Industrialization, Globalization,

and Labor Markets Introduction

In standard models of labor markets, wages are equal to the “marginal product” (or

incremental output) of an additional unit of labor. In other words, the amount a

worker earns is equal to the amount he or she can produce. Intuitively, firms take

on workers until the productivity of their last hire is equal to the market wage rate.Presentation

If the wage rate were below productivity, firms would find it profitable to hire

more workers, whereas if the wage were above productivity, firms would have an

incentive to shed workers. Under this reasoning, more productive workers get paid

more, which implies that labor productivity growth ultimately leads to wage

growth in the long term. Indeed, empirical evidence shows labor costs and labor

productivity are strongly related across nations.

Now consider the neoclassical growth model, where economic growth is driven byPresentation

physical capital accumulation, technology, and human capital. These factors all

increase labor productivity, and hence, labor demand. In essence, as economies

grow, more manpower is required, so labor demand increases. Provided the labor

supply doesn’t expand too quickly from pop- ulation growth, economic growth

leads to wage growth in a wide class of economic models. With the above primer

in mind, this chapter investi- gates the impact of globalization on labor markets

across developing and developed countries. It discusses common economicPresentation

models of develop- ment, industrialization, and industrial policies, focusing on

domestic labor market consequences, and it broadly analyzes the experiences of

American, Mexican, Chinese, and Indian labor markets in recent decades.

Lewis Model of Development

After World War II, many nations were rebuilding from the war or had just won

independence. This climate sparked a renewed interest in eco- nomic theories of

development. At the same time the neoclassical growth model was being

developed, in 1954 Sir Arthur Lewis devised what came to be known as the Lewis

two-sector “dual” model of development, for which he later won a Nobel Prize.

Born in St. Lucia, then a British colonial territory in the Caribbean, Lewis was

deeply knowledgeable about eco- nomic history. He had a lifelong interest inPresentation

practical development policy and spent years in the field, advising Ghana and

developing Caribbean nations. As opposed to the broader neoclassical growth

model, which describes long-run growth and the behavior of emerging economies

as they catch up to leading economies, the Lewis model shows how a traditional

agricultural economy transforms into a modern manufacturing and service-based

economy. According to Lewis, an abundant supply of cheap labor allows

underdeveloped agrarian economies to accumulate capital and industrialize.

While investigating the early Industrial Revolution in Britain, Lewis was puzzled

that wages had stagnated while savings, investment, and prof- its multiplied.

(Later research by other scholars challenged Lewis’s reading of those trends; some

have argued that, at least during the late Industrial Revolution, wages soared,Presentation

spurring laborsaving inventions in England.) Lewis remarked that in standard

economic models, a surge in investment should have resulted in rising labor

productivity and wages, alongside declining returns to capital. He cleverly solved

the conundrum by making several alternate assumptions. First, he assumed

developing economies possess two sectors, agricultural, where most of the

population initially resides, and urban, where industrial activity takes place.

Second, reminis- cent of the economics of Reverend Malthus, he assumed that in

the agri- cultural sector, labor was effectively in unlimited supply. This implied

that agricultural labor productivity was minimal and wages remained at a

subsistence level. Third, he proposed that the burgeoning urban sector possessed

higher productivity with substantial capital, akin to the neoclas- sical growth

model economy. In the Lewis model, capitalists in the urban sector pay relatively

low wages because it only takes a slight premium oversubsistence wages to attract

workers from the country to the city. Capital accumulation and technological

advancement cause productivity to increase in the urban sector, yet urban wagesPresentation

stay relatively flat due to the rural labor surplus.

The upshot is that urban business owners are able to make ample prof- its and

invest heavily in new capital. Over time, the urban sector expands and modern

manufacturing and service industries emerge. Urban labor demand stays strong

and workers from the agricultural sector keep moving to the big city. However,

because urban growth steadily diminishes the amount of labor in the countryside,

the economy eventually reaches a “turning point” (or labor supply constraint)

when rural labor is nearly exhausted. After the turning point occurs, wages in the

city begin to increase even faster, eating into industrialist profits. (Think of China

today.) By this time, most of the population lives in urban areas, and going

forward, the neoclassical growth model is broadly applicable. After the turning

point, labor disputes and strikes increase, since workers have new- found

bargaining power. Future generations become used to greater con- sumption levels

and have higher workplace expectations, inviting collective bargaining and

burgeoning regulatory regimes. Governments start financ- ing more basic

education, which increases human capital and enhances productivity. As the

economy becomes prosperous and more advanced, it orients itself toward services

and internal consumption, with an export sector that produces increasingly

complex goods requiring substantial skill and technology.

Unlike traditional models, the Lewis model illustrates why: (1) megacities in

developing nations have shantytowns on their outskirts, full of unskilled workers

from the countryside looking for urban work; (2) in developing economies,

workers typically prefer regular wage employment to self-employment but often

cannot find it; and (3) many individuals work full time yet are still poor. These

observations are con- sistent with the Lewis model. Due to the rural labor surplus,

the model predicts that developing countries feature low wages that do not

increase much initially as the population moves to cities. After the turning point,

wages may grow much faster. Higher incomes can be saved, supporting

investment and further economic growth. On the other hand, the financial sector in

emerging economies is often dreadfully underdeveloped. Worker may find few

safe havens to keep their savings, and it may be difficult to obtain loans for new

business ventures, even at very high interest rates. Due to deficient financial

intermediary institutions and a dearth of domestic savings, developing nations may

require foreign capital to finance indus- trial investment and economic growth. In

the 19th century, American states borrowed heavily from wealthier nations

abroad—to build canals, for example—and sometimes ended up defaulting.

Poverty Traps, Big-Pushes, and Take-Offs

During the 1950s, around the time that Lewis was formulating his two- sector

theory, another famous model dominated development economics. Called the

“big-push” model of economic development, it arose out of a paper by Paul

Rosenstein-Rodan in 1943. Its key insight was that some poor countries exist in

“poverty traps” which require substantial invest- ment to jump start economic

growth. The big-push model of development is based on the idea that poor

economies suffer from “coordination fail- ures,” meaning private sector

organizations lack the necessary incentives to adopt modern production techniques

and achieve economies of scale. Unless there is an expectation that other firms

will similarly invest in industrialization, there is unlikely to be sufficient consumer

demand and capital funding to make such costly investments worthwhile. Each

com- pany only kicks-off investment projects if the others do, yet it is difficult to

get companies to start investing all of a sudden. (Some call this type of conundrum

a “chicken or egg” problem, because it isn’t clear how one can come into being

without the other existing first.)

Consider the plight of a poor farmer in a traditional subsistence econ- omy. He

would like to improve the yield of his soil with fertilizers, so the economy requires

either the construction of a fertilizer factory or the import of foreign fertilizer.

However, a factory requires infrastructure (such as roads, electric power, and

water supply), trucks, fuel, capital investment, engineers, and packaging. And

importing requires a dock, roads, trucks, fuel, and credit from bankers. It isn’t at

all likely that any single farmer would be able to carry out either of these

scenarios. Mean- while, ordinary citizens do not invest in education and training

because there are no jobs available that would make use of higher level skills.

Foreign engineers, bankers, and lawyers may be required to fill the domes- tic

void. In this view, what is needed is a powerful entity—typically a national

government—to coordinate the decisions of firms and house- holds to overcome

market synchronization failures. This coordinating entity would provide

investment funding to the private sector to build: (1) an industrial base with new

technologies and (2) education and train- ing facilities for workers. The economy

would then “take off,” driven by consumer demand. One classic example of a big-

push success story is Meiji Japan, when the Japanese government—propelled by

Japan’s “zaibatsu,” or pyramidal business groups—coordinated a rapid

industrialization in the final decades of the 19th century. Another instance is the

postwar American South, which received a big-push catalyst from public capital

investments to build schools, hospitals, roads, dams, and power plants during the

Great Depression and World War II.

If the least developed economies are stuck in poverty traps and face massive

coordination failures, they probably won’t be able to solve their problems on their

own since tax bases and state coffers are too small. Development economists have

frequently argued that the least devel- oped economies need foreign aid and loans

(such as from the World Bank or International Monetary Fund) to get out of this

rut. These funds could be used for private sector investment and public goods like

infrastructure, education, and health care. If an economy is capable of supporting

an increasing returns industry, then the case for massive injections of capital is all

the stronger. Large-scale industries can support worker payrolls, drive export

growth, and provide tax revenues to gov- ernments. With substantial foreign

investment, an economy stuck in a poverty trap will hopefully begin to grow.

Then, after it has left the trap, growth will be self-sustaining. Ideally the economy

would obtain access to foreign technologies, build domestic universities, and

eventually con- duct its own research and development. Labor productivity would

grow quickly, resulting in higher wages for both skilled and unskilled workers.

The influential mid-20th century economist Alexander Gerschenkron argued that,

driven by heavy state involvement—and the adoption of foreign methods and

borrowed technology, as stressed by American economist Thorstein Veblen—

backward countries could accelerate eco- nomic growth.

Big-push development theory was the leading concept in development economics

throughout the 1950s and 1960s. It was thought that econo- mies all went through

the same stages of growth. The proper mix of sav- ings, investment, and foreign

aid was all that was needed to power them. International development aid was

intended to catalyze emerging econo- mies and ignite self-sustaining growth. Big-

push thinking lost favor during the 1970s and 1980s, in part due to the apparent

failure of foreign invest- ment and aid to produce significant increases in

economic growth and productivity in Africa. The theory was displaced by market

liberalization and privatization policies, although big-push ideas—sometimes

combined with market liberalization—have reemerged over the past couple

decades, chiefly among economists in advanced nations who stress the importance

of foreign aid.

By and large, modern empirical studies lend little clear support to the big-push

model. If the poorest economies are stuck in poverty traps and a big-push effort is

essential to kindling growth, then developing nations receiving aid should grow

faster than economies receiving little or no aid. Yet if anything, the cross-country

data indicate the opposite is true. Also, the handful of countries that successfully

underwent major growth transitions—or take-offs—over the past half century

were disproportion- ately in East Asia. Despite the fact that their governments

were instrumen- tal in fostering economic growth, these economies only received

a small amount of foreign aid on average. Big-pushes require massive investment,

but with the exception of Singapore and possibly Hong Kong, investment was not

exceptionally high at the beginning of East Asian take-offs.

Some big-push proponents have remarked that over the past two cen- turies, the

output gap between the richest and poorest countries has gotten much larger,

meaning these two groups have diverged. By and large, the wealthiest economies

prospered while the poorest stagnated. Although it is possible many poor countries

(particularly in Africa) have been stuck in a classic poverty trap, the actual growth

trends are, at best, only broadly con- sistent with the need for big-pushes. Recent

studies suggest weak institutions are probably a better explanation for the

lackluster growth of the poorest economies over this long time frame. Many critics

of foreign aid to sub- Saharan Africa and other poor regions point to studies

showing a negative statistical relationship between the volume of foreign aid and

subsequent economic growth. Based on this evidence, they argue that aid erodes

insti- tutional quality by increasing the power of kleptocratic elites and corrupt

government officials, and in practice, is really just a windfall for despots.

Proponents of foreign aid contend that such destructive outcomes can be prevented

through enhanced monitoring and accountability measures.

Industrial Policy

Big-push investment projects—whether financed with tax revenues, domestic

savings, or foreign credit—are a form of “industrial policy.” By definition,

industrial policies consist of sector-specific initiatives that enhance

industrialization, productivity growth, and national competitive- ness, all aiming to

promote the national interest. These policies have tradi- tionally involved

economic restructuring in the industrial, manufacturing, and agricultural export-

oriented sectors. Half a century ago, in line with big-push thinking, development

economists believed that forceful govern- ment interventions were the key to

industrial policy. Based on historical evidence and theoretical developments,

economists today are more likely to stress the importance of industrial policy

driven by private initiative, albeit within a framework supported by the public

sector. These concepts are potentially relevant to all economies, whether advanced

or developing, and the optimal set of industrial policies differs according to the

circum- stances of each economy.

Although implementing industrial policies involves controversy and risk, the

rewards can be enormous. Government officials and private firms can work

closely together to implement efficient restructurings, though in practice, these

alliances may also increase corruption. One classic industrial policy is the

subsidization of a brand new industry: governments may pro- vide infrastructure,

low-cost capital, or even protection from overseas com- petitors in the form of

trade barriers. For example, in recent years China has given favored domestic

firms free land, subsidized energy, low-interest loans, insider information, and

favorably rigged bids. If successful, new industries take off, resulting in demand

spillovers across other domestic sectors, which generate even greater employment

and output.

Critics argue that industrial policies are likely to be disastrous because

governments are poor candidates to predict which industries will thrive.

For one, the venture capital industry has trouble forecasting which projects will

ultimately be successful, so it is difficult to see how a government agency, using

taxpayer funds, could do better. Even if the bureaucracy in charge of an industrial

policy project is honest and relatively efficient, critics contend that it probably

wouldn’t be able to execute ventures with nearly the same resourcefulness and

drive as private sector businesses. Furthermore, once an industrial policy directive

is underway, it is difficult to gauge the success of long-term projects or thwart the

rent-seeking efforts of powerful private sector agents. There is certainly evidence

from past industrial policy failures to support these charges. With its “Cassa del

Mezzogiorno” (or Fund for the South) program to develop and industri- alize its

backward southern economy after World War II, Italy experienced tremendous

waste and corruption. At least a third of the funds were esti- mated to have been

squandered. Factories never became operational and sham enterprises existed only

to collect government grants. In post- colonial Africa, bureaucracies have often

been dominated by political, tribal, and family influence, leading to a long list of

failed industrial policy projects across many nations.

Other countries have succeeded with their industrial policies in the past. Japan’s

“Ministry of International Trade and Industry” (MITI) coor- dinated industrial and

trade policy after World War II, supporting the development of the petrochemical

industry in the 1950s, the electronics industry in the 1960s, the computer industry

in the 1970s, and the biotechnology and aviation industries in the 1980s and

1990s. China has picked a number of winners in its manufacturing sector. If not

for generous public assistance, it is possible that some Chinese industries would be

much smaller or not exist at all today. Chile is another exam- ple. Chilean grapes,

forest products, and salmon are all successful export industries that were aided by

government assistance and subsidies. Industrial policies may take different forms

within an industry over time. In Mexico, the motor vehicle and computer

industries were ini- tially supported by import-substitution policies that

encouraged local production to take the place of imports. Later they benefitted

from pref- erential tariff policies under NAFTA. Finally, governments must mon-

itor subsidized industries and quickly phase out the support of failures. This is

difficult to do in practice. East Asian governments have been much more

successful than Latin American governments at this aspect of industrial policy.

Restructuring, Diversification, and Development

Economic development requires a shift from subsistence agriculture to modern

industries exhibiting higher productivity levels. At low levels of development,

economic growth entails a decreasing degree of concentration—meaning

production becomes more diversified across sectors. At this stage of development,

sectors within an economy exhibit vastly uneven productivity and growth.

Entrepreneurs and businesses are discovering their own cost structures and

learning how to improve their bottom line.

Research shows that when economies reach per capita income of approximately

$15,000 to $20,000 in today’s American dollars, they reach a tipping point: their

economies start to become more concentrated and less diversified. At this stage of

growth, economies have found their com- parative advantages, and they are

leveraging economies of scale. Their export sector is usually well developed,

concentrating on a small number of manufactured goods that are highly popular

with buyers around the world. Historical patterns of production, resource

advantages, superior entrepreneurship, and pure chance all play vital roles in

determining the basket of goods an economy specializes in producing and

exporting. As these economies grow and prosper, their production shifts to

complex goods that exhibit complementarities in production—meaning high-

quality labor and capital inputs are necessary—and provide greater value-added.

In economies that develop successfully, labor moves from less produc- tive

activities to more productive ones, raising output and wages. This can be achieved

by sectoral reallocations, such as transitioning from agriculture to manufacturing.

In fact, labor in developing countries is about three to four times more productive

in manufacturing than in agriculture, and wages are consequently higher. By

successfully expanding the manufactur- ing sector, a developing economy can

raise productivity and output, even in the absence of major technological

improvements. Over the past several decades, this is precisely what happened in

developing Asian nations such as China, India, the Philippines, and Indonesia.

These economies much more successful than Latin American governments at this

aspect of industrial policy.

Restructuring, Diversification, and Development

Economic development requires a shift from subsistence agriculture to modern

industries exhibiting higher productivity levels. At low levels of development,

economic growth entails a decreasing degree of concentration—meaning

production becomes more diversified across sectors. At this stage of development,

sectors within an economy exhibit vastly uneven productivity and growth.

Entrepreneurs and businesses are discovering their own cost structures and

learning how to improve their bottom line.

Research shows that when economies reach per capita income of approximately

$15,000 to $20,000 in today’s American dollars, they reach a tipping point: their

economies start to become more concentrated and less diversified. At this stage of

growth, economies have found their com- parative advantages, and they are

leveraging economies of scale. Their export sector is usually well developed,

concentrating on a small number of manufactured goods that are highly popular

with buyers around the world. Historical patterns of production, resource

advantages, superior entrepreneurship, and pure chance all play vital roles in

determining the basket of goods an economy specializes in producing and

exporting. As these economies grow and prosper, their production shifts to

complex goods that exhibit complementarities in production—meaning high-

quality labor and capital inputs are necessary—and provide greater value-added.

In economies that develop successfully, labor moves from less produc- tive

activities to more productive ones, raising output and wages. This can be achieved

by sectoral reallocations, such as transitioning from agriculture to manufacturing.

In fact, labor in developing countries is about three to four times more productive

in manufacturing than in agriculture, and wages are consequently higher. By

successfully expanding the manufactur- ing sector, a developing economy can

raise productivity and output, even in the absence of major technological

improvements. Over the past several decades, this is precisely what happened in

developing Asian nations such as China, India, the Philippines, and Indonesia.

These economies

At the other extreme, the absence of managerial capital in emerging economies

can impede economic growth and entrepreneurship. As emerg- ing economies

grow and develop educational institutions, their stock of managerial capital builds.

To bridge the gap in the meantime, they can import foreign managers, copy the

best practices of multinational managers, or hire consulting firms to increase

managerial capital.

Industrialization and Population Growth

There is no doubt that industrialization is responsible for the massive increase in

world population over the past two centuries. During the early Industrial

Revolution, the British were able to maintain their living stan- dards despite rapid

population growth because industrialization and inter- national trade created such

robust demand for their domestic labor. In the early-19th century, after the

Industrial Revolution ignited in Britain then spread elsewhere, there were one

billion people on the planet, compared to over seven billion today. Just in the past

50 years, the world population has doubled (although world population growth

rates have steadily declined after peaking in the 1960s). All developing nations go

through the “demographic transition” process: first death rates decline due to

better living conditions and medical care, and thereafter birth rates fall due to

lower infant mortality rates and more work opportunities for women. Economic

development also extends life expectancy. Today it ranges from about 80 years at

birth in the United States, Japan, and much of Europe, to 50 years in parts of

Africa, such as Zimbabwe and Somalia.

Theory of Globalization and Labor Markets

In canonical economic growth models, wages increase as economies develop.

Emerging economies accumulate capital and improve their tech- nologies, thereby

increasing labor productivity and boosting labor demand and wages. At the same

time, an increased labor supply resulting from population growth puts downward

pressure on wages during the industri- alization process. By and large, the

evidence suggests development leads to higher wages in spite of population

growth, at least after a Lewis turning