Urban Unemployment, Terms of Trade and Welfare

Abstract

It is generally accepted prior to 1970 that a deterioration in the terms of trade results in lower social welfare. In particular, Prebisch [11] and Singer [12] have expressed the basic concern with the terms of trade; the secular deterioration in the terms of trade facing less developed countries (LDCs) leads to income and welfare losses. Batra and Pattanaik [2] nevertheless shows that a deterioration in the terms of trade in the presence of an intersectoral wage differential may raise welfare. Bhagwati and Brecher [5] demonstrate that a decline in the terms of trade can improve real income if capital is mobile internationally. Recently, Anam [1] obtains a similarly interesting result for an economy engaging in quota-induced rent seeking activities. It is notable that none of these studies considers a key feature inherent in a typical LDC, namely, the existence of substantial urban unemployment. Thus, the purpose of this paper is to examine the welfare impacts of terms of trade losses for LDCs plagued by pervasive urban unemployment. The well-known Harris-Todaro [7] framework of sector-specific unemployment is utilized.' In addition, we derive and contrast various welfare effects of a change in the terms of trade when a LDC pursues alternative import substitution policies, i.e., tariffs vs. quotas over the short vs. the long run. The paper is organized as follows. Section II develops the model and provides the transformation relation between urban and rural outputs. Section III examines the welfare effects of an exogenous shift in the terms of trade for a tariff or quota-distorted economy in the short run as well as in the long run. Finally, concluding remarks are set out in section IV.