Variable Returns to Scale, Urban Unemployment and Welfare

Abstract

The proposition that free trade is superior to no trade has a classical ancestry. Adam Smith and Ricardo were amongst the first proponents of free trade. Samuelson [26] proved, and it is held by economists today, that free trade is the optimal policy in the presence of standard Paretoconditions. It is also generally agreed amongst economists that lower trade intervention is superior to higher trade intervention, given competitive conditions in a small country. These propositions do not hold, however, in the presence of factor market imperfections such as wage differentials in a small country and therefore production or wage subsidies improves social welfare. The two models which are generally used to investigate the positive as well as normative aspects of trade theory in the presence of unemployment, are the uniform real minimum wage model which is based on the assumption of general rigidity of real wage in one or two sectors of production and the sector-specific minimum wage model which focuses on the phenomenon of rural-urban migration in the face of large scale urban unemployment. These two models are commonly utilized by trade theorists to analyze trade and unemployment. Specifically, studies by Haberler [13], Johnson [16], Batra and Seth [3], Findlay [12] and Brecher [6; 7] investigate the consequences of rigid factor prices for a small country, whereas the normative as well as positive aspects of sector specific unemployment have been explored by Harris and Todaro [15], Bhagwati and Srinivasan [4; 5] and more recently by Batra and Naqvi [2], Das [10] and Kahn [19]. It has been correctly observed that the introduction of an exogenously specified real minimum wage among other things generates unorthodox results concerning unemployment and gains from trade. A large body of research has also been concerned with the welfare implications of different commercial policies in the context of variable returns to scale.' Kemp and Negishi [20] have pointed out the beneficial effects of trade in the presence of variable returns to scale, production subsidy and consumption taxes. Eaton and Panagariya [11] have analyzed the question of gains from trade in the presence of variable returns to scale and in the context of Pareto welfare criterion, whereas Choi and Yu [8] have examined the welfare implications of tariffs and consumption taxes as well as the welfare rankings of these policies under variable returns to scale, while Panagariya and Succar [25] have modified the necessary and sufficient conditions for stability under increasing returns to scale in urban sector.