Human Capital, Minimum Wage and Unemployment: A Harris-Todaro Model of a Developed Open Economy

Abstract

In many developed countries unemployment is a serious and persistent problem. Although the character of this problem is highly complex, one of its features which can easily be observed is the substantially higher incidence of unemployment among unskilled workers than among those who are skilled. A possible explanation for this is the existence of an institutionally given minimum wage, which exceeds the market-clearing wage for unskilled labour but lies below the equilibrium wage for skilled labour. Moreover, for those who find themselves unemployed because of the minimum wage, the principal source of job opportunities tends to be the services sector of the economy, which is relatively intensive in its use of unskilled labour. The objective of this paper is to develop a simple model of a small, open economy based on these observations and to examine the policy implications that emerge from it in connection with the unemployment problem. The focus of the analysis, however, is not on the cyclical aspects of this problem but rather on its steady-state nature. The basic structure of the model is as follows. Our economy has two sectors engaged in the production of consumption goods. One of these goods is assumed to be traded internationally and the other is non-traded. Following Rodriguez (1975), I draw a further distinction between the two sectors: nontraded goods, which may be regarded as services, are assumed to require the use of only capital and unskilled labour as inputs, while the traded-goods sector uses only capital and skilled labour. Skills are viewed as productive human capital which can be acquired through formal training. In order to sharpen the focus of our analysis on the process of human capital formation, I will ignore the problems of physical capital accumulation and population growth.' The economy is assumed to be small, facing a given world price of traded goods as well as a given rental at which the supply of capital from abroad is infinitely elastic. In contrast with the assumption of perfect capital mobility, neither type of labour is mobile internationally. With only one traded commodity and one mobile factor, international trade for this economy amounts to an exchange of the single traded consumption good for the services of capital at fixed terms of trade. Section I of the paper presents the model and solves for the stationary composition of the labour force (i.e. skilled v. unskilled) and the equilibrium values of relative factor and commodity prices. Section II introdluces an institutionally given minimum wage which is binding only in the market for unskilled labour. In the spirit of Harris and Todaro (1970), it is assumed that