An Analysis of Wage Differentials for a Small Open Economy

Abstract

While the bulk of trade theory is concerned with the behavior of economies that save and invest nothing and suffer no trade imbalance, Bruno [4, 199-221] has provided a two period model of production and factor allocation that is capable of handling these issues rather conveniently.' In this paper we explore the positive theory of inter-industry relative wage differentials in a framework similar to Bruno's. Such an exercise leads to a considerably richer body of results. We obtain some new results regarding the implications of interindustry wage differentials for the pattern and level of investment and for the trade balance of a small open economy. In addition, we demonstrate that a striking result of Batra and Pattanaik [1, 638-49], that an increase in the inter-industry wage differential does not necessarily reduce the value of output at fixed product prices, is valid only in the long run equilibrium, and that it ceases to hold in the short run when the capital stock is fixed and sector specific. We further demonstrate that the output response to goods-price change turns out to be unambiguously normal even in the presence of inter-industry wage differentials, in contrast to the perverse output response noted by Bhagwati and Sinivasan [3, 19-35]. Finally, Magee's [5, 623-43] result on the ambiguous impact of an increase in the wage differential on the pattern of production, we demonstrate, does not withstand the introduction of endogenous saving and investment into the standard two-sector model. It is worth emphasizing that we are concerned with inter-industry wage differentials that take the form of relative rather than absolute differentials. While Schweinberger [6, 95-115] has shown that most of the propositions in the positive theory of inter-industry relative factor-price differentials are overturned in the case of absolute differentials, we show that these standard propositions cease to hold even if the differentials are relative. For our tools of analysis we draw upon the specific factor model, cast it in an intertemporal decision making framework, assume international capital mobility, and obtain a trade model similar to Bruno's [4, 199-221] two-sector, two-period model in which endogenous saving and investment are explicitly incorporated. In contrast to Bruno's model, however,