Sunday, May 14, 2006

Low-skilled wages

Why do low-skilled wages differ so much by country? Illegal Mexican immigrants in the U.S. who work at construction jobs can expect to be paid at least $8 / hour or $64 for a full work-day. In many poor countries, by contrast, wages converted at current exchange rates for equivalent jobs might be more like $5 per day, if that. Some of this difference can be explained by the fact that the cost of living in the U.S. is higher than in poor countries but this does not explain the difference away. On the contrary, one of the main reasons the cost of living is so much higher in the U.S. or Western Europe than the developing world is that unskilled and low-skilled wages are much higher.

The standard Econ 101 explanation for why wages rise over time is changes in technology and capital per worker. However, we quickly run into trouble with this explanation as people like waiters and taxi drivers have about the same amounts of capital and technology to work with in rich and poor countries, yet their wages still differ by enormous amounts. Education doesn't seem to be a direct explanation either, since, by definition, low-skilled jobs do not require much education. The standard result from labor economics is that an additional year of schooling raises one's wage by 10% so we would need huge differences in education levels to explain differences in low-skilled wages across countries.

I think once we eliminate all of the false explanations for differences in wages, we get down to two possible explanations. The first is that higher levels of education, more capital, better technology, etc. do not directly raise low-skilled wages but instead channel more people who would otherwise work in low-skilled jobs to the skilled labor force because of higher wages in the skilled sector. The reduction in labor supply for low-skilled workers then raises low-skilled wages.

The second possible explanation is that wages for the poor are more a product of politics than economics. The U.S. and Western Europe have extensive regulations in place to restrict the supply of low-skilled workers such as immigration restrictions, minimum wage laws, licensing requirements, unionization, and the like. Standard economics tells us that these regulations combined will cause unemployment but the magnitude of this effect depends on the size of the pool of unskilled and low-skilled workers. Naturally, the ability to implement these policies depends on a country already having a high-level of average income.

I personally would put more weight on the first explanation but would not completely discount the second. In any case, my view of the evidence is that wage differentials between countries can be best explained by differences in labor supply. This raises its own set of uncomfortable questions, however. Given that all democratic countries feel political pressure to ensure that even the poor have wages above a certain level, does that make protectionism and restrictions on immigration inevitable in the long-run? It would be nice to live in a world where immigration of low-skilled workers has no effect on wages but I'm not convinced that's the world we actually live in. The empirical evidence on these questions for the U.S. is indecisive, but that may be more of a commentary on how tough it is to come to solid conclusions based even on high-quality economic data.

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