Wages, Productivity, and Foreign Direct Investment Flows

By Larudoo, Mehrene; Koechlin, Tim | Journal of Economic Issues, June 1999 | Go to article overview

Wages, Productivity, and Foreign Direct Investment Flows


Larudoo, Mehrene, Koechlin, Tim, Journal of Economic Issues


Will an increase in economic openness cause relocation of capital and jobs from high-wage countries to low-wage countries? The standard textbook response is that it will not: low wages reflect low levels of labor productivity and thus provide no incentive for mobile firms to relocate. Wage rates vary widely by country; unit labor costs (ULCs) do not. "The nation as a whole," William Baumol and Alan Blinder [1998, 396] conclude in their popular introductory text, "need not fear competition from cheap labor . . . [L]abor will be cheap only where it is not very productive." This sentiment is widely echoed [Hufbauer and Schott 1993, 171-172; Krugman and Obstfeld 1997, 25-26; Lovely 1994; Golub 1995a, 1995b].

Here we question this commonplace conclusion. We argue that wage differentials between countries can have an independent influence on flows of foreign direct investment (FDI). Even when two countries have the same average reported unit labor cost in manufacturing, there are still reasons why a positive net annual flow of FDI from the high-wage to the low-wage country will likely occur.

In a controversy often muddied by vague claims, we begin with some clarification. The claim that production relocation is likely from high-wage to low-wage countries is often called the "sweatshop labor argument." This argument is often caricatured by its critics, who reduce it to the assertion that wages are the only determinant of FDI. For example, Stephen Golub [1995a, 1] comments that if the sweatshop labor argument were correct, "countries with rock-bottom labor costs, such as Bangladesh and Botswana, would rule world trade." Former U.S. Trade Representative Carla Hills used the same argument against NAFTA opponents [Hufbauer and Schott 1993, 12]. We agree that wages are not the only determinant of FDI flows; but it simply does not follow that concerns about low wages are unfounded. Our claim is that the host country average wage has some independent influence on FDI flows to that country. Before we offer support for this claim and reply in detail to the critics, however, we state their case more fully.

The Critique of the "Sweatshop Labor Argument"

The critique of the "sweatshop labor argument," based in Ricardian trade theory, holds that a country's wage level tends to align itself with its level of labor productivity. This may occur through adjustment in wages, exchange rates, or product mix.

To illustrate this, Golub [1995b] presents measures of average labor compensation (wages plus benefits), labor productivity, and ULCs in manufacturing for six newly industrializing countries, or NICs (India, South Korea, Malaysia, Mexico, the Philippines, and Thailand), for 1970-1992. For each of these countries, both wages and labor productivity were much lower than in the United States. Further, the ranking of these countries by productivity matched their ranking by labor compensation. Hence each country's ULC differential with the United States was dramatically smaller than its wage differential. In fact, for four of them (India, Malaysia, Mexico, and the Philippines), average ULCs rose above those of the United States for a few years. Golub [1995a, 3] concludes that "low wages are a symptom of low productivity, not an independent source of international competitiveness . . . fears about unfair competition of low wage NICs are greatly exaggerated and should not stand in the way of free international trade, which benefits both the US and developing countries."

But this familiar conclusion does not follow from Golub's analysis. Golub's findings undermine only a crude caricature of the sweatshop labor argument - that wage differentials provide an unambiguous measure of ULC differentials and thus inevitably motivate capital flight. We acknowledge that national average wages bear some relationship to national average labor productivity, but this does not constitute proof that wage differentials have no independent effect on FDI. …

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