This is “Intuition of Real Wage Effects”, section 4.9 from the book Policy and Theory of International Trade (v. 1.0).
This book is licensed under a Creative Commons by-nc-sa 3.0 license. See the license for more details, but that basically means you can share this book as long as you credit the author (but see below), don't make money from it, and do make it available to everyone else under the same terms.
This content was accessible as of December 29, 2012, and it was downloaded then by Andy Schmitz in an effort to preserve the availability of this book.
Normally, the author and publisher would be credited here. However, the publisher has asked for the customary Creative Commons attribution to the original publisher, authors, title, and book URI to be removed. Additionally, per the publisher's request, their name has been removed in some passages. More information is available on this project's attribution page.
For more information on the source of this book, or why it is available for free, please see the project's home page. You can browse or download additional books there. You may also download a PDF copy of this book (19 MB) or just this chapter (694 KB), suitable for printing or most e-readers, or a .zip file containing this book's HTML files (for use in a web browser offline).
When the United States and France move from autarky to free trade, the U.S. price of cheese rises and the United States begins to export cheese. The French price of wine rises and France begins to export wine. In both of these industries, the higher prices generate higher revenue, and since profits must remain equal to zero because of competition in the industry, higher wages are paid to the workers. As long as the factors remain immobile, other workers do not enter the higher wage industry, so these higher wages can be maintained. Thus in both countries real wages rise for workers in the export industries.
The movement from autarky to free trade also causes the price of wine to fall in the United States while the United States imports wine and the price of cheese to fall in France while France imports cheese. Lower prices reduce the revenue to the industry, and to maintain zero profit, wages are reduced proportionally. Since workers are assumed to be immobile, workers cannot flee the low-wage industry and thus low wages are maintained. Thus in both countries real wages fall for workers in the import-competing industries.
But isn’t it possible for the owners of the firms in the export industries to claim all the extra revenue for themselves? In other words, maybe when the price rises the owners of the export firms simply pay the CEO and the rest of management a few extra million dollars and do not give any of the extra revenue to the ordinary workers. Actually, this is unlikely under the assumptions of the model. First of all, the model has no owners or management. Instead, all workers are assumed to be the same, and no workers have any special ownership rights. But let’s suppose that there is an owner. The owner can’t claim a huge pay increase because the industry is assumed to be perfectly competitive. This means that there are hundreds or thousands of other export firms that have all realized a price increase. Although workers are assumed to be immobile across industries, they are not immobile between firms within an industry.
So let’s suppose that all the firm’s owners simply pocket the extra revenue. If one of these owners wants to make even more money, it is now possible. All she must do is reduce her pay somewhat and offer her workers a higher wage. The higher wage will entice other workers in the industry to move to the generous firm. By increasing workers’ wages, this owner can expand her own firm’s output at the expense of other firms in the industry. Despite a lower wage for the owner, as long as the increased output is sufficiently large, the owner will make even more money for herself than she would have had she not raised worker wages. However, these extra profits will only be temporary since other owners would soon be forced to raise worker wages to maintain their own output and profit. It is this competition within the industry that will force wages for workers up and the compensation for owners down. In the end, economic profit will be forced to zero. Zero economic profit assures that owners will receive just enough to prevent them from moving to another industry.
Jeopardy Questions. As in the popular television game show, you are given an answer to a question and you must respond with the question. For example, if the answer is “a tax on imports,” then the correct question is “What is a tariff?”