Calibrating Wage-Productivity Responses in CGE Model Simulations of Trade Policy Impacts

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It is well established in theory that trade liberalization impacts on productivity through the reallocation of market share to more productive firms. Since more productive firms tend to pay higher wages, the market reallocation effect also increases average wages. In addition to these intra-sectoral effects, changes in the composition of output at the economy-wide level result in reallocation of factors of production to higher-productivity sectors. At the same time, the positive demand shock from trade liberalization typically generates increased returns to factors, and thus results in higher real wages for labour. For these various reasons, we anticipate a positive relationship between changes in productivity and changes in real wages in response to trade liberalization. This is consistent with the observed long-run relationship across countries and over time between wages and productivity and is also consistent with the theoretical expectation that labour is paid its marginal product. In a computable general equilibrium modelling environment, various methods have been developed to build in productivity effects from trade liberalization. There is little guidance however as to how strong these effects should be. We propose an elegant solution to the calibration problem by imposing a unitary elasticity of the supply of labour input to the wage rate. This generates an endowment effect, interpreted as labour productivity rather than jobs, that rises proportionately with wages. This approach to endogenization of productivity in a CGE environment thus uses the model-generated contribution of factor inputs to production and the stylized facts about the relationship between wage and productivity growth to calibrate the productivity impact of trade liberalization.