disappear from the U.S. and 

that all consumption of good 2 is, like sisal or (ignoring Hawaii) coffee, imported from other 

countries. When industry 2 disappears so that good 1 is the only product produced in the 

economy that is subject to international competition, the economy is said to have left the cone of 

diversification, in which domestic relative factor prices are determined internationally. In this 

case, labor market equilibrium in the economy looks very much the way it does in the closed 

economy model39—the relative demand function looks very much like figure 1 rather than figure 

2. 

 A great deal of recent empirical work by international economists has attempted to 

reconcile certain apparent inconsistencies between observed behavior and the traditional open 

economy model by allowing for diversity between countries in technology and qualitative 

endowments rather than just quantitative endowments (capital per worker and the skill 

distribution of the workforce).40 The model emerging from this line of research is that of a 

multiple-cone equilibrium in which each economy specializes in the subset of goods that is most 

appropriate given both the qualitative and quantitative nature of that country’s endowments and 

technology. 

 A second departure from the standard open economy model arises from the possibility 

that many goods are sufficiently heterogeneous that versions produced in different countries are 

less than perfectly substitutable for each other. An alternative approach, first suggested by 

Armington (1969), is to specify that for each relevant good there is an elasticity of substitution in 

consumption between the domestic and foreign version of the good, the Armington elasticity.41 

For example, with a finite value of this elasticity with respect to vehicular equipment, the U.S. 

relative demand for domestic versus foreign-produced automobiles would depend negatively on 
their relative price. As the price of foreign relative domestic cars increases, consumers shift away 

from Volvos toward Hummers. But because of differences in tastes of consumers for different 

aspects of motor vehicles, one would expect that this substitution would be partial; i.e., the 

Armington elasticity would be finite. Other products, such as petroleum and sugar, are not 

differentiated by source, and there is no reason to suspect any home bias in consumption 

demand. In these cases, there is no reason to suppose that the Armington elasticities are less than 

infinity. 

 This suggests that—at least for many products—import demand functions will have a 

finite relative price elasticity (in terms of the U.S. price of the foreign good, including tariffs and 

transportation costs, divided by the price of the foreign alternative). Each import demand 

function will also depend on a taste parameter, reflecting among other things, the popularity of 

the foreign versus the domestic version of the good. If Armington elasticities are finite in the 

U.S., they should be finite elsewhere, which means that the demand for exports of the typical 

good will have a finite absolute elasticity equal to (approximately) the Armington elasticity. 

Each export demand function will also depend on a taste parameter that is shifted by changes in 

the popularity, prices held constant, of American versus other versions of the good.42

 The resultant relative labor demand function with an Armington elasticity that is finite 

(but greater than one) is illustrated in the figure 3 case as (H/L)d

Intermediate, the dashed line that is 

in between the downward-sloping demand function of the closed economy and the horizontal 

demand function for the open economy. In the intermediate case, the demand function is the 

more horizontal—the closer to the open economy case—the larger is the value of the Armington 

elasticity. The implications of the intermediate case are, needless to say, strictly between those of 

the two extremes that were discussed in sections 2.1 and 2.2. 

Figure 3. The Relative Demand for High- and Low-Skilled Labor in Three Cases 

 rel (H/L)s

 

U.S. Department of Labor 

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 (H/L)d

Open 

 

 

 (H/L)d

Intermediate 

 

 (H/L)d 

Closed 

 

 (H/L) 

 
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Empirical evidence on Armington elasticities varies a great deal. A recent survey by 

McDaniel and Balistieri (2002) concluded that estimates tend to be higher if they: refer the long 

run than for the short run; are based on very disaggregated product data; and focus on crosssectional data with adjustment for supply conditions than single equation time series regressions. 

It is interesting to note that there is some evidence, due to Slaughter (2001), that labor demand 

elasticities in the U.S. became more elastic from the 1960s to the early 1990s, and this could be 

interpreted as reflecting increases over this period in the average value of the relevant Armington 

elasticities. 

 A generalization of this approach to changes in preferences is the model of Rauch and 

Trindade (2003) that focuses on the dynamics of information exchanges across national borders. 

They note that in the 1990s, there were tremendous increases in the number of periodicals 

devoted to international trade and commerce and the development of the Internet that greatly 

facilitated entry of entrepreneurs in one country into other countries.43 These sorts of 

technological changes yield what Rauch and Trindade call “familiarity,” and this, in turn, causes 

labor market integration among different countries. A key result of their paper is that complete 

familiarity makes the absolute relative wage elasticity of the labor demand function to go to 

infinity (in terms of the framework in this report, to move from figure 1 to figure 2 over time).44

 The principal conclusions of the various more realistic models of the long-run and 

medium effect of trade on the labor market are: 

• The correct specification of the effect of international developments on the U.S. labor 

market is, for several reasons, a blend of the closed and the open economy models. 

• This means that in the long run relative wages are affected by both international 

factors (foreign prices and trade policies) and domestic factors (relative supplies, 

domestic consumer demand, and skill-biased technological change). 

2.6 Trade and Economic Growth 

One of the more interesting empirical topics in the international economics literature 

concerns the ceteris paribus effects of policies toward trade on the equilibrium rate of economic 

growth in the economy. In particular, we can posit that over some time interval (like from 2005 

to 2020) the average annual rate of growth (gY) depends on a set of internal factors that affect 

growth (X) and a representation of the set of policies relating to openness to international 

interdependence, say Θ (theta for “trade”), that is: 

(1) gY = f(X, Θ). 

The X variables would include the average rate of growth of the labor force, changes in the skill 

distribution of the economy, changes in the social infrastructure (roads, public safety, etc.), and 

various types of technical change. The Θ variables include the absence of tariffs, nontariff 

barriers, currency exchange controls, and laws restricting capital mobility. In other words, a set 

of policies that encourages, rather than discourages, the openness of the economy is represented 

by a high value of Θ. 
U.S. Department of Labor 

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What would we expect to be the effect of an increase in Θ on the rate of economic 

growth? First, we have already seen in section 2.3 that a reduction in tariffs tends, at least under 

most conditions, to cause aggregate GDP to rise. The same qualitative conclusions apply to 

reductions in nontariff barriers and other restrictions on international commerce. Since an 

increase in aggregate GDP in the long run requires that Y must for some time grow faster than it 

would have without the policy change, we would thus expect the value of gY to be higher during 

the relevant adjustment period after an increase in Θ. Depending on the form of the policy 

change, this adjustment period could last for 10 or more years. After the adjustment period, 

however, one would expect no further positive effect of trade liberalization on Y, and hence its 

rate of growth due to the increase in economic efficiency. 

Most of the literature on the effect of trade policy on economic growth deals with the 

permanent effect of Θ on gY rather than its temporary effect. Table 6 reports average rates of 

growth since 1929 of GDP and employment between various points at which the economy was at 

full employment. 

Table 6. Average Annual U.S. Percentage 

Rates of Growth In Real GDP and Employment 

Selected Sub-Periods: 1929-2000 

Subperiod 

GDP 

(gY) 

Employment

(gN) 

1929-1948 3.4 1.0 

1948-1973 3.9 1.5 

1973-1989 3.1 2.0 

1989-2000 2.9 1.3 

The idea is that the average rate of growth over a specific interval of time may be 

affected by international economic policy. For example, between 1973 and 1989, would gY have 

been higher or lower than 3.1 percent if the United States had had less restrictive policies toward 

imports of goods and capital from the rest of the world? If the ceteris paribus relation between gY

and Θ were positive, less restrictive policies might have made the actual average rate of growth 

of GDP equal to, say, 3.4 percent rather than the actual 3.1 percent. Since the average real wage 

in the economy tends to be proportional to average productivity,45 the ratio of GDP to 

employment would (in the likely absence of labor supply effects) have grown at 0.3 percentage 

points per year over the 16 years from 1973 to 1989, which would have made the average real 

wage rate in 1989 approximately 5 percent higher than it actually was. Similarly, the trade 

liberalization component of the NAFTA agreement of 1994 would, under the assumption of a 

positive effect of Θ on gY, have increased the observed rate of growth of U.S. GDP during the 

second half of the 1989-2000 period, and it would be expected to do so for all years after 2000.

There are many theoretical reasons for suspecting that trade liberalization has a positive 

effect on growth. In recent years there have been attempts to link the effects of increased 

specialization brought about by increased trade on the rate of technical change in the context of 

endogenous growth models.46 On a more common sense level, exposure to and competition with 
U.S. Department of Labor 

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production systems from other countries can obviously cause an increase in the rate of Hicksneutral technological change through technology transfers.47 On the other hand, there is an 

alternative argument that the protection of “infant industries” and policies, followed by Japan in 

the 1970s and 1980s and more recently by Korea, that promote exports through explicit 

subsidies, which are represented by a reduction in the value of Θ, cause economic growth to 

increase.48

 Estimation of the effects of trade policy of economic growth must necessarily involve 

comparisons across countries, so the conclusions of the various studies of this sort do not apply 

exclusively to the United States. The consensus of the early papers on this (for example, Dollar 

(1992) and Sachs and Warner (1995)), which tended to focus on developing economies, was that 

trade liberalization caused increases in economic growth; i.e., there is a positive ceteris paribus 

relation between gY and Θ. There were, as pointed out by Rodriguez and Rodrik (2001), severe 

econometric problems with each of these studies49—to the point that the consensus of a positive 

relationship has been replaced with agnosticism about its sign and magnitude. 

Indeed, some trade economists (Hallak and Levinsohn 2004) now maintain that the 

question of the extent to which trade policy affects growth has to be studied in a microeconomic 

context—with attention paid to the modeling of the specific mechanisms by which trade policy 

affects the economy—rather than a macroeconomic context. 

At this stage, therefore, when someone claims that liberal trade policies will definitely 

make GDP and real wages grow faster in the long run (or says that they will have the opposite 

effect), the honest, up-to-date answer is “perhaps.” The principal conclusion with respect to the 

question of the effect of a liberal trade policy on the long-run rate of economic growth is: 

• The evidence that liberalized trade policy increases economic growth is somewhat 

inconclusive. 

2.7 Outsourcing 

 Perhaps the most contentious “trade” issue of the last several years is the growing 

practice of many U.S. firms to have parts of their production performed abroad. This is most 

often referred to as “outsourcing”—although the term “offshoring” may be more popular in the 

press.50 Although the outsourcing of jobs to another country is, in principle, no different from the 

purchase of imported goods with a given skill content,51 shifting a production line in Gary, IN to 

suburban Shanghai seems to have a more disturbing effect on workers than the purchase of 

finished goods from China that used to be produced in the United States. 

 U.S. data on the quantity and form of outsourcing are considered, by those who try to 

work with them (Feenstra and Hanson 1999, 2001), to be quite poor, and estimation of the 

effects of the practice—even in its magnitude and the products for which it is used—is often 

fairly indirect and anecdotal.52 It seems to be a safe prediction that the volume of outsourcing 

will grow rapidly over the next several years, and, to the extent that we want to mesh labor 

market policies dealing with trade dislocations with what is effective and necessary, it would be 

a very good thing for efforts to improve data on outsourcing be undertaken as soon as possible.53
 Most of the work on outsourcing has focused on the case in which firms profitably shift 

their assembly and related functions (which are relatively low-skilled intensive), to low-wage 

countries, leaving the planning and management functions (which are high-skilled intensive) in 

the U.S. The result of this adjustment in any sort of model with less than horizontal demand 

function (like models with the qualifications discussed in section 2.5)54 is a rightward shift in the 

downward-sloping relative demand function given in figure 3. In this case, the effects of 

outsourcing on relative employment demand and on equilibrium relative wages are just like the 

effects of skill-biased technical change. If, on the other hand, the outsourcing of jobs is balanced 

in the sense that the relative demand for labor by skill is not changed (i.e., there is proportionally 

as much outsourcing of high- as of low-skilled positions), the relative demand function does not 

shift, and the equilibrium value of rel is unaffected. 

 Given the recent focus on the incidence of the outsourcing of high-skilled jobs, the 

effects of an increase in outsourcing that is (more or less) balanced across skill groups are 

interesting to explore.55 The first three items of appendix A of this report discuss this in the 

context of a straightforward one-sector macroeconomic model. Part of the flow of labor services 

can be purchased abroad, although almost all jobs are more efficiently performed within the U.S. 

and would not be outsourced unless wages were sufficiently lower in the source country or 

countries (this author will focus on just one country). A decrease in transportation or 

communication costs and/or a general increase in productivity—either private or through 

improvements in public infrastructure—make outsourcing more likely.56

The demand curve for domestic employment (N) as a function of the average real wage 

rate (W) is illustrated in figure 4. Once the practice had begun, further improvements in the 

efficiency of outsourced labor (represented in appendix A by the parameter b) have an 

ambiguous effect on the demand for domestic labor. 

Figure 4. Effects of an Increase in the Efficiency of Outsourcing 

in the Short, Medium, and Long Runs 

 W Ns

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 W” 

 W 

 Nd” 

 W’ 

 Nd 

 N’ Nd’ 

 N 

 
U.S. Department of Labor 

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If domestic and outsourced labor are sufficiently substitutable for each other in the 

relevant range, the aggregate labor demand function shifts to the left from Nd to Nd’ as in figure 

4. In the short run, if the real wage rate does not adjust from its original value, employment falls 

to N’. The increased outsourcing “destroys jobs” in a net sense in the way some in the popular 

press interpret the “jobless recovery” in the present time (see section 1.3). In the medium run, the 

real wage is bid down to W’, and the employment level goes back to where it would have been 

without the increase in the efficiency of outsourcing. 

 The effect of the increased outsourcing on the labor demand function and the equilibrium 

real wage rate in the long run depends on the nature of the supply of capital. If the supply of 

capital is perfectly elastic with respect to its return, the labor demand function shifts back beyond 

its original value to Nd”, thus causing the real wage rate in the U.S. to be higher as a result of 

outsourcing. If the supply of capital is less than perfectly elastic with respect to the return on 

capital, the shift back to the right may exceed or fall short of the original demand function, so 

real wages may rise or fall as a result of the increased efficiency of outsourcing. If the 

outsourcing requires foreign direct investment by U.S. firms, the likelihood that an increase in 

the efficiency of output causes a long-run increase in the real wage rate in the U.S. is lessened. 

 Another way that outsourcing, as well as direct trade in goods, can affect wages is by 

lowering the ability of workers to extract “rents” from employers.57 As labor demand functions 

become more elastic, unions will be increasingly less able to negotiate higher than market wages 

for their members. This, alas, may be one reason why private sector unionism, which represented 

about 35 percent of employment in 1955, has fallen to a representation level of a little less than 9 

percent at the present time. To the extent that the employment effects of unionism are subject to 

an absolute wage elasticity of less than one (which might require some explicit bargaining over 

employment), the lowering of the rents for a portion of the labor force would lower the average 

wage of workers who used to be well represented by private sector unionism—the relatively lowskilled. Of course, there is not much room for private sector unionism to fall further, so this 

effect clearly refers to the past rather than the future. 

The conclusions of this section on outsourcing are: 

• The outsourcing of parts of individual production processes is, in principle, just like 

the importation of goods with similar skill content. 

• To the extent that intermediate trade of the 1980s and 1990s was more low-skilled 

intensive than the products involved, estimates of the contribution of international 

developments to increased earnings inequality must be revised upward. 

• The long-run effect of outsourcing on the average real wage is positive. 

• The shorter-run effects of outsourcing on employment demand is ambiguous. 
U.S. Department of Labor 

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2.8 Future Trends in the Sensitivity of the U.S. Labor Market to the Rest of the World 

There are very large differences in the way labor markets are expected to work between 

situations in which international factors are fairly unimportant (the closed economy model 

discussed in section 2.1) and situations in which trade is quite important (the open economy 

model of section 2.2) and its subsequent modifications. Just how far the U.S. labor market has 

moved from quite closed, as it was around 1950, to very open is subject to some disagreement, 

but there has obviously been a great deal of movement. It is natural to ask whether there will be 

further movement toward a “fully open” economy labor market during the next few decades. Can 

we expect that the U.S. labor market will be more integrated into the world economy in, say, 

2025 than it is today? 

First, part of the answer to this question depends on the answer to the questions posed in 

section 1.3 concerning future trends in exports and imports as a fraction of U.S. GDP. Given 

continued international political stability and further decreases in transportation and 

communication costs, as well as an endogenous “globalization dynamic” (Americans getting 

used to consuming foreign goods), the indications of further integration with the world economy 

are fairly clear. But it is possible that some unforeseeable catastrophic event or events (terrorism 

comes to mind) or political change (a populist move toward extreme protectionism) could turn 

this trend around such that the economy becomes less open in 2025 than it is in 2004. 

In the absence of a political disruption, however, there are two reasons why one would 

expect the U.S. labor market to become more integrated with the rest of the world. First, with the 

passage of time and the secular increase in international communication, we would expect 

Armington elasticities to get larger (the degree of home bias to get smaller), which would imply 

secular increase in labor demand elasticities within the U.S. Similar results would be expected on 

the basis of the Rauch-Trindade informational dispersion model. 

The second reason for suspecting that the U.S. labor market will continue during the next 

few decades to become more open and more inter-dependent with foreign labor markets is the 

potential for the growth of outsourcing. Mann (2003) and Bardhan and Kroll (2003) both 

document the recent growth in the outsourcing of white collar positions, and an implication of 

their findings is that there is probably a great deal of potential for further migration of these types 

of functions. 

Interestingly, one brake on the rate at which U.S. jobs are outsourced is the effect of U.S. 

fiscal policy on future values of the exchange rate. Given that the U.S. has opted for relatively 

permanent, large structural government and foreign trade deficits, the fraction of net assets in the 

U.S. held by foreigners will continue to grow for some time. As long as this happens, there will 

be constant downward pressure on the real value of the U.S. dollar relative to other major 

currencies. This will cause the price of labor in the U.S. to fall relative to its price in countries 

that are potentials for outsourcing (see Swenson (2000) for evidence concerning this effect) and 

thus lower incentives to U.S. firms to outsource. 
3.0 Short-Run Adjustment and Trade Adjustment Assistance 

3.1 The Simple Adjustment Model 

Section 2.0 of this report highlighted many ways in which international shocks of various 

kinds can influence the demand for various types of labor. These shocks include reductions in 

world prices of certain goods caused by an increase in the productive efficiency of the 

production of those goods elsewhere in the world, reductions in transportation costs or tariffs, 

which have the same effect on the prices of relevant goods as reductions in prices, and, more 

recently, an increase in the outsourcing of certain types of labor in some industries. 

It is instructive to consider a simple model, represented in figure 5, in which a particular 

type of labor is employed in either sector 1 (the diagram on the left) or sector 2 (the diagram on 

the right). Initially, total employment of this type of labor in the economy, N = N1 + N2 is equal 

to the aggregate effective supply of labor, and the prevailing wage in both sectors is equal to 

W’,58 which is defined in annual full-time units. 

Figure 5. Labor Market Adjustment Between Sectors 

Following a Negative International Shock

 W1 W2 

U.S. Department of Labor 

Employment and Training Administration 29 

 W’ 

 

 W” 

 Wlow D1 D2

 

 N1” N1

’

 N2

’

 N2

” 

 Now assume that there is some sort of international shock that lowers the demand for 

labor in sector 1 without affecting demand in sector 2.59 This is represented by a leftward shift in 

the D1 curve. What happens eventually (in what was referred to in section 2.3 as the medium 

run) is that N1’ – N1

”

 workers in sector 1 migrate to industry 2 such that the wage for this type of 

labor falls from W’ to W”. Thus, after the adjustment period, each worker of this type—

regardless of the initial industry of employment—loses (W’-W”) per year. 

 To keep matters as straightforward as possible, assume that: the wage in both sectors 

adjusts immediately to the new equilibrium level W” from its pre-shock value W’; there is an 

out-of-pocket transfer cost of T (some combination of the total costs of training, migration, and 

job search) for each person who moves from sector 1 to sector 2; all adjustment of the labor force 
to sector 2 is complete after (arbitrarily) 2 years; the average fraction of 2 years that it takes a 

displaced worker to obtain a job in sector 2 is 2S years; and (e) the (appropriately discounted) 

worklife expectancy of Ω years.60 There are three different categories of workers within this 

labor type: the N1

’

-N1

”

 job losers in sector 1 who have to move to sector 2; the N1

”

 members of 

the original workforce in sector 1 who are lucky (or have enough seniority) to be retainers of 

their jobs in that sector; and the N2

’

 original employees in sector 2. 

 The breakdown of the effects of the trade shock on net earnings per person of the three 

categories is given in table 7. Both the sector 1 job retainers and the original workers in sector 2 

incur lifetime losses of (W’-W”)●Ω, the annual earnings reduction due to the trade shock times 

average years remaining in the labor force. The average lifetime loss of the N1

’

-N1

” job losers is 

(W’-W”)●Ω + T +2●(1-S)W”. This is obviously the higher, the larger is the resource cost of 

adjustment, T, and the lower is the speed of adjustment, S. If S were equal to one; i.e., displaced 

workers found jobs in the other sector immediately, the loss per displaced worker would be equal 

to those of all other similar workers plus the resource cost of changing sectors, T. If, for 

example, S = 0.5, it takes an average of 1 year for a displaced worker to find a new job, and the 

additional cost to a displaced worker is T plus 1 year’s earnings, W”. 

Table 7. Hypothetical Effects of Trade Shock on 

Various Members of the Affected Labor Group 

Category 

Number in 

category 

Two-year 

adjustment period 

Remainder of 

worklife 

Sector 1 job losers N1’ – N1” - T+2●(W’

 –S●W”) - (Ω-2)●(W’-W”) 

Sector 1 job retainers N1” - 2●(W’-W”) - (Ω-2)●(W’-W”) 

Original sector 2 N2’ - 2●(W’-W”) - (Ω-2)●(W’-W”) 

 The aggregate losses as a fraction of the original wage bill due to the trade shock of this 

labor type as a fraction of the original wage bill are given by: 

⎥

⎥

⎦

⎤

⎢

⎢

⎣

⎡

⎟

⎟

⎠

⎞

⎜

⎜

⎝

⎛ − ⎟

⎠

⎞ ⎜

⎝

⎛

Ω

+−

+ − = Ω − '

1

"

1

'

1

'

")1(2

'

"'

' )13( N

NN

W

TWS

W

WW

NW

LOSS

This is equal to the proportionate change in the wage of the labor type due to the trade 

development plus the ratio of total adjustment costs per displaced worker to the original wage, all 

times the fraction of workers who are displaced by the shock. Total displacement costs are 

resource costs plus the lost output due to unemployment. In the aggregate, the trade development 

creates a benefit to all other factors of production in terms of increased real incomes that, 

presumably, is greater than the loss in (3-1). 

 The major conclusions of this section are: 

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• In the short run, the principal effect on a negative trade shock on a group of affected 

workers is the unemployment of those workers in the industry directly affected by 

the shock. 

• In the long run, the trade shock results in lower wages for all workers in that skill 

class—whether or not they were initially employed in the affected industry and 

whether or not they were initially unemployed as a result of the trade shock. 

• Losses incurred by those who lose their jobs as a result of the trade shock are the 

greater, the lower is the rate of labor market adjustment and the higher are the out-ofpocket costs of adjustment. 

3.2 Trade Adjustment Assistance Programs 

 The purpose of the Trade Adjustment Assistance (TAA) is to compensate groups of 

workers who can be identified as having received trade-related losses.61 In practice, however, 

groups of individuals must be clearly identified as having lost their jobs as a result of a particular 

trade development in order to be eligible for TAA. Thus, TAA is limited to helping compensate 

negatively affected workers for the second term in (3-1). It does not attempt to do anything about 

the long-run losses of groups—like the low-skilled workers in the various discussions in section 

2.0—who may be negatively influenced by international economic developments, but who do 

not lose their jobs directly as a result of shocks that are directly (i.e., administratively) 

attributable to trade shocks. 

 Table 8 reports the budget (actual, estimated, and proposed) for TAA for the 3 fiscal 

years (FY) 2003, 2004, and 2005. About 70 percent of the TAA budget goes for adjustment 

assistance (primarily unemployment compensation) and a little over 20 percent goes to job 

retraining. 

Given that adverse trade developments for some groups may affect relative wages and the 

real wage, the adequacy of existing TAA programs in terms of distributional equity is, almost by 

definition, in question. The primary evaluation questions that one would ask about TAA from the 

point of view of economic efficiency concern the effects of payments to displaced workers on 

S—the average time to reemployment in alternative sectors. To the extent that the program 

provides useful information and, in some cases, training to displaced workers about alternative 

job openings and the like, S would fall, and aggregate output would rise. On the other hand, 

income subsidies tied to nonwork can have disincentive effects that lower S and thus lower 

aggregate output. 
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Table 8. Budget for Trade Adjustment Assistance 2003–2005 

($ millions) 

Activity 

FY 2003

(actual) 

FY 2004

(est) 

FY 2005 

(est) 

Adjustment assistance 399 523 750 

Training 259 259 259 

Wage insurance Demo. --- 14 48 

Reimbursable programs 17 40 40 

Total 675 836 1097 

Source: appendix to FY 2005 Budget, pp. 707-08 

It is interesting to speculate about the adequacy of the TAA budget in the face of the sorts 

of trade shocks that the U.S. has experienced over the past 25 years. In particular, we can 

compare the size of the TAA budget with the aggregate losses incurred by the groups that are 

made worse and those made better off due to trade developments. For example, assume that 

0.013 of the increase in the high-/low-skill relative wage from 1979 to 2003 can be attributed to 

changing trade conditions (0.013 is on the high end of the Borjas, Freeman, and Katz (1997) 

estimates and below those of Baldwin and Cain (2000)). The nominal value of the aggregate 

wage bill, including employer supplements, in the third quarter of 2003 was $5.1041 trillion. In 

terms of the hypothetical effects of a reduction in the price of the low-skilled intensive good 

discussed in table 5 in section 2.3, the effects of a change in the relative price of the low-skilled 

intensive good, P2, such that rel = WH/WL increases by 1.3 percent means that the wage bill of 

high-skilled workers increases by $21.7 billion and the wage bill of low-skilled workers 

decreases by $11.4 billion.62 The 2005 proposed expenditure on TAA is about 10 percent of the 

total. 

The major conclusions of this section are: 

• Trade adjustment assistance provides partial compensation only to those in the 

affected group who lose their jobs directly due to the trade shock. 

• Trade adjustment assistance does not provide any compensation to the two other 

groups in the affected labor class—those who retain their jobs in the affected industry 

and those in other industries, both of whose wages fall in the long run. 

• Trade adjustment assistance can be evaluated with respect to its contribution to 

economic efficiency. 

3.3 Individual Job Displacement Effects 

The implicit assumption in figure 5 and the associated algebra of a single wage for all 

members of a particular labor group as well as the focus on the average speed of adjustment S 

provide some insights into the adjustment process, but they miss a great deal of the story. We 

know that workers identified by any set of observable characteristics are very heterogeneous in 
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Employment and Training Administration 33 

the sense that there is an enormous amount of unexplained variation across samples of 

individuals. The same is true for the effect of job displacement on individuals’ subsequent 

employment and earnings.63

The thrust of the empirical work on the effects on this topic reveals some regularities. 

First, reemployment rates at a given time after displacement are higher for those with more 

education and are lower for older, female, and minority workers. Second, the average negative 

effects of displacement on the probabilities of employment in subsequent years tends to diminish 

to zero the longer the period of time since displacement. Third, the amount of earnings loss as a 

proportion of predisplacement earnings is smaller for workers with high levels of education, for 

younger, and—not surprisingly—those with low values of tenure on the job. Fourth, the large 

negative effect of displacement on subsequent earnings per unit of time worked diminishes 

somewhat with time since displacement, but it does not seem to disappear.64

 One interesting finding that calls into question the simplistic “changing sectors” approach 

is that individuals who are subject to job displacement in manufacturing, including trade 

sensitive industries, do significantly better in terms of subsequent earnings when they are 

reemployed in manufacturing industries than when they move in trade, services, or any other 

industry (Kletzer 2000, 2004). The reason for this is probably that displaced manufacturing 

workers have certain skills that are specific to that sort of work so that they do better remaining 

in jobs that are close in terms of skills to what they have been doing for most of their working 

lives. With normal labor turnover, these displaced workers will have a reasonable chance of 

obtaining relatively high-paying manufacturing employment even if there is, as a result of past 

layoffs in the area, a socially suboptimal oversupply of people looking for those jobs. 

 It is interesting to reflect on the implication of this empirical stylized fact for the 

evaluation of part of the TAA program. Suppose that there is a training program component of 

TAA and that a fraction of displaced workers enter a training program that attempts to get 

participants prepared for careers in other industries like health services. Some proportion of 

participants complete the program successfully and take jobs in the sector for which they were 

prepared. 

 Now spurred by pressure from the various budget authorities, DOL decides that it wants 

to evaluate the training component of TAA and commissions the collection and analysis of data 

on the postprogram experience of TAA recipients, some of whom were trainees and others 

nontrainees. As part of the evaluation of the training component of TAA, researchers run a 

multiple regression of earnings 12 quarters after leaving the program on a dummy variable 

indicating whether the person had received training as part of his/her TAA experience in addition 

to the usual adjustment variables. 

 What would one conclude if the estimated coefficient on TAA training program 

participation was not significantly different from zero?65 One would, of course, conclude 

nothing. The expenditure of public resources to get some of the redundant manufacturing labor 

supply into other occupations that were likely to have been characterized by tight, if low-paying, 

labor markets may well have been a very good investment from a social point of view. The over 
U.S. Department of Labor 

Employment and Training Administration 34 

simple evaluation framework that has been posited, however, would never pick up the positive 

contribution of the training program to net aggregate welfare. 

 There are many reasons for job displacement to occur. These include cyclical downturns, 

changes in technology, mismanagement, and shifts in consumer demand as well as the sort of 

trade-related shocks that motivate TAA. Kletzer (2004) summarizes an attempt to figure out the 

fraction of total job displacement in the U.S. between 1979 and 1999 that came from trade 

sources. She identifies a set of high-import competing manufacturing industries,66 which 

composed 5.2 percent of nonagricultural employment during this period, but had 14.2 percent of 

nonagricultural displacement. At first blush, this suggests the potential for a lot of trade-induced 

displacement. Looking more deeply at these numbers, as she did with a slightly earlier data set in 

Kletzer (2000), she concludes that trade-related job displacement over this period was probably a 

fairly small part of total displacement.67

 The major conclusion with respect to the literature on job displacement is that: 

• Trade-related job displacement incurs greater costs, in terms of longer periods of 

unemployment and larger decreases in reemployment. 

3.4 Wage Insurance 

 An implication of various approaches to the welfare economics of international trade is 

that an equitable and (relatively) efficient way to compensate losers due to some development is 

by establishing a system of “wage insurance” for displaced workers (Dixit and Norman 1986; 

Kletzer and Litan 2001). A feature of the changes in TAA in the U.S. contained in the Trade Act 

of 2002 is the introduction of a limited version of wage insurance to workers who are displaced 

by trade. Wage insurance is currently confined to displaced workers over the age of 50 who 

obtain a different job within 26 weeks at a wage of less than $50,000 per year. This is called the 

Alternative Trade Adjustment Assistance (ATAA) program. ATAA pays participants half of the 

difference between their previous earnings level and the earnings in their new job for up to 2 

years, and the insurance payment is capped at $5,000 per year. The wage insurance component 

of ATAA is still quite small (see table 8), but it could, in the future, be expanded to cover the 

entire population of displaced workers (i.e., the age restriction on eligibility could be eliminated). 

 In terms of equation (3-1), wage insurance gives a payment of the subsidy rate times (W’-

W”) for up to 2 years so long as S is less than a certain value. For the current ATAA, the subsidy 

rate is 0.5 and the critical value of S is 0.25. Thus, some of the additional losses of those who 

lose their jobs directly through trade-related shocks can be compensated with a wage insurance 

scheme. Wage insurance has the advantage over transfers based solely on unemployment 

compensation of increasing incentives to gain reemployment swiftly as well as to lower 

incentives to wait for the possibility of recall to the old jobs. By confining participation to those 

who directly lose their jobs in an affected industry, however, wage insurance does nothing for 

other workers in the relevant skill group who are not directly affected through job displacement. 

This feature, however, is common to all TAA programs. 
U.S. Department of Labor 

Employment and Training Administration 35 

 The focus of ATAA on older displaced workers is understandable in the light of the 

empirical facts mentioned in section 3.3 about the effects of age on the average reemployment 

rates and income losses of older workers. However, this restriction makes evaluation of wage 

insurance programs difficult, for whatever one observes that is different about ATAA 

participants is as likely to be attributable to age as to the parameters of the wage insurance 

system. It would be useful to set up an experimental design study in which some younger (under 

age 50) displaced workers were randomly chosen for eligibility for wage insurance. The resultant 

effects on reemployment rates and subsequent earnings between the experimental group and 

control group of noneligibles would provide the information necessary to evaluate the efficacy of 

wage insurance. 

4.0 Recommendations for Future Research and Information Gathering by 

DOL 

What DOL should be doing now to prepare for the future with respect to the labor market 

effects of trade-related developments depends rather crucially on the answer to one question: 

Will the scope and size of Trade Adjustment Assistance programs be expanded in the future? 

Whether the U.S. should or should not do this is a political value judgment. It is common, 

especially when new trade liberalization pacts are discussed, for politicians over almost the 

whole range of the U.S. political spectrum to call for an expansion of TAA. 

For example, among the recommendations in the November 2000 “Issues Report” of the 

bipartisan U.S. Trade Deficit Review Commission were the following: 

• Increasing private and public efforts to provide more effective adjustment assistance 

with such efforts extending to all workers bearing the costs of adjustment to 

economic change irrespective of why they have lost their jobs or whether they are 

eligible for specific trade adjustment aid. 

• Expanding the educational and training opportunities available to all Americans 

because a more productive workforce is the key to our long-term international 

competitiveness. 

• Promoting labor mobility by removing barriers to retraining and to taking new jobs. 

Serious consideration should be given to providing wage insurance to temporarily fill 

some of the gap between a displaced worker's old wage and a lower wage in a new 

job. Depending on the adequacy of funding, the program might also include providing 

for health insurance coverage during periods of sustained unemployment. 

 It is interesting to note that the first and third of these recommendations were, to some 

extent, followed in the 2002 amendments to the TAA program. Its budget was expanded 

significantly (to $1.1 billion for FY 2005 from $0.4 billion in 2002), and a health insurance 

subsidy (in the form of a tax credit equal to 65 percent of total health care insurance premiums) 

was added. In addition, a wage insurance scheme, along the lines of that proposed by Kletzer and 

Litan (2002), was introduced for affected workers over the age of 50. 
U.S. Department of Labor 

Employment and Training Administration 36 

 At the same time, these programmatic remedies do not touch the secondary effects of 

trade-related developments on the general level of wages of certain affected groups (the first 

term in the right hand side of equation (3-1)). If economic policy were to attempt to try to fulfill 

the goal of Corden’s “conservative social welfare function”—that no one would be worse off as 

a result of any trade liberalization—government policy would have to attempt to raise the net 

incomes of those groups that lose as a result of the policy. Such a policy, for the reasons 

discussed throughout this report, goes beyond those who are temporarily dislocated as a result of 

a trade shock and eligible for TAA. The policy would have to involve other branches of 

government, principally the Treasury Department, for it would most likely have to involve a 

serious revision of the tax code. 

 At the same time, trade-related developments are likely to become increasingly important 

to the future determination of labor market outcomes in the United States, and informed policy 

decisions will require an understanding of these effects and the constraints the international 

economic environment may impose. Consequently: 

• It would be very useful for policymakers within the DOL (and elsewhere in the 

Government) to have access to the results of a general parameterized model that 

would provide an indication of the effects of international economic developments 

on wage and employment levels in the U.S. This would require the attention of a 

group of specialists within the DOL to build the model, with consultation by trade 

and labor economists. 

• The group of specialists within DOL assigned to work on the model should monitor 

on a continuous basis empirical studies of the effects of trade-related developments 

on labor market variables and adjust the model accordingly. 

• Much more information on outsourcing of functions and the imports and exports of 

services generally than what we currently get from the national accounts dealing with 

data. It would probably be useful to be able to identify outsourcing in a large sample 

at the firm level. The data from “free trade zones,” which were discussed in section 

2.7, are an example of the sort of data that would be very useful in this regard. 

The preceding three suggestions refer to issues that are relevant to general government 

policy toward the effects of international development on the labor market. Policies toward these 

issues are not uniquely the province of DOL—although the economics of the trade/labor market 

relation have major implications for other DOL programs. DOL’s current programmatic 

responsibilities with respect to the international economy are much more related to short-run 

adjustment. Two suggestions along these lines are: 

• Work should be undertaken to attempt to improve information from the Displaced 

Worker Survey of the Current Population Survey on those job losses that are trade 

related and, with respect to the previous point, due to outsourcing. 
U.S. Department of Labor 

Employment and Training Administration 37 

 

• With the data from the preceding suggestion, work could then be done to determine if 

the patterns and time path of adjustment to new employment tend to be significantly 

different for those displaced by trade and outsourcing than for those displaced for 

other reasons. 

The wage insurance variant of TAA that is a small part of the current program (although 

restricted to older workers) seems especially promising—and seems to have gained support from 

virtually the whole range of the political spectrum. We are probably not going to learn much by 

observing the older workers in the program—although the analysis of the distribution of 

payments will be of some interest to analysts. Therefore, it is recommended: 

• A sample of younger TAA participants should be selected to participate in a wage 

insurance experiment. How does the presence of the wage insurance option affect job 

search, length of time to a new job, earnings on new job, and so forth? 

Endnotes

1

 An important exception to this is the fact that women’s earnings relative to men’s rose significantly over this 

period which, since women earn less on average than men, lowered inequality. The primary reason that this 

happened, however, is that women’s average labor market skill rose considerably faster than men’s over this period. 2

 College equivalents are assumed equal to full time equivalent employment of college graduates plus 0.8 times 

one-half of the employment level of workers with some college; high school equivalents are equal to the 

employment of workers with exactly 12 years of schooling plus 0.8 times the employment of dropouts plus 1.2 times 

one-half of the employment level of workers with some college. The ratio in table 1 is mildly sensitive to the 

somewhat arbitrary 50/50 assumed allocation of the some college group. 

3

 There is some concern that the U.S. is close to reaching the end of the rapid growth in the average level of 

completed schooling. This is primarily because rates of school attendance of young persons have not increased very 

much since the 1960s, so entering cohorts of the labor force will soon have a very similar educational composition 

than cohorts of retirees. Day and Bauman (2000), for example, forecast a range of distributions of educational 

attainment in 2028 that would imply an annual rate of growth in relative supply of between 0.6 and 1.0 percent. The 

evolution of enrollment trends in the U.S. is examined extensively in Card and Lemieux (2000). 4

 For an expression of similar sentiments by a practicing economist, see Blecker (1999). 5

 If the successfully executed goal of monetary policy were to maintain exchange rates between the dollar and other 

major currencies at fixed target values, trade policy would have an effect on domestic demand. But anybody who 

has been to Europe over the past 2 years knows that the $/€ is not fixed. 

6

 A regression of the annual value of net exports per unit of GDP for the U.S. on the value of the government 

deficit/GDP and the household saving rate suggests that (a) and (b) are approximately equally responsible for the 

chronic trade deficit. 

7

 Discussing the question of what is likely to happen to the extent of openness of the U.S. economy, Rodrik (2000) 

admits that “economists rank second only to astrologists in their predictive abilities.” 8

 For the period in tables 1 and 2, there were seven such NBER turning points, occurring in 1960-II, 1969-IV, 1973-

IV, 1980-I, 1981-III, 1990-III, and the last in 2000-I. 

9

 When the model is estimated separately for the 1948-1973 and 1974-2000 subperiods, there is a statistically 

significant difference between the subperiods in both the length and amplitude of recession-related increases in 

unemployment. Recessions in the more recent period are less severe (in the sense that the proportional rise in the 

unemployment rate following a cyclical turning point is lower), but the adjustment of the aggregate unemployment 

rate to its noncyclical low was significantly slower in the 1974-2000 subperiod than during the 1948-1973 

subperiod. 

10 This has also received the attention of applied economists. See, for example, Groshen and Potter (2003). 
U.S. Department of Labor 

Employment and Training Administration 38 

 

, 21 1 −− αααα 21 = KLHAQ iiiii

11 The model is as follows: gN = b1gY + b2gY(-1) + bo(t), where gY is the value of the percentage change in GDP 

and gY (-1) is its lagged value and the constant term is assumed to be different (in fact, significantly higher) for the 

1974-1994 interval because of the very low productivity growth during that time. In addition, the path of the 

unemployment rate during the recession that began in the first quarter 2001 has been much different from that 

implied by the model of the adjustment of the unemployment rate described earlier in this section. Based on 

estimated parameters for the 1974-2000 period, the unemployment rate in 2004-I should have fallen to a value of 4.9 

percent from its quarterly high of 5.9 percent during the downturn. However, the actual 2004-I value was 5.6 

percent, which suggests a much lower rate of adjustment during the current recession than during for other 

recessions since 1973. 

12 The latter set of results would probably not be picked up by www.saveamericanjobs.com. 13 One example in which the heterogeneous labor force is aggregated into two types is the use of “high school 

equivalents” for L and “college equivalents” for H as in Katz and Murphy (1992) and Johnson (1997). The flow of 

college equivalent labor is equal to the employment of BAs plus the employment of workers with graduate degrees 

adjusted for their higher relative earnings plus one-half the number of workers with some college adjusted for their 

lower earnings relative to BAs. The flow of high school equivalent labor is similarly constructed, weighting the 

employment of workers with less than high school by their average earnings relative to high school graduates and of 

half the employment of employees with some college with an appropriately higher weight. Although this approach 

has the benefits of computational feasibility and is obviously suggestive, it does not confront many interesting 

complications—some of which will be discussed in other contexts below. 

14 The model could easily be modified to reflect inter-industry wage differentials due either to nonpecuniary factors 

or trade union wage policy. For example, wages in industry 1 (autos) may tend to be 25 percent greater than wages 

in industry 2 (fast food retailing) either because jobs in industry 1 are onerous relative to those in industry 2 and 

require a 25 percent compensating differential or because a trade union in industry 1 successfully keeps the wages of 

its members 25 percent higher than the nonunion wages in industry 2. Given constant relative wages across 

industries, such a modification does not alter the conclusions of the analysis with respect to the variables of interest. 15 In appendix A of this report, the properties of a simple (but illuminating) model are set out, in which two of the 

industries are completely high-skilled intensive and the other two are completely low-skilled intensive. Item 1 of this 

appendix sets up the model, and item 2 examines the comparative statics of the closed model. 

16 The absolute value of the proportional change in rel in response to a proportional increase in (H/L) is the 

reciprocal of a weighted average of the elasticity of substitution between high- and low-skilled labor and the 

elasticity of substitution between goods in consumption. 

17 In terms of an aggregate production function for that industry, take the simplest case: 

where Qi is output of industry i, and Hi, Li, and Ki inputs of the two types of labor and of capital, Ai is 

the Hicks-neutral technical change parameter, an increase in which represents an increase in overall productive 

efficiency. 

18 Most labor economists sign on to this view, but not all. See, for example, Card and DiNardo (2002) for a 

skeptical view. 

19 Skill-biased technological change is best thought of, in terms of the Cobb-Douglas production function in the 

previous endnote, as a reduction in the value of α2 and an increase in the value of α1, a transfer in the relative 

importance in the production process from low- to high-skilled workers. 

20 In a more realistic specification of the labor market there would be several (versus two) types of labor, which 

might be arrayed in terms of skill equivalents. A typical training program would attempt to move its participants one 

or more rungs up the skill ladder. 

21 This means that there is no “outsourcing” of parts of the production function. This assumption is relaxed in 

section 4.2. 

22 This means that there is no “home bias” at home or abroad in consumption. The implications of lifting this 

assumption are explored in section 4.2. 

23 For a discussion of the analysis of union effects in the open economy model see Johnson and Stafford (1999). 

24 Item 3 of appendix A derives the major implications of the open economy model in the context of a simple 

Ricardian model of the economy. 

25 The demonstration of this result, following Jones (1965), is as follows: The zero profit condition in industries 1 

and 2 is, ignoring, for the sake of expositional convenience, capital input, given by: 
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Employment and Training Administration 39 

 

2,1,0 1 1 ==−− −

iiii iLiH iLMHMLHAP αα ii

),(log)1()(log)(log)(log)(log

)(log)1()(log)(log)(log)(log

2 22 2

1 11 1

a H L

a H L

WdAdPdPd Wd

WdAdPdPd Wd

α α

where MH and ML are the nominal wages of high and low-skilled labor and the assumption that industry is more 

skill intensive than industry 2 means that α1>α2. Differentiating these conditions totally yields two equations in the 

proportional changes of the two wage rates: 

α α

− + + = −+

− + + = + − 

where Pa is the average price level in the economy (so that WH = MH/Pa). The solution change in the high-/lowskilled relative wage rate is then: 

⎟

⎟

⎠

⎞

⎜

⎜

⎝

⎛

⎟

⎟

⎠

⎞

⎜

⎜

⎝

⎛

⎟

⎟

⎠

⎞

⎜

⎜

⎝

⎛

− = − =

22

11

21

log 1 )(log)(log)(log AP

AP

H WdWdreld L d

αα . 

Then, given that the wages of the two types of labor have been determined in industries 1 and 2, the prices of the 

nontraded goods, P3 and P4, are determined as functions of these wages and the productivity parameters in those 

industries. 

26 This led Freeman (1995) to characterize the open economy model by the question: “Are Your Wages Set in 

Beijing?” His answer, unlike the model set out in this section, was “no.” 

27 Total net exports of the economy are equal to P1(Q1 – C1) + P2(Q2-C2) and are predetermined in a macroeconomic 

setting (equal to zero for the average country in the world), where Qi is domestic output and Ci is domestic 

consumption. Since P1 and P2 are set in international markets, the rise in C1 due to a change in tastes with no 

changes in Q1 or C2 means that Q2 must rise. 28 This property of open economy models—that changes in factor supplies cause adjustments in the mix of goods 

produced rather than adjustments in wages and prices—is referred to in international trade theory as the Rybczynski 

theorem. An interesting test of the theory across states in the U.S. is reported in Hanson and Slaughter (2002). 

Leamer and Levinsohn (1995) refer to the property of the model that factor supplies do not affect relative factor 

prices the Factor Supply Irrelevance theorem. 

29 See Haskel and Slaughter (2002) for a detailed analysis of this proposition. 

30 These include lifting the “small country” assumption and, from the “new trade theory,” some degree of 

monopolistic competition and/or increasing returns to scale in certain industries of the economy. For a very readable 

and perceptive discussion of the political economy of trade policy, see Rodrik (1995). 

31 This is an example of what Corden (1974) called the “conservative social welfare function,” which implies that 

no one should be worse off as a result of a change in trade policy or any other international event. This would be a 

very strong interpretation of the intent of TAA policy—much stronger than what actual policies in the United Sates 

have tried to do. 

32 This example uses the Ricardian model with unitary price elasticities that is set out in item 3 of appendix A. It is 

assumed that 40 percent of the labor force is high skilled, i.e., H/(L+H) = 0.4 and that the domestic consumption 

share of the high-skilled imported good (β1) is 0.1, the share of the low-skilled imported good (β2) is 0.2, and that the 

share of the nontraded goods that are high-skilled and low-skilled intensive (β3 and β4) are equal to, respectively, 

0.25 and 0.45. Initial international prices without the tariff and the productivity parameters are such that the initial 

value of the relative wage of skilled workers is rel = 1.5. Initially, exports and imports (all of the former being of the 

high-skilled intensive good and all of the latter of the low-skilled intensive good) are each equal to 15 percent of 

GDP.

33 This is a common conclusion of more detailed computable general equilibrium models of trade effects (see, for 

example, Brown, Deardorff, and Stern (1992)) and of any sort of standard welfare analysis of the effects of 

“distortions.” The overall efficiency loss due to the imposition of tariffs of given magnitude may, of course, be 

larger than those implied by table 1 under certain alternative parametric and other assumptions. 

34 The procedure and parametric assumptions underlying this computation are the same as in the example associated 

with figure 1. 

35 The example stops with a relative price of good 2 of 0.818 because at this point industry 2 “disappears;” i.e., all 

low-skilled workers are employed in the production of nontradables. 

36 The equation for FCA in the context of the Ricardian trade model is set out in item 3 of appendix A. 

37 The introduction of FCA was by Deardorff and Staiger (1988). Its use is only strictly correct if all production and 

utility functions have unitary elasticities of substitution; although a variant of the approach can be used if these 
U.S. Department of Labor 

Employment and Training Administration 40 

 functions all have the same constant elasticity of substitution (see Deardorff 2000). The magnitudes of the biases 

involved in departures from these assumptions are discussed in Johnson and Stafford (1999). Further skepticism 

about FCA is expressed by Panagariya (2000) and, more strongly, by Leamer (2000). Krugman (2000) addresses 

some of the arguments against FCA and thinks that they are over wrought. He concludes that the results from a 

simple FCA calculation “at least suggests that it is unlikely that trade has played a dominant role” in the observed 

increase in the relative demand for high-skilled labor in Organization for Economic Cooperation and Development 

(OECD) countries. 

38 A recent and compelling example of this is the results in Borjas (2003) with respect to the negative effects of 

immigration on wages in the U.S. Recall from section 4.2 that an unambiguous prediction of the open economy 

model is that immigration—after an adjustment period—causes product mix rather than relative prices to change. 39 See item 5 of appendix A for the explicit derivation of the demand function for the case in which the equilibrium 

of the economy is “outside the cone.” In terms of the endnote below, there is only one equation in d(log P1) so that 

the changes in WH and WL are no longer uniquely determined by the exogenous values d(log P1) and d(log P2). To 

determine changes in domestic wages, one has to make reference to the nontraded sector—just as one must do in the 

analysis of the closed economy labor market. 

40 These papers include, among many others, Harrigan (1997), Trefler (1995), Davis and Weinstein (2001), and 

Schott (2003). 

41 The associated utility function with the Armington elasticities given by the ωi’s is discussed in item 6 of appendix 

A. 

42 During the past year there have been well publicized examples of taste shifts associated with a foreign policy 

disagreement—Americans boycotting French wine and cheese and Europeans doing the same with certain visible 

United States exports. 

43 In this regard, another related factor that has had a large impact on economic integration is the worldwide 

adoption of English as a second language and the principal language of international commerce. This, of course, 

makes the U.S. especially open to the rest of the world. 44 It is, however, useful to remember the point by Rodrik (1997)—that globalization is limited by the cultural and 

legal frameworks of different countries. Full information would probably increase demand elasticities but leave 

them short of infinity. 

45 Given a unit elasticity of substitution between the labor aggregate and capital, the average real wage is given by 

W = αY/N and the annual rate of growth of the real wage is gW = gY – gN. 46 See, for example, Grossman and Helpman (1991). A very accessible survey of the various approaches to the 

relation between gY and Θ is Baldwin (2003). 47 An example of this is the use by United States manufacturers of the Japanese “just-in-time” inventory 

management system. Thoenig and Verdier (2003) propose the hypothesis that the source of much observed skillbiased technological change is an endogenous reaction to foreign competition. 

48 The conventional wisdom among economic historians is that ∂gY/∂Θ has been positive in the 20th century but was 

negative in the 19th century (Henry Clay’s “American Plan” for the U.S. being a case in point). Clemens and 

Williamson (2001) refer to this as the “tariff-growth paradox” (but resolve it by an argument that the “true” 

empirical growth-tariff relationship involves some complicated interaction terms). 

49 These problems include simultaneous equations bias (countries that are growing tend to open up, those that are 

not growing tend to introduce trade restrictions), omitted variables (not controlling adequately for X in equation (1)), 

and errors in variables (an imprecise specification of Θ). 50 Feenstra (1998) cites several other terms for outsourcing used by prominent international economists. These 

include “kaleidoscope comparative advantage,” “slicing the value chain,” “delocalization,” and “intra-mediate 

trade.” One could also mention the “disintegration of production,” which he uses in the paper, and “global 

production sharing,” which he uses in another paper. Jones (2000) titles his report 7 on this topic “Fragmentation of 

the Production Process.” 

51 See Bhagwati (2004) for a very accessible exposition of the proposition that outsourcing and trade have similar 

effects. Bernanke (2004) makes similar points but more in a short-run than a longer-run context. 

52 Looking at much the same data, for example, Feenstra and Hanson (2001) come to a much different conclusion 

about the potential effects of outsourcing than do Berman, Bound, and Grilliches (1994). 

53 One problem here is similar to that identified with testing trade theories featured in many of the recent papers 

cited in section 4.2.5, the high level of heterogeneity of products produced in even the most detailed industry 

breakdowns. There is now a preference for the use of plant level data. The same sorts of concerns with making 
U.S. Department of Labor 

Employment and Training Administration 41 

 wrong inferences would apply to work involving outsourcing. Doing it right, however, would be both very difficult 

and very expensive. 

54 Item 4 of appendix B derives the effects on relative wages of an increase in the efficiency of outsourcing of lowskilled functions on relative wages and compares them to the effects of skill-biased technical change. 55 However, according to Scheve and Slaughter (2001), the perception of the public is that trade and direct foreign 

investment leading to outsourcing are focused on products and production processes on the low-skilled side of the 

spectrum, for the potential skill level of respondents is positively associated with favorable attitudes toward trade. 

It will be interesting to see if this holds up in the future. 

56 An interesting paper by Swenson (2000) found that there was a statistically significant (but “economically 

small”) effect in the expected direction of changes in exchange rates on the extent of outsourcing. Illustrating how 

poor are current data on outsourcing, this paper used data from firms in foreign trade zones in the U.S. Firms in 

these areas are legally required to keep and report data that are simply not available in the general economy. 57 The theme in this paragraph is consistent with Borjas and Ramey (1995), who applied it to trade in goods in 

general rather than to outsourcing in particular. 

58 One could easily allow for different wage rates in the two sectors, either because of the effect of unions or 

nonpecuniary differences in the jobs in the two sectors. This modification, however, does not alter the basic point of 

the model and will be ignored. 

59 In general, as we saw in section 4.2.2 and item 3 of appendix A, a shock such as a fall in the relative world price 

of low-skilled intensive tradable goods may have (at least eventually) small, positive effects on the demand for lowskilled intensive nontradable goods. We ignore this in the present discussion because of its complexity, and it does 

not affect the qualitative point being made. 

60 One could also assume that it takes time for both wage rates to adjust to the new equilibrium through some sort of 

sectoral Phillips adjustment mechanism. This is fairly easily done, but it would simply complicate the analysis and 

shift attention away from the main point without adding anything important. 

61 TAA is usually identified in the economics literature as a “bribe” to groups of workers who are likely to lose as a 

result of trade liberalization (Fung and Staiger 1996). It is an attempt to follow Corden’s “conservative social 

welfare function”—trade policy should not make anyone worse off; i.e., it should be “Pareto Optimal”—discussed 

in section 4.2.3. 

62 These losses of low-skilled workers are, of course, contingent on the true quantitative effect of trade 

developments over the past quarter on the structure of wages. Feenstra and Hanson (2001), for example, believe that, 

because of outsourcing, the quantitative effect is much higher than the conventional wisdom. 63 Two excellent surveys of the (rather large) job displacement literature are Fallick (1996) and Kletzer (1998). 64 A much-cited large estimate of the effect of displacement for a sample in Pennsylvania on earnings 4-6 years later 

is 25 percent. See Jacobsen, Lalonde, and Sullivan (1993). 

65 This is a fairly accurate description of table VI.2 of the last program evaluation of TAA, Corson et al. (1993). To 

be fair to the authors of that study, they did not seem to be very surprised at the results with respect to TAA training 

programs. 

66 The largest industries in this set are electrical machinery, radio-TV, apparel, motor vehicles, computing 

equipment, blast furnaces, footwear, textiles, and rubber products. 67 Kletzer’s conclusions are endorsed very strongly by Bernanke (2004), and he extends this to the more recent 

phenomenon of large-scale outsourcing. 
Appendix A: A Simple Ricardian Model with Two Skills and Four Goods 

 Many of the propositions in trade theory discussed in section 2.0 are very neatly derived 

from a very simple (and quite extreme) version of the open economy model. The two relatively 

high-skilled intensive industries, industry 1, which produces goods that are potentially tradable, 

and industry 3, which produces goods that are non-tradable, are assumed to hire only high-skilled 

labor. Similarly, the two low-skilled intensive industries, 2 and 4, are assumed to hire only lowskilled labor. This means, in terms of the two-labor-type model set out in section 2.0, that α1 = 

α2 = 1 and α2 = α4 = 0. 

1. The Basic Model

 The production functions for the four industries are given: 

nonskilledlowUAQ traded good

nonskilledhighHAQ traded good

skilledlowUAQ tradableypotentiall good

skilledhighHAQA tradableypotentiall good

= −

= −

=

− =

,

,

,

)1( ,

444

333

222

111

where Qi (i = 1,2,3,4) is the rate of production of each of the four goods, Ai is the industry 

productivity parameter, and the Hi’s and Ui’s are the inputs of the relevant types of labor into the 

four industries. The economy is at full employment, so the fixed supply of each type of labor is 

allocated among the four industries: 

42

31 )2(

UUU

A HHH

+=

− +=

 The nominal wage rates (in terms, arbitrarily, of the price of good 1) of each type of 

labor, MH and ML, are assumed to be equal in each of the two sets of industries and are equal to 

the relevant marginal revenue product of labor. This implies that: 

4422

331 )3(

APAPM

A APAM

L

H

==

− ==

where the Pi’s are the price levels in industries 2, 3, and 4 relative to the price in industry 1. 

 Aggregate nominal expenditure (again, in terms of the price of good 1) on the four goods 

in the economy is equal to nominal income, I, minus net exports, or: 

U.S. Department of Labor 

Employment and Training Administration 42 
( A − )4 +++ 4433221 = − NXICPCPCPC

where: 

4433221 A − )5( ++= + QPQPQPQI

Since goods 3 and 4 are non-traded, C3 = Q3 and C4 = Q4. It then follows that nominal net 

exports in the economy are equal to: 

)6( )()( A − +−= − CQPCQNX 22211

For the average country in the world NX is equal to zero, so if good 2 is imported, 

C2 > Q2, good 1 must be exported, Q1 > C1. For countries with high net exports (like Japan), both 

goods could be exported; for countries with large trade deficits (like the United States since the 

mid-1980s), both goods could be imported. 

 The utility function for the economy is assumed to take the simplest possible form: 

21 3 4

4321 )7( ββ β β A − = CCCCU

where the sum of the exponents is one. One could use a more general utility function; for 

example, one that assumed that the elasticity of substitution between different goods was 

different from one, but the major result of this would be to increase the algebraic complexity of 

the presentation. 

Maximization of utility subject to (A-4) implies that the nominal expenditure on each 

good is: 

( A − )8 β iii ( ) −= NXICP

The aggregate price level for the economy is given by: 

21 3 4

4321 )9( ββ β β A − A = PPPPP

P1 has been set equal to one, and, by (A-3), P3 = (A1/A3) and P4 = (A2/A3)P2. Thus: 

42 3 4 3 4

43212 )10( +ββ β β −β −β A − A = AAAAPP

2. The Closed Economy 

U.S. Department of Labor 

In this case, there are no imports or exports of goods 1 and 2, which means that the output 

of each industry is consumed domestically, NX = 0 and Qi = Ci for all four industries. The 

equilibrium of the labor market for the closed economy case, which was discussed in section 2.1 

of the text, is easily derived in the Ricardian model. By summing up the demand across 

industries for each type of labor, the relative demand for skilled labor is easily shown to be 

Employment and Training Administration 43 
1

31 )11(

−

⎟

⎟

⎞

⎜

⎜

⎛

⎟

⎟

⎞

⎜

⎜

⎛

+

+ ⎟ = ⎞ ⎜

⎛ − H

d

W

W

L

H A

ββ

ββ

⎠⎝ 42 L ⎠⎝⎠⎝

This is consistent with figure 1 in the text, in which the relative demand for skilled labor depends 

on the relative wage, rel = WH/WL, and the distribution of product demand across the four goods. 

If the elasticity of substitution between consumption goods mentioned after formula A – 7 has 

been assumed to be greater (less) than one, an increase in the value of A1 or A3 would shift the 

relative demand function to the right (left). With the Cobb-Douglas assumption (a unitary 

elasticity), changes in the values of the Ai’s have no effect on relative demand. 

 The solution real wage rates for each type of labor in the closed economy model are 

given by: 

)(

31

42

4321

)(

31

42

4321

31

21 3 4

42

21 3 4 )12(

ββ

ββ β β

ββ

ββ β β

ββ

ββ

ββ

ββ

+

+−

⎟

⎟

⎠

⎞

⎜

⎜

⎝

⎛

+

+ ==

⎟

⎟

⎠

⎞

⎜

⎜

⎝

⎛

+

+ − ==

L

H AAAA

P

M

W

L

H AAAA

P

M A W

A

L

L

A

H

H

 

Each wage rate is affected in proportionally the same way by each of the four industry 

productivity parameters. 

3. The Open Economy 

 Under the assumptions about the economy underlying section 2.2, the solution of the 

model of labor market equilibrium is much different than in the closed economy. Now the prices 

of the traded goods are determined internationally. The price of good 1 is assumed to equal one, 

so the key exogenously determined price that is relevant for the solution of the model is the price 

of good 2 relative to that of good 1, P2. 

From (A-3) it then follows that the high-skilled nominal wage rate is MH = A1 and the 

low-skilled nominal wage is ML = P2A2. This means that the high-/low-skilled relative wage is 

given by: 

22

1 )13( AP

A

M

M

M

M A rel

L

H

L

H − ===

This is the relative demand for skilled labor function depicted in figure 2 in the text. 

Since rel must take a certain value given the values of P2, A1, and A2, the relative demand for 

skilled labor, (H/S)d

, is infinitely elastic with respect to its relative price. 

 The solution real wage rates of the two types of labor are given by: 

U.S. Department of Labor 

Employment and Training Administration 44 
42 3 4 3 4

42 3 4 3 4

43

1

21

)(1

2

432

1

1

)(

2 )14(

ββ β β β β

ββ β β β β

AAAAP

P

M

W

AAAAP

P

M A W

A

H

L

A

H

H

+− − −

+− − −

==

− ==

Since the average real wage in the economy is WA = [WHH+WLL]/(H+L), the proportional 

change in the average real wage rate, = d(log WA), etc., is: WA

ˆ

[ ][ ][ ] 242 13 443324 ˆ ˆ ˆˆˆ

ˆˆˆ )15(

s AAAsAsP

A sWsWW

L H L

LLHHA

ββ β ++−+−+−−= βββ

− += 

where sL = WLL/Y is the share of GDP going to low-skilled labor and sH = 1 – sL is the share for 

high-skilled labor. Assuming that the ratio of net exports to GDP is approximately equal to zero, 

the coefficient on in (A-14) is equal to the share of GDP arising from the production of good 

1, and the coefficient on 2 the same for good 2. Thus, the effects of changes in the efficiency 

parameters on the average real wage is the same in the open and the closed model, but the effects 

of changes in A1 and A2 on the distribution of wages is very different in the two specifications. 

1 Aˆ

Aˆ

 The coefficient on 2 , sL – β2 – β4, is positive if the country is a net exporter of good 2 

and negative if it is a net importer. Thus, an exogenous decrease in the international price of 

good 2 relative to the price of good 1 causes the high-skilled real wage to rise and the low-skilled 

real wage to decline, and the average real wage in the economy increases if, initially, the country 

was a net importer of that good. 

Pˆ

 A key assumption of the open model is that firms in the economy find it profitable to 

operate in both industries 1 and 2. If this is not so, the resultant model has very different 

implications, which will be pointed out in item 5 of this appendix. It is, however, possible that all 

low-skilled workers will be employed in the nontraded sector, industry 4, and that the entire 

amount of good 2 that is consumed is imported. Alternatively, it is possible that industry 1 could 

disappear so that all high-skilled workers are employed in the nontraded sector—although this is 

a less likely possibility for the United States. International trade theorists refer to an equilibrium 

in which both tradable goods are produced as occurring within the cone of diversification. The 

condition for this to be true (i.e., for both H1 and L2 to be positive) is: 

⎥

⎦

⎤ ⎢

⎣

⎡ − − >>+ − − LAP

NX

LAP

HA

LAP

NX A

3 22

3

22

1

4 22

4 1

1

1 )16( β

β

β

β 

The left hand inequality is necessary for industry 2 to be profitable, and the right hand inequality 

is necessary for industry 1 to be profitable. 

U.S. Department of Labor 

Employment and Training Administration 45 
 In the context of the United States, the question of whether the low-skilled intensive 

industry continues to exist is obviously the more interesting of the two. This is the more likely 

the lower is β4 (i.e., the less demand there is for low-skilled workers in the non-traded sector), 

the higher is NX (i.e., the lower are foreign trade deficits, the higher is the international price of 

the tradable low-skilled intensive good relative to the tradable high-skilled intensive good (P2)), 

the more productive is industry 2 relative to industry 1 (A2/A1), and the larger the supply of less 

skilled relative to high-skilled workers (L/H). 

4. Factor Content Analysis 

 An interesting implication of the open economy model is that, under certain very strong 

assumptions about technology and product demand parameters, one can derive the effects of 

changes in the relative international prices of traded goods by looking at the amounts of different 

types of labor necessary to produce the resultant changes in net exports. Note that the 

technology and product demand parameters are, due to Deardorff and Staiger (1988), that the 

underlying production and utility functions both have unit elasticities of substitution; i.e., they 

are of the Cobb-Douglas form. Deardorff (2000) generalized this approach to the case in which 

both the production technology and utility functions are characterized by the constant elasticity 

of substitution function with the same substitution parameter in each case. The Ricardian system 

with a Cobb-Douglas utility function used in this appendix satisfy the Deardorff-Staiger 

requirement. 

Factor content analysis (FCA) has been widely used to estimate the contribution of 

globalization to changes in relative factor prices. What is done in FCA in the context of our 

simple Ricardian system is to set up a synthetic demand system in the context of a closed 

economy model: 

[ ]

[ ]

1

22

2

11

1

42

31

1

*

*

42

31

1

1

)17(

−

−

⎟

⎟

⎟

⎟

⎠

⎞

⎜

⎜

⎜

⎜

⎝

⎛

−−

−−

⎟

⎟

⎠

⎞

⎜

⎜

⎝

⎛

+

+ = ⎟

⎟

⎠

⎞

⎜

⎜

⎝

⎛

⎟

⎟

⎠

⎞

⎜

⎜

⎝

⎛

+

+ − =

CQ AL

CQ AH

L

H A rel

ββ

ββ

ββ

ββ

 

H* is equal to the supply of high-skilled labor plus (1/A1)[Q1-C1], which is the amount of skilled 

labor needed to produce the exports of good 1 if it is exported or the negative of the amount of 

skilled labor that would have produced imports of good 1 if it had not been imported. L* is 

interpreted analogously. 

A little algebra quickly confirms that rel = (A1/A2P2). Thus, if the relative price of lowskilled intensive goods falls, we will see imports of good 2 rise and exports of good 1 rise such 

that the proportional decrease in H*/L* is equal to the proportional decrease in P2. 

5. The Welfare Economics of Trade Policy 

 The preceding model of the equilibrium of the labor market was based on the implicit 

assumption that there are no tariffs on the importation of goods 1 or 2 into the economy. The 

U.S. Department of Labor 

Employment and Training Administration 46 
reasons that the relative price of good 2 relative to good 1, P2, may fall exogenously include a 

fall in the world price of good 2 because of large productivity advances abroad and a decrease in 

the cost of transporting good 2 into the U.S. The effect of a decrease in the tariff rate on the 

domestic level and distribution of net real income is through a reduction in P2, but it has to be 

modeled slightly differently. 

 It is now assumed that the relative price of good 2 is equal to the exogenous world 

relative price, P2w, plus one plus the tariff rate, t. Thus, the domestic relative price of good 2 is P2

= (1+t)P2w, and the nominal (i.e., in terms of the price of good 1) revenue from the tariff on good 

2 is tP2w(C2 – Q2), the tariff rate times the nominal value of imports. It then follows that 

aggregate nominal income in the economy is: 

[ ] 1 22 4422

2224433221 )18( )(

CPCPtLAPHA

A QCtPQPQPQPQI

w w w

w

+++=

− ++= + + −

 

where P4w = (A2/A4)P2w is what the price of the low-skilled intensive nontraded good would be if 

there were no tariff on good 2. Since (for NX = 0) each consumption level is Ci = βiI/Pi, the 

nominal value of aggregate income in the economy is equal to I = (1+t)Iw/(1+(β1+β3)t), where Iw

= A1H + P2wA2L is nominal national income in world prices. Division of this value by the price 

level, (A-10), yields aggregate real national income: 

( ) 42 3 4 3 4

31

4321

)(

2

31 )(1

)1( )19( ββ β β β β

ββ

ββ

AAAAPI

t

t A Y ww

+− − −

+

++

+ − = 

The familiar proposition that “free trade yields maximum aggregate welfare” is easily verified 

from (A-19) by showing that Y is highest, ceteris paribus, when t = 0. 

 Given that WH/WL = A1/P2w(1+t)A2 and WHH + WLL = I/PA, we can also solve the net 

real wages of the two types of labor: 

( )( ) ( )

( )( ) ( ) 31 3 4 3 4

31

31 3 4 3 4

31

43

1

21

)(1

2

22 31

1

432

1

1

)(

2

22 31

1

)1(

1

)1( )20(

βββ β β β

ββ

βββ β β β

ββ

ββ

ββ

AAAAPI

LAtPI t

t W

AAAAPI

LAtPI t

t A W

ww

w w

L

ww

w w

H

−+− −

++

−+− −

+

+ ++

+ =

+ ++

+ − =

It is straightforward to show that an increase in the tariff rate always lowers WH and, so long as t 

is not too large, raises WL. Of course, since Y falls as t is raised, the increase in low-skilled 

labor’s net income in response to an increase in the tariff rate is smaller than the decrease in the 

net income of high-skilled labor. 

U.S. Department of Labor 

Employment and Training Administration 47 
6. Equilibrium Outside the Cone of Diversification 

 An important assumption of the open economy model is that production is profitable in 

both of the traded goods industries, 1 and 2. This requires that both of the inequalities given by 

(A-16) be satisfied. Of particular relevance to the U.S., the unskilled intensive tradable good, 

industry 2, will, in the absence of tariffs, not be produced if it cannot be produced profitably 

domestically. Industry 2 is the more likely to disappear the lower are the values of P2, A2, L, and 

NX. 

 If domestic production of industry 2 is zero and all consumption of that good is in the 

form of imports, the resultant model of the labor market is more like the closed model in item 2 

of this appendix rather than the open economy model of item 3. This is so even though the 

economy is in fact fully open to trade rather than closed. 

 To see this, note that, with industry 2 absent, all low-skilled labor is employed in the 

nontraded goods sector, industry 4, and all consumption of good 2 is imported. The nominal 

wage rate for high-skilled labor is still determined in the tradable goods sector, industry 1, for 

MH = A1 = P3A3. The price of low-skill intensive nontraded good is determined domestically, for 

I = A1H/(1-β4) and P4 = β4I/Q4 = (β4/(1-β4))A1H/A4L. This means that ML = P4A4 = (β4/(1-

β4))A1H/L so that the relative demand for labor function is given by: 

1

4

1 4 )21(

−

⎟

⎟

⎠

⎞

⎜

⎜

⎝

⎛

⎟

⎟

⎠

⎞

⎜

⎜

⎝

⎛ − ⎟ = ⎠

⎞ ⎜

⎝

⎛ −

L

H

d

W

W

L

H A

β

β 

and the real wage rates for the two types of labor are given by: 

4

21 3 24

4

21 3 24

1

4

4

2431

4

4

2431

1

1 )22(

β

ββ β ββ

β

ββ β ββ

β

β

β

β

−

+ −

−

+ −

⎟

⎟

⎠

⎞

⎜

⎜

⎝

⎛

− ==

⎟

⎟

⎠

⎞

⎜

⎜

⎝

⎛

− − ==

L

H PAAA

P

M

W

L

H PAAA

P

M A W

A

L

L

A

H

H

 Even though this economy is very much open to international trade, (A-21) and (A-22) 

are very similar to (A-11) and (A-21) for the closed model. The only difference is that A2 does 

not determine real wage levels because that industry no longer exists in the country. The relative 

demand for labor function has the same sort of finite elasticity that one obtains in the closed 

economy and, this, is represented by figure 1 rather than figure 2. 

7. Product Differentiation 

 An important assumption of the open economy model is that consumption of foreign and 

domestic versions of the two tradable goods, Cif and Cid for i = 1,2, are perfect substitutes for 

each other. Thus, we don’t distinguish between the consumption of foreign and domestic 

versions of the same thing; instead, Ci = Cif + Cid. 

U.S. Department of Labor 

Employment and Training Administration 48 
 An alternative to this is to recognize that there may be a difference between the domestic 

and foreign versions of each of the potentially tradable goods so that there is simultaneous 

consumption within the U.S. of both versions of both tradable goods. Now instead of (A-7) the 

utility function for the economy becomes: 

3 4

2

2

2

2

2

2

2 1

1

1

1

1

1

1

43

1 1

22

1

22

1 1

11

1

11 )23( )1( )1( β β

β ω

ω

ω

ω

ω

ω β ω

ω

ω

ω

ω

ω

A λ CU d λ C f λ C d λ C f CC

− − − − − −

⎥

⎥

⎦

⎤

⎢

⎢

⎣

⎡

−+

⎥

⎥

⎦

⎤

⎢

⎢

⎣

⎡ − −+=

where ωi is the elasticity of substitution between the domestic and foreign versions of good i 

(which is usually referred to as the Armington elasticity) and λi is a shift parameter indicating the 

relative tastes for the domestic version of good i. If both ωi’s are infinite, (A-23) reverts to (A-9). 

If both ωi’s were equal to one, the utility function would be Cobb-Douglas in the six different 

goods (two versions each of goods 1 and 2) and the resultant product demand functions would 

each have absolute price elasticities of unity. 

 It is reasonable to suppose that for most potentially importable consumption goods there 

is some degree of home bias; i.e., the value of ω is less than infinity (although greater than one). 

When one incorporates the 1 < ω < ∞ assumption into the complete model of labor market 

equilibrium (Johnson and Stafford 1999), the resultant relative labor demand elasticity is 

between one (its value in the closed economy model with Cobb-Douglas preferences) and 

infinity (its value in the open economy model). 

U.S. Department of Labor 

Employment and Training Administration 49 
Appendix B: The Effects of the Outsourcing of Jobs on Employment, 

Average Real Wages, and the Distribution of Earnings in the Short, 

Medium, and Long Runs 

 This appendix sketches a relatively simple model in which there is the potential for firms 

in the economy to purchase some of their labor functions from outside the country. They can 

“outsource” or “offshore” some of their high- and/or low-skilled jobs. 

 What are the implications of increased outsourcing? The effects depend very much on 

which variables are assumed to be variable and which are fixed. Three cases will be 

distinguished: (1) the short run, in which real and/or relative wage rates may be fixed so that 

outsourcing may affect domestic employment levels, (2) the medium run, in which relative 

wages adjust so that the economy returns to full employment, and (3) the long run, in which the 

capital stock adjusts in response to changes in profitability. 

1. The Model 

This approach to the analysis of the effects of “offshoring” uses a one sector framework 

in order to focus on the major issues. Feenstra and Hanson (1999, 2001) set out an N sector 

model that is, as one would suspect, easily integrated into the standard trade model. This author 

makes similar assumptions—inspired by their model—about the nature of outsourcing, but the 

focus is more macroeconomic in nature. Aggregate real output in world prices (Y) depends on 

the effective inputs of labor services (G) and the capital stock (K). The aggregate production 

function is assumed to take the form: 

−αα − = 1 B )1( KAGY

Firms in the aggregate are assumed to hire N workers in the domestic market, but they

may outsource some the work to foreign countries, hiring No foreign workers. The relevant 

production functions for the flow of labor services are assumed to be Constant Elasticity of 

Substitution (CES) and are given by: 

( ) 1 1 1

)2( )1( − − −

⎥

⎦

⎤ ⎢

⎣

⎡ − −+= τ

τ

τ

τ τ

τ

B υNG υ Nb o 

where b is an efficiency parameter indicating how effectively jobs can be performed outside of 

the country. The elasticity of substitution between domestic and outsourced workers is assumed 

to be equal to τ, which is assumed to be finite but greater than one. Diminishing returns to both 

types of outsourced labor is implicitly assumed in this formulation (the result of the assumption 

that τ < ∞). For example, a United States company may (as a result of the development of the 

Internet, represented by an increase in b) find it profitable to shift programming jobs to India, but 

it still needs some computer aces around the home office to keep the local system running. 

U.S. Department of Labor 

Employment and Training Administration 50 
Similarly, because of low transport costs and political stability (an increase in the value of b), 

assembly functions may be moved to Mexico or China, but truck drivers and sweepers must 

operate in the United States. The proportional change in the flow of labor flow services is then: 

B NG ( bN ) o

ˆ ˆ )1( ˆ ˆ − )3( γγ +−+=

γ is the share of the total wage bill of each type of labor that goes to domestic workers. If b is so 

small that there is no outsourcing of labor, G would equal N. 

Given competitive product markets and at least some outsourcing of the marginal 

conditions for the two varieties of labor input (domestic and outsourced labor) are: 

( ) τ

τ

τ

υα

αυ

1

1 1

1

1

)4(

⎟

⎟

⎠

⎞

⎜

⎜

⎝

⎛ −= ∂

∂ =

⎟

⎠

⎞ ⎜

⎝

⎛ = ∂

∂ − =

−

o o

o N

G

G

Y b

N

Y W

N

G

G

Y

N

Y B W

where the W’s are the relevant real wage rates domestic and outsourced labor. If, instead of just 

the first, both levels of the production function were Cobb-Douglas (so that τ = 1), υ would equal 

γ, and it is easily seen in this case that domestic labor’s share of aggregate GDP would be αγ, 

which would be independent of any parameters of the model. 

2. Effects of Increased Outsourcing of Labor in the Short and Medium Runs 

The two equations in (B-4) determine the values of N and No as functions of 

W, Wo, and b (in addition to the values of A and K). Taking proportional changes and solving, 

the solution changes in the employment levels are seen to be: 

( )

N W W b

B N W bW

o o

o

ˆ )1( 1

ˆ 1 )1( 1ˆ 1 1

1

ˆ

ˆ ˆ

1

)1( 1 1

ˆ 1 )1( 1 1

1

ˆ )5(

⎥

⎦

⎤ ⎢

⎣

⎡ −+ −

− + ⎥

⎦

⎤ ⎢

⎣

⎡ − +− − ⎟ − ⎠⎞ ⎜

⎝

⎛ −− − −=

− −

⎟ − ⎠

⎞ ⎜

⎝

⎛ −−

+ ⎥

⎦

⎤ ⎢

⎣

⎡ ⎟ +− ⎠

⎞ ⎜

⎝

⎛ −− − − −=

αγ

τ

γα

α

τ

τ

γ γα

α

τ

τ

α

α

τγ

α

γτ

τ

α

τ

γ

τ

α

α

τ

U.S. Department of Labor 

Employment and Training Administration 51 
The own real wage elasticities of the demand domestic and outsourced labor, ∂(log N)/∂(log W) 

and ∂(log No)/∂(log Wo), are both negative. The effect of an increase in Wo on domestic demand 

is positive if: 

U.S. Department of Labor 

Employment and Training Administration 52 

α

τ − − >

1

1 B )6( 

Given the assumed Cobb-Douglas aggregate production function, this requires that the 

elasticity of substitution between domestic and outsourced labor must be greater than between 

2.5 and 3 in order for ∂(log N)/∂(log Wo) to be positive. Interestingly, an increase in the 

efficiency of outsourcing (that has no effect on the real wage in the countries in which the 

potential outsourcing takes place), represented by an increase in b, decreases domestic labor 

demand if (B-6) is satisfied. If it is not satisfied—if domestic labor and outsourced labor are not 

highly substitutable—labor demand is increased by an increase in the profitability of 

outsourcing. 

One can easily calculate the net value of “lost jobs” due to outsourcing within this 

framework. The short-run change in expenditure on outsourced labor due to an exogenous 

increase in b is given by WoNo∂(log No)/∂(log b), and the change in expenditure on domestic 

labor is WN ∂(log N)/∂(log b). Substituting in the appropriate derivatives from (B-5) and 

dividing the latter by the former, this displacement ratio, evaluated at a low rate of outsourcing 

(i.e., γ ≈ 1) is seen to be: 

⎟

⎠

⎞ ⎜

⎝

⎛ −−

−−

− =

τ

α

τ

α

1 1)1(

1 1

B )7( displace

There is a dollar for dollar displacement of WN by WoNo if domestic and outsourced labor are 

infinitely substitutable. The value of α for the U.S. is approximately 2/3. For a value of τ equal to 

4.0, the value of displace is 0.33 (each dollar spent abroad reduces the domestic real wage bill by 

33 cents). On the other hand, for τ equal to 2.5, the value of displace is -0.33. (The improved 

efficiency raises employment in the U.S.) 

The aggregate demand function for domestic labor in the economy is illustrated 

geometrically in figure B-1. The figure assumes (without evidence one way or the other) that (B6) is satisfied. 
Figure B-1. Equilibrium of the Domestic Labor Market 

With an Increase in Outsourcing in the Short and Medium Runs 

 

 W Ns

U.S. Department of Labor 

Employment and Training Administration 53 

 W’ 

 W” 

 Nd

│b,Wo

 

 N” N’ N 

In the short run, the real wage rate of domestic labor is assumed to be fixed (at W’ in the 

figure). An increase in the value of b shifts the demand for labor function to the left. With W 

fixed, the employment level falls N’, the value at which employment is equal to the effective 

labor force Ns

, to N”. 

In the medium, run the real wage rate changes such that unemployment returns to its 

“natural” state. The real wage rate falls to W” (again assuming that (B-6) is satisfied; otherwise 

W rises). The effect of an increase on b on W is found from (B-5) to equal: 

τ

γ

τ

α

γ

τ

α

1 )1( 1 1

)1( 1 1

)(log

)(log )8(

⎟ +− ⎠

⎞ ⎜

⎝

⎛ −−

⎟ − ⎠

⎞ ⎜

⎝

⎛ −−

−= ∂

∂ − bW B 

This is, of course, negative or positive as (B-6) is or is not satisfied. 

3. The Long-Run Effects of Outsourcing on Wages 

An increase in the efficiency of outsourcing raises the marginal productivity of capital, 

and it is reasonable to suppose that this increases investment and, thus, the stock of capital in the 

long run. If we make the extreme assumption that capital stock adjusts in the long run such that 

the marginal product is unchanged by any external events, the conclusion concerning the effects 

of outsourcing on wages is quite different. 
We will now assume that the capital supply equilibrium condition is: 

K

Y

K

Y B r = α

∂

∂ ( − )9 =

where r is the world rental price of capital. From (B-1) this implies that K will adjust such that it 

is proportional to G, which, in turn, means that the long-run value of Y/G depends only on r and 

A, but is not influenced by any labor parameters such as b. 

In the long run W can vary, but domestic employment is equal to effective aggregate 

domestic supply. An increase in b thus affects the amount of outsourcing (No), but not the value 

of N. Differentiating the second equation of (B-4) totally with respect to No and b, under the 

restriction that in the long run Y/G is unchanged by b, the proportionate change in outsourced 

labor is seen to be: 

B o bN ˆ 1 ˆ )10(

τ

γ

τ

γ

−

− =

The proportional change in the domestic real wage rate is found by letting b and No change in the 

first part of (B-4), or: 

B W [ ] o bbN ˆ 1 ˆ ˆ 1 ˆ )11(

γ

γ

τ

γ − =+ − − =

The long-run effect of an increase in the efficiency of outsourcing on the domestic real wage rate 

is, given the assumption of an infinitely elastic supply of physical capital, unambiguously 

positive. Further, the long-run value of ∂(log W)/∂(log b) is always greater than its medium run 

value, (B-8), so long as α < 1. 

 If one assumes that the supply of capital is less than infinitely elastic (because, for 

example, resources for investment have to be raised domestically), the effect of an increase in b 

on the real wage rate is a blend of (B-8), the medium-run case, and (B-11), the long-run case 

with an infinite supply elasticity for capital. An increase in the efficiency of outsourcing in this 

case would raise or lower W in the long run, but W will be higher (possibly less negative) in the 

long than in the medium run. 

 An interesting variant of the model, which will not be discussed at length here, is based 

on the assumption that the U.S. must engage in foreign direct investment in order to take 

advantage of outsourcing. In this case, the aggregate production functions (B-1) and (B-2) above 

are replaced by: 

( ) ( )

U.S. Department of Labor 

Employment and Training Administration 54 

1 1

1

1

1 )'1( )1( − − − − −

⎥

⎦

⎤ ⎢

⎣

⎡ − = −+ τ

τ

τ

τ αα ττ αα B υ KNAY d υ KbN oo
where Kd is capital supplied for domestic production and Ko is capital supplied for foreign 

production (the result of past foreign direct investment by U.S. firms). 

 This modification leads to similar qualitative conclusions to the model based on the 

assumption that all capital is based in the U.S. about the short- and medium-run effects of b and 

employment and the real wage in the U.S. In the long run, however, the fact that Kd and Ko

compete with each other lessens the potential beneficial effects of increases in the efficiency of 

outsourcing. 

4. Effect of Outsourcing on the Distribution of Earnings 

Just one type of labor has been focused on to this point in the appendix. This approach is 

of some current interest; the recent spate of “offshoring” has been alleged to be somewhat 

balanced with respect to skills. Much of the literature on outsourcing focuses on an imbalanced 

incidence, and this requires that more than one type of labor be introduced into the model. 

The aggregate production function is now assumed to be a 3-level CES of 

the following form: 

( )

( )

( ) 1 1 1

1 1 1

1 1 1

1

)1(

)1(

)1(

)12(

− − −

− − −

− − −

−

⎥

⎦

⎤ ⎢

⎣

⎡

−+=

⎥

⎦

⎤ ⎢

⎣

⎡ = −+

⎥

⎦

⎤ ⎢

⎣

⎡ = −+

− =

τ

τ

τ

τ τ

τ

τ

τ

τ

τ τ

τ

σ

σ

σ

σ

σ

σ

αα

τ τ

τ τ

δ δ

LL oLL

H H oHH

HS L

LG Lb

HG Hb

GbG G

B KAGQ

 

GH and GL are the flows of high- and low-skilled labor services, H and Ho are inputs of domestic 

and outsourced high-skilled labor services, and L and Lo are inputs of domestic and outsourced 

low-skilled labor services. σ is the elasticity of substitution between high- and low-skilled labor 

services, and an increase in bS represents skill-biased technical change. bH and bL play the same 

role as b in earlier sections of this appendix; they are just specific to each labor type. 

U.S. Department of Labor 

Employment and Training Administration 55 
U.S. Department of Labor 

The real wage rates of the two types of domestic labor equal their marginal products, that is: 

σ τ

σ τ σ

τδα

αδτ

1 1

1 1

1 1

)1(

)13(

⎟

⎠

⎞ ⎜

⎝

⎛ ⎟

⎟

⎠

⎞

⎜

⎜

⎝

⎛ −= ∂

∂ =

⎟

⎠

⎞ ⎜

⎝

⎛ ⎟

⎟

⎠

⎞

⎜

⎜

⎝

⎛ = ∂

∂ − = −

L

G

G

G

G

Y

L

Y W

H

G

G

G

G

Y b

H

Y B W

L

L

L L

H

H

H SH

The high-/low-skilled relative wage is then: 

στ τ σ

τ

τ

δ

δ

11 1

1 1

1 )14(

− − −

⎟

⎠

⎞ ⎜

⎝

⎛ ⎟

⎟

⎠

⎞

⎜

⎜

⎝

⎛

− − == L

H

G

G b

W

W B rel

L

H

S

L

H

L

H

assuming there is no outsourcing of either labor type, GH = H and GL = L and τH = τL = 1. The 

relative labor demand function then reduces to a somewhat simpler and more familiar relation 

with (H/L)-1/σ

, replacing the (GH/GL)

1/τ-1/σ

(H/L)-1/τ in (B-14). A more general production, say Y = 

F(GH, GL, K, ...), would allow for the possibility of different degrees of complementarity 

between capital and the two types of labor (versus the assumption of the 3-level CES that the 

two elasticities of complementarity are identical). 

The elasticity of substitution between domestic and outsourced labor (τ) is presumably 

greater than the elasticity of substitution between high- and low-skilled labor aggregates. That 

means that the exponent on (GH/GL) in (B-14) is negative, so an increase in GH/GL, H/L held 

constant, should lower the relative demand for high-skilled labor. 

If, as seems to be true at least until fairly recently, outsourcing of jobs was concentrated 

at the low- rather than the high-skilled end of the distribution (the result of an increase in bL

rather than bH). This would make GL rise relative to GH and (with τ > σ) cause the relative 

demand for low-skilled labor to fall, resulting in a fall in the employment of L’s with relative 

wages fixed and a reduction in rel after labor market adjustment. This is, as pointed out by 

Feenstra and Hanson (2001), exactly what one would observe with skill-biased technical change 

(an increase in bs with the inter-labor substitution elasticity, σ, greater than one). 

There has recently been a great deal of publicity given to outsourcing of high-skilled jobs 

(programming functions to India, etc.), a result of an increase in bH. This would shift the relative 

demand function in the opposite direction as would an increase in bL, resulting in a fall in H/L in 

the short run and in rel in the medium and long runs. If changes in opportunities for outsourcing 

were balanced (i.e., changes in bH and bL over a time interval had roughly the same proportional 

effect on GH and GL), the resultant effects on wages would be the approximately the same for 

both groups. The resultant outcomes in this case would be like those for the one labor type model 

discussed in items 1-3 of this appendix. 

Employment and Training Administration 56