GED Explains: Is Globalization Driving Down Wages?

In our Globalization Report 2016 we demonstrated that globalization has a positive impact on the gross domestic product of all countries participating in globalization. Simultaneously, globalization produces winners and losers in each country. In this post we analyse the wage effects of globalization in industrialized and developing economies.

Labor markets in closed economies = high wages in industrial countries

The market for labor follows a classic demand curve, with wages increasing in tight labor markets and declining when labor is plentiful. The labor market is in balance if the wage achieves that level at which labor demand of companies equals labor supply of individuals.

The wage level which is necessary to achieve an equilibrium however, differs between countries. Developing countries such as India have a large population and hence a large workforce. Due to the abundance of labor, the price for labor is relatively low (w^IND in figure 1). Industrialized countries such as Germany are relatively short of labor. Hence their equilibrium wage is higher than in less developed countries (w^GER in figure 1).

Migration reduces wages in industrialized countries

The situation of labor markets changes noticeabley if we open borders and allow migration between countries. In this case, workers from developing countries have an incentive to migrate to countries with higher wages. Hence labor supply in a developing economy declines. Due to the growing scarcity of labor, wages rise in developing economies such as India (from w^IND₀ to w^IND₁ in figure 2).

In Germany, this kind of migration increases the supply of labor and hence reduces the wage level for workers. In theory, migrations flows end if the wage level in Germany equals the level in India.

Foreign trade reduces wages in industrialized countries

Due to these wage effects, industrialized countries very often are reluctant to open their borders for foreign workers. But even if migration is not allowed at all between Germany and India, there is a tendency to equalize wages in both countries. This equalization is due to cross border trade.

In the example discussed so far, India has a low wage level. Therefore, in terms of international competitiveness, India has an advantage concerning production processes which need plenty of labor. Hence India increases the production of labor-intensive goods. These goods are sold to Germany. In return, Germany produces more goods that use a lot of capital but little  labor.

This kind of international division of labor has the same consequences for wages as migration: In India, exporting work-intensive products increases the demand for labor. Once again the result is a rise of wages (from w^IND₀ to w^IND₂ in figure 3). In Germany, reducing the production of labor-intensive products reduces the demand for labor and therefore lowers wages (from w^GER₀ to w^GER₂) as well as employment (from L^GER₀ to L^GER₂).

Conclusion and policy recommendations

Even though the analysis made so far is a simplification of economic reality, it nevertheless clarifies the fundamental effects of a closer integration of markets. Undoubtedly such an integration increases economic growth in all participating countries. However, it is equally clear that international division of labor and international trade can have negative impacts on employment and wages in industrialized countries. This phenomenon is quite well documented in the relationship between the U.S. and China. It also applies to Germany as we demonstrated in our Focus paper “Effects of International Trade for the Manufacturing Sector”.

In order to achieve a just distribution of globalization gains in industrialized countries it is necessary to find compensatory measures for those parts of the workforce which suffer from growing globalization. The concrete mechanisms can vary from country to country: unemployment insurance benefits, training courses, income support payments and/or other mechanisms. If industrialized countries such as Germany and the U.S do not succeed in solving this distributional conflict, there is a danger of growing rejection of free trade and globalization.

This would be harmful for everyone, wasting the increase in living standards we all gain from comparative advantages through international division of labor.