Economic Liberalization and Wage Inequality in the Presence of Labour Market Imperfection

Abstract

Removal of tariff restrictions from the relatively low-skill sectors; growth in foreign direct investment; and, decline of trade union strength of the unskilled workers are cited in the empirical literature as the prime factors responsible for the growing incidence of wage inequality in many of the developing countries in the liberalized trade and investment regime. This paper has made an attempt to provide a theoretical foundation of those empirical findings in terms of a three sector general equilibrium model reasonable for at least a few developing economies. The analysis of the paper has found that the wage inequality rises unambiguously due to policies like an increase in the relative price of the high-skill commodity and a reduction of import tariff from the low-skill manufacturing sector. However, an inflow of foreign capital produces a favourable effect on the wage inequality under a reasonable factor intensity condition. Interestingly, contrary to the common wisdom, a policy of labour market reform may raise the competitive unskilled wage and improve wage inequality under reasonable condition.