International Trade Theory and Policy
by Steven M. Suranovic

Trade 40-9A

Real Wage Effects of Free Trade

The focus on real wages allows us to see the effect of free trade on individual consumers in the economy. Nominal wages are not sufficient to tell us if workers gain since, even if wages rise, the price of one of the goods also rises when moving to free trade. If the price rises by a greater percentage than the wage, the ability to purchase that good falls and the worker may be worse off.

For this reason we must consider real wages.

Real Wages represent the purchasing power of wages, that is the quantities of goods the wage will purchase.

Real wages are typically measured by dividing nominal wages by a price index. The price index measures the average level of prices relative to a base year. The nominal wage is the amount of dollars the worker receives.

In this model we need not construct a price index since there are only two goods. Instead we will look at the real wage of worker in terms of its purchasing power of each good. In other words we will solve for a real wage in terms of purchases of both wine and cheese.

Calculating a real wage: Numerical Example

Consider the real wage of a worker is in terms of cheese. Suppose the worker earns $10 per hour and the price of cheese is $5 per pound. The real wage can be found by dividing the wage by the price to get,

This means the worker can buy 2 pounds of cheese with every hour of work.

The Real Wage of Cheese Workers in Terms of Cheese

The real wage of cheese workers in terms of cheese is the quantity of cheese that a cheese worker (or cheeser) can buy with a unit of work. It is calculated by dividing the workers wage by the price of cheese, written as . Since zero profit obtains in each producing industry we can simply rewrite the relationship derived above to construct the following formula for the real wage.

This means that the real wage of a worker in terms of how much cheese can be purchased is equal to labor productivity in cheese production. In other words the amount of cheese that a worker can buy per period of work is exactly the same as the amount of cheese the worker can make in that same period.

The Real Wage of Cheesers in Terms of Wine

The real wage of cheesers in terms of wine is the quantity of wine that a cheese worker can buy with a unit of work. It is calculated by dividing the cheeser's wage by the price of wine, written as . Using the relationship between wages and prices when zero profit obtains in the cheese industry implies,

This means that the real wage of cheesers in terms of wine is the product of labor productivity in the cheese industry and the price ratio. Labor productivity gives the quantity of cheese a cheeser makes in an hour of work. The price ratio gives the quantity of wine that exchanges for each unit of cheese. The product gives the quantity of wine that a cheeser can buy with a unit of work. To calculate the autarky real wage, simply plug in the autarky price ratio. To calculate the free trade real wage, plug in the free trade price ratio.

The Real Wage of Wine Workers in Terms of Wine

The real wage of wine workers in terms of wine is the quantity of wine that a wine worker (or winer) can buy with a unit of work. It is calculated by dividing the workers wage by the price of wine, written as . Since zero profit obtains in each producing industry we can rewrite the relationship to get,

As with cheese, the real wage of a worker in terms of how much wine can be purchased is equal to labor productivity in wine production. In other words the amount of wine that a worker can buy per period of work is exactly the same as the amount of wine the worker can make in that same period.

The Real Wage of Winers in Terms of Cheese

The real wage of winers in terms of cheese is the quantity of wine that a cheese worker can buy with a unit of work. It is calculated by dividing the winer's wage by the price of cheese, written as . Using the relationship between prices and wages when zero profit obtains in the wine industry implies,

This means that the real wage of winers in terms of cheese is the product of labor productivity in the wine industry and the price ratio. Labor productivity gives the quantity of wine a winer makes in an hour of work. The price ratio gives the quantity of cheese that exchanges for each unit of wine. The product gives the quantity of cheese that a winer can buy with a unit of work. To solve for the autarky real wage simply plug in the autarky price ratio. To find the free trade real wage, plug in the free trade price ratio.

Real Wages in Autarky

To calculate autarky real wages we simply plug the autarky price ratio into the real wage formulae.

Recall that the autarky price ratio is, . Plugging this in and simplifying yields,

Autarky Real Wages

In terms of

Real Wage of, Cheese Wine
Cheese

Workers

Wine

Workers

Notice that in autarky the real wages of cheesers are exactly the same as the real wages of winers with respect to purchases of both goods. This occurs because labor is assumed to be homogeneous, i.e. all labor is the same.

Comparison of Autarky Real Wages Between Countries

Suppose the US has an absolute advantage in the production of both goods. In this case, and . This implies that the real wages of workers in both industries in the US are higher than real wages in France. Put another way, workers in France earn lower wages in both industries.

Sometimes cross-country wage comparisons are made and it is suggested that firms in a high wage country cannot compete with firms in low wage countries. However, wage comparisons of this kind are not sufficient in this model to determine who will produce what or whether trade can be advantageous. Instead what matters is relative wage comparisons. In this model a country will tend to specialize in the good in which it has the greatest real wage advantage. Thus if,

the US has relatively higher real wages with respect to cheese purchases than it does in wine purchases. When trade opens the US will specialize in its comparative advantage good, which, by rearranging the above inequality, can easily be shown to be cheese.

Effects of Free Trade on Real Wages

Suppose two countries, the US and France, move from autarky to free trade. If the US has the comparative advantage in cheese production then which implies . When the two countries move to free trade, the free trade price ratio will lie somewhere between the autarky price ratios. This means that rises in the US when moving from autarky to free trade while falls when moving to free trade.

The other major change that occurs is that the US specializes in cheese production while France specializes in wine production. This means that real wages in free trade for wine workers in the US need not be calculated since the US will no longer have any wine workers. Similarly for real wages for cheese worker in France.

Thus we can calculate the following changes in real wages as shown in the Table.

Changes in Real Wages (Autarky to Free Trade)

In terms of

Real Wage of, Cheese Wine
US Cheese

Workers


no change

rises
French Wine

Workers


rises

no change

First consider the fate of US cheese workers. Since the unit-labor requirement for cheese does not change in moving to free trade, there is also no change in the real wage in terms of cheese. However, since the price of cheese in terms of wine rises, US cheese workers can get more wine for each unit of cheese in exchange. Thus the real wage of cheesers in terms of wine rises. This means cheese workers are at least as well off in free trade as they were in autarky.

The worst outcome occurs if a cheese worker has no demand for wine. Perhaps an individual abstains from alcohol consumption. In this case the worker would be able to buy just as much cheese in free trade as in autarky, but no more. Such a person would receive no benefits from free trade.

However, every worker who demands both wine and cheese will be able to buy more of both goods.

As for the workers who worked in the wine industry in the US in autarky, they are now cheesemakers earning cheesemaker wages. Since real wages for wine workers were the same as wages for cheese workers in autarky, and since cheese workers are no worse off with free trade, then wine workers must also be no worse off in free trade. Of course the model assumes that the movement of workers from one industry to another is costless. In the Immobile Factor Model we address the implications of adjustment costs across industries.

In France, the real wage of winemakers in terms of how much wine they can buy remains constant while the real wage in terms of cheese must go up. French cheesemakers have all become winemakers because of specialization, which means all French workers are no worse off and most likely better off as a result of free trade.

The likely welfare effect of free trade, then, is that everyone in both trading countries benefit. At the very worst some individuals will be just as well off as in autarky. This result occurs for any free trade price ratio that lies between the autarky price ratios.

In Ricardo's original numerical example, he demonstrated that when both countries specialize in their comparative advantage goods and engage in free trade then both countries can experience gains from trade. However, his demonstration was only true for particular numerical values. By calculating real wage changes, it is shown that it doesn't matter which price ratio emerges in free trade as long as it is between the autarky prices. Also, because all workers receive the same wage in each country, the real wage calculations tell us that everyone benefits equally in each country.

International Trade Theory and Policy - Chapter 40-9A: Last Updated on 7/18/06

PREVIOUSNEXT