Trade Policies and Welfare in a Harris-Todaro Economy

Abstract

In many developing countries rising unemployment is often attributed to increases in foreign imports, triggered by declining foreign prices of imports. To correct the chronic unemployment problem, some developing countries chose an import substitution strategy by shutting off imports, whereas others adopted an outward-oriented policy by promoting exports. North American Free Trade Agreement (NAFTA) was favored by Mexico but opposed by organized labor in this country because it was feared that NAFTA may increase unemployment in the U.S. Which of these policies is more effective in reducing unemployment and raising domestic income? Protection has been ardently supported as a practical cure for unemployment in Chile and Argentina and many other LDCs in Latin America.' Similarly, India adopted import substitution strategies behind high protection and a considerable bias against exports [1]. The literature has also justified the use of tariffs for small countries under uncertainty and unemployment [10; 9]. But in general, protection distorts the trade pattern and magnify the extent of the Leontief Paradox by limiting imports of capital intensive products into these developing countries that suffer from high labor unemployment [7]. In the literature there have been two types of models that analyze trade problems in the presence of unemployment. The generalized unemployment models have been developed by Brecher [5; 6] and Batra and Seth [3].2 In these models, wage rigidity is ubiquitous and unemployment exists in all sectors, and they are appropriate to analyze the impact of trade policies on unemployment in developed economies. The Harris-Todaro (HT hereafter) model [13], on the other hand, assumes sector-specific wage rigidity and permits unemployment only in the urban sector. Thus, the HT model is appropriate for investigating the impacts of trade policies of LDCs that suffer