The Effects of Increasing Openness and Integration to the MERCOSUR on the Uruguayan Labor Market: A CGE Modeling Analysis

Abstract

Uruguay is a small economy. Its integration to MERCOSUR has increased the exposure to regional macroeconomic inestability. The aim of this paper is to assess the impact of regional integration and trade openness on labour market and poverty. The analysis of the Uruguayan labour market shows clear evidence of the existence of wage differentials between sectors and labour categories. We estimated wage differentials between labour categories, finding a 60% wage gap between formal and informal workers. Taking this into account, a CGE model with an efficiency wage specification for unskilled labour and full employment was developed. There is an informal perfect competitive sector where laid-off workers from formal efficiency wage sectors go. Other than this it is a conventional perfect competence model with Armington specification. Following Cox (1994) it is assumed that Uruguay is a quasi-small open economy with three trading partners: Argentina, Brazil and Rest of the World. One clear conclusion of the simulations carried out within that model is that the Mercosur economies deeply affect the Uruguayan economy through changes in relative prices. Similarly, a restriction on external savings as a consequence of the instability in the region have significant and negative effects on the Uruguayan labour market. The consideration of efficiency wage model is particularly important when shocks lead to a reallocation of resources towards sectors intensive in unskilled labour. The simulation of a specific policy –a 10% direct subsidy on formal unskilled employment- show that wage differentials and informality can be reduced, but in the long run this type of policy might have negative effects on investment and human capital accumulation. Finally, microsimulations were carried out in order to assess the impact of those shocks on poverty and income distribution. The results obtained are consistent with the results of the CGE experiments. The evidence presented in this paper show the importance of taking into account the existence of imperfections in the labour market. The effects of external shocks, as well as the impact of some policies, are clearly different in the presence of those imperfections. This fact emphasizes the need to make an appropriate diagnosis of the labour market when modeling the economy of a particular country.