Real Wage Convergence in an Open Labour Market - TARA

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Jul 4, 1996 - between Ireland and the UK since the 1960s. The Irish ... part of the United Kingdom until independence in 1922, there were a series of.
The Economic and Social Review, Vol. 27, No. 4, July, 1996, pp. 321-340

R e a l Wage Convergence in an Open Labour Market*

J O H N CURTIS University of Maryland J O H N D. FITZ GERALD The Economic and Social Research

Institute

Abstract: T h i s paper looks at how the I r i s h experience of integration has affected the labour market, bringing about convergence i n labour costs between Ireland and the U K . A model of this process is developed and estimated which takes account of the fact that productive capacity and output are mobile within the E U economy and that integration affects the supply of labour through the potential for migration and changing expectations. The results indicate that changes in tax rates in the U K can affect the Irish labour market.

1 INTRODUCTION

T

he r e l a t i o n s h i p between economic i n t e g r a t i o n a n d convergence o f l i v i n g standards has been t h e subject of a number of studies b o t h at a n i n t e r n a t i o n a l and a regional level, for example, B a r r o (1991) a n d B a r r o a n d S a l a - i - M a r t i n (1991). The possible effects of E U i n t e g r a t i o n on p e r i p h e r a l regions have been widely debated i n I r e l a n d and elsewhere (Kennedy, 1992). T h e c e n t r a l importance of trade to t h i s process of i n t e g r a t i o n has focused a t t e n t i o n on the r e a l goods m a r k e t as t h e channel for t r a n s m i t t i n g change. T h e i n i t i a l shock of free trade may be felt t h r o u g h pressures on t h e price of goods and also t h r o u g h changes i n demand due to g r o w t h i n trade. Free trade *The authors would like to thank their colleagues J o h n Bradley, Patrick Honohan and Jonathan Wright for assistance, advice and inspiration i n preparing this paper. They would also like to t h a n k Brendan W a l s h of University College Dublin and two referees for helpful comments. The research was undertaken as part of a European network on The Fiscal Implications of European Integration which is funded under the E U H u m a n Capital and Mobility Programme.

on its o w n can be expected to affect prices i n the factor markets, i n c l u d i n g the domestic labour m a r k e t . I n a d d i t i o n to freeing of trade, the i n t r o d u c t i o n of free movement of labour and capital, w h i c h have been essential components of the European i n t e g r a t i o n process, can be expected to have major effects on t h e m a r k e t s for l a b o u r and other factors. T h i s paper looks at how the I r i s h experience of i n t e g r a t i o n has affected the economy t h r o u g h the labour m a r k e t as reflected i n movements i n labour costs. I n particular, i t examines how the openness of the labour m a r k e t has influenced the convergence i n labour costs between I r e l a n d and the U K since t h e 1960s. 1

The I r i s h economy over the last seventy years has provided a very interest­ i n g test-bed o f the effects of economic i n t e g r a t i o n . H a v i n g been a n i n t e g r a l p a r t o f t h e U n i t e d K i n g d o m u n t i l independence i n 1922, there were a series of changes over the following t e n years w h i c h introduced major restrictions on t r a d e . I n the e a r l y 1930s v e r y h i g h tariffs encouraged the development of local i n d u s t r y t o supply t h e domestic m a r k e t r e s u l t i n g i n a s u b s t a n t i a l g r o w t h i n i n d u s t r i a l employment. However, t h e new f i r m s were very s m a l l w i t h l o w productivity. 2

W i t h t h e progressive d i s m a n t l i n g of tariffs from the late 1950s the I r i s h economy, i n c l u d i n g t h e protected i n d u s t r i a l sector, was opened to major new forces t h r o u g h t h e subsequent g r o w t h i n trade. Two l a n d m a r k s i n t h i s pro­ cess were t h e A n g l o - I r i s h Free Trade Agreement of 1965 a n d E U e n t r y i n 1973 w h i c h abolished a l l r e m a i n i n g barriers to trade w i t h the E U . Between 1930 a n d 1960 I r i s h i n d u s t r i a l labour costs remained a r o u n d 60 per cent o f the level o f labour costs i n the U K . However, from 1960 to 1980 t h e gap between t h e t w o was closed. I r e l a n d has not been u n i q u e i n experiencing such a r a p i d convergence. Spain has undergone a s i m i l a r u p ­ w a r d adjustment i n labour costs relative to its E U partners since the 1960s. The former East G e r m a n y is c u r r e n t l y undergoing such a process (relative to West G e r m a n y ) concentrated over a n even shorter space of t i m e . W h i l e there is only w e a k evidence t h a t freeing of trade leads to convergence o f labour costs at a n i n t e r n a t i o n a l level (Davis, 1992), the evidence for I r e l a n d suggests t h a t wage rates have converged on the E U n o r m m u c h more r a p i d l y t h a n have l i v i n g standards, as measured by G N P per head (Kennedy, 1992). The corollary has been a rise i n the unemployment rate to a level w e l l above the E U n o r m . T h i s paper develops a model w h i c h explains t h i s process o f con­ vergence of labour costs. L Throughout this paper labour costs are defined as the cost to employers, including labour taxes, of employing a unit of labour. U n l e s s otherwise stated, the term wage rates is treated i n this paper as synonymous with labour costs. 2. There was free movement of funds within the sterling area until Irish entry into the E M S i n 1979. However, u n t i l the m i d 1950s, there were extensive controls on direct foreign investment i n Ireland.

The t r a d i t i o n a l approach to m o d e l l i n g the i m p a c t o f openness on wage d e t e r m i n a t i o n assumes t h a t the price of o u t p u t a n d t h e t e r m s of t r a d e are the major external channels of influence (Dreze and Bean, 1990 a n d L a y a r d , N i c k e l l a n d J a c k m a n , 1991). However, t h e free m o v e m e n t o f c a p i t a l , especially the r i g h t to invest abroad, has helped create a n i n t e g r a t e d E U production system where the iocation o f production can be shifted from one region or country to another (Bradley a n d Fitz Gerald, 1988 and Pain, 1993). The free movement o f labour has also played a v i t a l role i n p r o m o t i n g change t h r o u g h i t s effects on the supply of labour. W i t h the exception o f t h e 1939-45 period, there has been u n r e s t r i c t e d movement o f l a b o u r between I r e l a n d a n d the U K since the n i n e t e e n t h century and m i g r a t i o n flows have been exceptionally h i g h by European standards over t h a t period. A study by W i l l i a m s o n (1990) indicates t h a t m i g r a t i o n was a n i m p o r t a n t factor i n b r i n g ­ i n g about convergence i n l i v i n g standards between I r e l a n d and Great B r i t a i n i n t h e n i n e t e e n t h century. M a n y studies have e x a m i n e d t h e m i g r a t i o n m e c h a n i s m i n I r e l a n d i n t h e t w e n t i e t h century ( W a l s h , 1974, Geary a n d M c C a r t h y , 1976, and Honohan, 1992). These studies identified the difference i n expected l i v i n g standards between I r e l a n d and the U K as the d r i v i n g force b e h i n d l a b o u r movements between t h e t w o economies. T h e difference i n l i v i n g standards was captured by differences i n u n e m p l o y m e n t rates as w e l l as differences i n remuneration. M i g r a t i o n , t h r o u g h changing the potential labour force, can a t least have a n i n d i r e c t effect on wage d e t e r m i n a t i o n . This was recognised by Geary and M c C a r t h y (1976) i n t h e i r model o f wage d e t e r m i n a t i o n . A s discussed i n Bradley, W h e l a n and W r i g h t (1993) t h i s mechanism plays a n i m p o r t a n t role i n d e t e r m i n i n g the dynamic adjustment of the I r i s h economy to exogenous shocks. However, the possibility o f m i g r a t i o n and the increasing awareness of standards o f l i v i n g elsewhere i n t h e E U , especially i n t h e U K , m a y have a direct effect on the u t i l i t y function w h i c h underlies the supply of labour. Section I I o f t h i s paper examines the behaviour o f wage rates a n d l a b o u r costs i n I r e l a n d and the U K over the last sixty years. Section I I I develops the model of wage determination i n a small open economy and Section I V applies i t to data for the I r i s h economy from 1962 to 1990. Conclusions are d r a w n i n Section V .

I I THE DATA I t is always difficult to make comparisons between t h e absolute levels o f prices o f goods or factors o f production i n different countries; comparisons o f movements over t i m e are easier to undertake. However, over the last t w e n t y years t h e S t a t i s t i c a l Office o f t h e E u r o p e a n C o m m u n i t i e s (SOEC) have

u n d e r t a k e n a series of surveys of labour costs, both direct and indirect, i n E U members w h i c h allow a direct comparison to be made of labour costs. I n F i g u r e 1 we have used these SOEC data to provide a benchmark com­ parison between labour costs per hour i n I r e l a n d and the rest of the E U for 1988. L a b o u r costs are defined t o include wages (direct r e m u n e r a t i o n ) , bonuses, pension contributions, t r a i n i n g costs and labour taxes. They provide a p i c t u r e o f t h e f u l l cost of l a b o u r to the employer. The r e m u n e r a t i o n of employees obviously differs from the cost to the employer due to the various indirect costs associated w i t h employment.

Figure 1: Hourly Labour Costs in Manufacturing 1988 As shown i n F i g u r e 1, I r i s h labour costs i n m a n u f a c t u r i n g i n 1988 were approximately 95 per cent of U K costs b u t s t i l l w e l l below the labour costs of t h e o r i g i n a l E C 6 and D e n m a r k . Portugal h a d labour costs w h i c h were under a t h i r d those i n I r e l a n d . T h e 1988 d a t a provide a useful b e n c h m a r k comparison o f r e l a t i v e labour costs faced by f i r m s i n I r e l a n d a n d the U K . U s i n g t h i s benchmark we have used t i m e series data' for I r e l a n d and the U K to g r a p h t h e movement i n relative labour costs over the period 1925 to 1990 (Figure 2). T h e data used are described i n more detail i n Appendix 1. The i n t r o d u c t i o n of protection i n the 1930s appears to have coincided w i t h some d o w n w a r d adjustment i n labour costs compared to the U K . G i v e n t h e relative abundance of labour a n d shortage of capital i n I r e l a n d relative to the U K i n t h e 1930s, i t i s n o t s u r p r i s i n g t h a t t h e move from free t r a d e to a u t a r c h y depressed t h e r e l a t i v e r e t u r n to the abundant factor i n I r e l a n d labour. There was a substantial g r o w t h i n the 1930s i n the n u m b e r o f new 3

3.

D a t a for S p a i n and Greece were not available in the survey.

1.10i

1.00

—

0.90 0.80 — 7 0.70 0.60 0.50

F i g u r e 2:

Relative Wages in Industry —Ireland

versus The United Kingdom

firms w i t h low p r o d u c t i v i t y p a y i n g low wage rates s u p p l y i n g t h e protected domestic m a r k e t . W h i l e factor m o b i l i t y can be a s u b s t i t u t e for t r a d e i n producing factor price equalisation ( M u n d e l l , 1957), i n the case of I r e l a n d i n t h e 1930s, w h e r e l a b o u r m o b i l i t y b e t w e e n I r e l a n d a n d t h e U K was considerable, t h i s d i d not prove to be the case. The period of serious trade restrictions between 1930 a n d 1960 coincided w i t h a r e l a t i v e l y stable relationship between I r i s h a n d U K labour costs. T h e openness of t h e labour m a r k e t t h r o u g h the m i g r a t i o n mechanism d i d not b r i n g about the conditions necessary for an equalisation of factor prices. T h i s failure is a l l t h e more significant i n the l i g h t of the v e r y considerable net emigration from I r e l a n d over the period. F r o m 1960 to 1980 t h e process o f i n t e g r a t i o n i n t o t h e E U economy coincided w i t h a r e l a t i v e l y r a p i d rise i n I r i s h labour costs compared to t h e U K . B y t h e late 1970s I r i s h l a b o u r costs were r o u g h l y equal to U K costs. Since t h e late 1970s t h e relationship, w h i l e showing considerable v a r i a t i o n , p r i m a r i l y due to exchange rate changes, has shown no obvious t r e n d . I r i s h labour costs i n 1978 were 95 per cent o f U K costs, a p p r o x i m a t e l y the same level t h a t they were i n 1988. T h e coincidence of the process of convergence i n l a b o u r costs w i t h t h e process of E u r o p e a n i n t e g r a t i o n suggests t h a t there m a y be some causal relationship. I n t e r n a t i o n a l trade theory has long suggested such a r e l a t i o n ­ ship w i t h factor price equalisation being possible t h r o u g h the mechanism o f free trade.

I I I T H E M O D E L OF W A G E R A T E S W e o u t l i n e f i r s t the more t r a d i t i o n a l closed economy s t r u c t u r a l model of t h e l a b o u r m a r k e t from w h i c h t h e related model of wage d e t e r m i n a t i o n is derived and we t h e n develop t h e open economy model. These t w o models can each be estimated as a single reduced form equation d e t e r m i n i n g wage rates. I n l i n e w i t h t h e Scandinavian model of i n f l a t i o n we concentrate on modelling wage d e t e r m i n a t i o n i n the tradable sector; wages i n the non-tradable sector follow those i n the tradable sector (Bradley et al., 1993). Closed Economy I n a closed economy model of wage b a r g a i n i n g a s t a n d a r d assumption is t h a t f i r m s a t t e m p t to m a x i m i s e profits, subject to a d o w n w a r d s l o p i n g d e m a n d c u r v e for t h e i r o u t p u t ( L a y a r d , N i c k e l l a n d J a c k m a n , 1992 a n d B r a d l e y , W h e l a n and W r i g h t , 1993). The firm's profit function is denned by E q u a t i o n (1). (Lower case variables indicate the n a t u r a l log of upper case variables. T h e suffix i indicates a domestic variable; the suffix u indicates a foreign variable.) n = f(Pi, w

k

i ;

i ;

mj)

(1)

where IT Pi w

;

= the firm's profit = t h e ouput price = t h e wage rate

k m ;

;

= the price of capital = the price of imported i n p u t s

L

— =— = f(w -p , ki-pj, mj-pj) Sw Q; i

i

(2)

where L*j = D e m a n d for labour and Q

;

= Output

T h e f i r m chooses a p p r o p r i a t e levels of o u t p u t a n d factor i n p u t s t o m a x i m i s e profits conditional on the o u t p u t price and the factor i n p u t prices. A s s u m i n g constant r e t u r n s to scale and homogeneity i n prices, the demand for l a b o u r can be derived from the profit function by d i f f e r e n t i a t i n g i t w i t h respect to t h e price o f labour (Hotelling's lemma), E q u a t i o n (2). I n t h i s case o u t p u t per h e a d ( p r o d u c t i v i t y ) is a function, among other t h i n g s , of t h e product wage. f

L l = g Wi,

2 i

Q ^ , t , f-,Ui,N ;

;

(3)

Employees, represented by trade unions, are concerned w i t h expected r e a l t a k e home pay, where t h e i r expectations are affected by t h e p r o b a b i l i t y of unemployment. As shown i n Equation (3), the supply of labour ( L ) i n a closed economy may be a function of a range of variables: i n d i v i d u a l s a n d unions w i l l be concerned about consumer prices (z) as they a t t e m p t to preserve or improve t h e i r standard of l i v i n g ; the t a x wedge (t) includes social insurance contributions payable by b o t h employers a n d employees; p r o d u c t i v i t y (out­ p u t per head) where employees b a r g a i n to m a i n t a i n t h e i r share of o u t p u t , a common practise i n European labour m a r k e t s (Dreze and Bean, 1990); t h e rate of unemployment (U) and unionisation (N). A range of other factors, such as t h e replacement rate and demographic variables, could also affect t h e supply of labour. s

4

w* - p ; = a + a^Zj - ^ +1;) + a ( q - 1 ) + a U + a N ; 0

2

s

5

3

;

4

(4)

Employers and employees, represented by t h e i r unions, bargain over wage rates and, given t h e outcome of the b a r g a i n i n g process, the employers t h e n set employment and o u t p u t so as to maximise profits. The objectives of t h e t w o agents are described by Equations (2) and (3). The t a x wedge t e r m i n the r e s u l t i n g equation for t h e real product wage, (4), incorporates an a d d i t i o n a l adjustment to take account of the difference between o u t p u t a n d consumer prices due to i n d i r e c t taxes and changes i n the t e r m s of trade. The wedge t h e n represents the difference between the price of labour paid by employers, w h i c h includes a l l l a b o u r taxes, a n d the r e t u r n s to l a b o u r after t a k i n g account of a l l taxes on labour, indirect taxes, and any change i n t h e t e r m s of trade; employees are here assumed to b a r g a i n i n t e r m s of t h e r e a l after t a x wage rate. For simplicity the prices of factors of production other t h a n labour have been o m i t t e d . The star indicates t h a t the wage rate is t h e o p t i m a l or desired rate w h i c h may differ from the actual rate due to adjustment costs. Open Economy T h i s model of wage d e t e r m i n a t i o n m u s t be changed i n a n u m b e r of ways w h e n m o v i n g from a closed economy to an open economy. L a y a r d , N i c k e l l and J a c k m a n (1991) assume t h a t firms' p r i c i n g i n an open economy is affected by e x t e r n a l factors a n d t h a t the wedge between consumer and o u t p u t prices is affected by the terms of trade. However, i f the open economy is small t h e n the o u t p u t price is exogenously d e t e r m i n e d ( C a l l a n a n d F i t z G e r a l d , 1989). I f t h e r e is free movement of capital and goods t h e n o u t p u t for t h e world firm can be sourced i n a range of different locations depending crucially on 4 T h e tax wedge variable t, is defined as l / d - t y i ) where tyj is the average rate of direct taxation.

5

t h e cost of p r o d u c t i o n i n each location (Bradley a n d F i t z Gerald, 1988). K r u g m a n , 1995, refers to t h i s process of "slicing up the value chain" and i t s role i n increasing the volume of trade. O n certain conditions t h e w o r l d firm's s u p p l y decision can t h e n be b r o k e n i n t o t h r e e stages: a decision on the o p t i m a l factor m i x w i t h i n each country; a decision on the o p t i m a l choice of location; a decision on the profit m a x i m i s i n g o u t p u t . O p t i m i s a t i o n m a y involve changing the location of o u t p u t for different stages of t h e production process or changes i n the sourcing of i n p u t s used as p a r t of the production process. I n either case the r e s u l t i n g o u t p u t produced by t h e world firm w i l l be produced by a combination of factors of production d r a w n from m a n y different countries. T h i s model is consistent w i t h both a w o r l d of m u l t i n a t i o n a l firms and a w o r l d of smaller firms (also price takers), each located i n a single country, where t h e i r success or failure depends on the extent to w h i c h t h e i r products are purchased as i n p u t s i n the production of a composite w o r l d output. I n such a model the choice of location and, therefore, decisions on e m p l o y m e n t i n a region or a country depend crucially on the relative cost of production i n different locations; changes i n the price of labour i n one country can affect employment i n another and can, as a result, affect a firm's b a r g a i n i n g behaviour. 6

C

w

=c(Q ,w w

i ;

ew , k , ek , m u

;

u

i ;

em ) u

(5)

W e do n o t model t h e w o r l d f i r m s ' decision on o p t i m a l w o r l d o u t p u t . I n s t e a d , i n t h i s open economy w o r l d , f i r m s are assumed to m i n i m i s e t h e i r w o r l d cost of production C , consistent w i t h producing a given w o r l d output, a n d g i v e n t h e costs o f t h e factors i n the different p r o d u c t i o n locations, E q u a t i o n (5). The rate of exchange between the domestic country and the rest of t h e w o r l d is e. 7

w

1

(

f-q = io +2

b +di 3

, 1-3 —

2

(b -dj)

b

c

_ , i- —

, Li

(b -dj) 2

,

(.b -ij) 2

b

* (ba-di)

Because of the v o l a t i l i t y of t h e exchange rate ( I r i s h pounds per p o u n d sterling) over t h e 1979-90 period i t was assumed t h a t f i r m s and employees react to the expected exchange rate, proxied by a four year m o v i n g average. I t made l i t t l e difference whether the unemployment rate used was the domestic r a t e or t h e r a t e for the U n i t e d K i n g d o m . As a r e s u l t , t h e U K r a t e was preferred, being a t r u l y exogenous variable. The t a x wedge t e r m i n t h i s equation reflects the wedge between employers' l a b o u r costs a n d employees' after t a x earnings. The model, consisting o f Equations (9) a n d (11), was estimated u s i n g non-linear least squares and t h e estimation results are shown below i n Table 3. The o v e r a l l f i t of t h i s equation is s u b s t a n t i a l l y better t h a n t h a t for t h e closed economy model, t h o u g h s i m i l a r to t h a t for the closed economy model augmented by the r e a l after t a x U K wage rate. The significance of y suggests 2

the presence o f a n e q u i l i b r i u m relationship as described by Equation (8). The coefficient y, is also significant and, together w i t h y , they b o t h i m p l y quite a r a p i d adjustment o f the actual to the "equilibrium" or desired wage rate. 2

Table 3: Results Coefficient

-7.1606 0.1672 0.6054 0.9075 -0.0016 0.0238 0.7708 0.5939

:

=2

C3 c

4

Co

Yi Y2 2

R St. Error DW

Model t Statistic

Value

CO c

for Open Economy

3.9 1.5 2.5 4.9 0.4 4.0 5.2 3.5

0.9128 0.0158 1.97 Implied structural coefficients -2.36 3.62 -3.07 0.0096 -0.1420

% ba b b 3

4

b

5

T h e coefficient o n t h e U K wage r a t e , c , is w e l l defined a n d is n o t s i g n i f i c a n t l y different from u n i t y i m p l y i n g a complete pass t h r o u g h o f U K wage i n f l a t i o n i n t o t h e I r i s h economy. The t i m i n g of t h i s transmission w i l l be affected by movements i n exchange rates. W h i l e t h e parameters of the s t r u c t u r a l equation for labour demand i m p l y a v e r y h i g h o w n e l a s t i c i t y of demand for labour i n the i n d u s t r i a l sector, a another study for I r e l a n d (Bradley, Fitz Gerald and Kearney, 1993) has found a s i m i l a r l o n g - r u n o w n elasticity of demand for the t r a d i t i o n a l m a n u f a c t u r i n g sector w h e n o u t p u t is m o b i l e . The coefficient on the U K unemployment rate, c , is not significant t h o u g h i t has t h e r i g h t sign. The coefficient on the rate o f unionisation, c , is w e l l 3

1(

10

4

5

10. O n a closed economy basis, with fixed output, the elasticity was very low. However, when allowance w a s made for the possibility of shifting the location of output, a much higher own elasticity of demand for labour was obtained.

d e t e r m i n e d i m p l y i n g a significant positive effect on wage rates from t h i s factor t h r o u g h its effects on the supply of labour. The specification imposes a u n i t a r y elasticity on the wage rate demanded by employees w i t h respect to the t a x wedge. However, given the r e l a t i v e l y equal strengths o f the t w o parties to the b a r g a i n i n g process, the e v e n t u a l direct impact of a one percentage point rise i n the tax wedge w i l l be a rise of a l i t t l e over 0.6 percentage points i n labour costs w i t h the direct incidence o f the t a x being shared relatively evenly between employers and employees. The results shown i n Tables 2 a n d 3 confirm t h e importance of develop­ ments i n wage rates i n the U K i n d e t e r m i n i n g wage rates i n I r e l a n d over t h e l a s t t h i r t y years. Economic i n t e g r a t i o n has affected domestic labour cost developments t h r o u g h changing conditions for b o t h the d e m a n d a n d t h e supply o f labour. The effect of these changes has been to promote a conver­ gence i n wage rates between the two economies. I n t e g r a t i o n o f the t w o economies also means t h a t changes i n tax rates i n t h e U K can i n d i r e c t l y affect labour costs i n I r e l a n d . The results suggest t h a t w h e n direct taxes were cut i n the U K i n the 1980s labour costs rose for I r i s h employers as they had to m a t c h some of the improvements i n after tax wages available i n the U K . V CONCLUSIONS I n t h i s paper we have developed a model of wage d e t e r m i n a t i o n i n an open economy w h i c h allows for the fact t h a t productive capacity and o u t p u t are m o b i l e w i t h i n t h e E U economy. I t also t a k e s account o f t h e fact t h a t European i n t e g r a t i o n can significantly affect the supply of labour t h r o u g h the p o t e n t i a l for labour m i g r a t i o n and changing expectations. The model allows separate identification of some key parameters of t h e u n d e r l y i n g s t r u c t u r a l model o f the labour market. The application of the model to data for the I r i s h economy showed t h a t U K labour costs play a major role i n d e t e r m i n i n g l a b o u r costs i n I r e l a n d . The t r a n s m i s s i o n of shocks from the U K to the I r i s h labour m a r k e t takes place b o t h t h r o u g h t h e demand and the supply o f labour. To the extent t h a t i t has happened t h r o u g h the demand for labour i t h i g h l i g h t s the importance o f free t r a d e i n p r o m o t i n g factor price equalisation. However, the results suggest t h a t changes i n t h e expectations of the w o r k force consequent on economic i n t e g r a t i o n have also been i m p o r t a n t i n b r i n g i n g about the convergence i n labour costs between the I r i s h a n d t h e U K economies over t h e l a s t t h i r t y years. The movement from a closed economy low labour cost e q u i l i b r i u m to a new e q u i l i b r i u m o f p a r i t y w i t h U K l a b o u r costs i n v o l v e d a c o n t i n u i n g loss o f

competitiveness vis-a-vis t h e U K . T h i s adjustment took place r e l a t i v e l y r a p i d l y . O t h e r studies have indicated t h a t the capital stock is slow to adjust to changing circumstances (Bradley, F i t z Gerald, and Kearney, 1993) so t h a t w h i l e l a b o u r costs m a y have adjusted f u l l y to economic i n t e g r a t i o n , t h e capital stock m a y l a g behind. T h i s could explain some of the exceptional rise i n s t r u c t u r a l unemployment i n the I r i s h economy. A s i m i l a r process may also help e x p l a i n the current h i g h level of unemployment i n Spain. The closed economy model o f wage determination, where there is a u n i t a r y e l a s t i c i t y o n domestic p r o d u c t i v i t y , i m p l i e s t h a t m u c h of the benefits of g r o w t h w i l l accrue as h i g h e r labour costs r a t h e r t h a n higher employment. This l i n k is b r o k e n i n the open economy model. I f the U K rate of productivity g r o w t h determines t h e r a t e of r e a l wage i n f l a t i o n i n the U K i t w i l l also determine the rate of wage i n f l a t i o n i n I r e l a n d i n the future. I f t o t a l factor p r o d u c t i v i t y is higher i n I r e l a n d t h e n I r i s h competitiveness w o u l d t e n d to i m p r o v e over t i m e r e s u l t i n g i n increased employment g r o w t h . B y contrast Borooah a n d Lee, 1991, show t h a t i n the N o r t h e r n I r e l a n d economy, w h i l e absolute l a b o u r costs are d e t e r m i n e d i n the U K labour m a r k e t , as i n the Republic o f I r e l a n d , t o t a l factor p r o d u c t i v i t y is lower g i v i n g rise to r i s i n g relative u n i t labour costs, w i t h a consequential cost i n terms of employment. The experience of I r e l a n d m a y have i m p o r t a n t lessons for other European countries such as P o r t u g a l where labour costs are s t i l l w e l l below the E U n o r m . I f economic i n t e g r a t i o n results i n labour costs i n those countries adjusting more r a p i d l y t h a n the capital stock to the new environment there could be a r a p i d rise i n unemployment. The r e s u l t s also suggest t h a t t h e openness of t h e labour m a r k e t places restrictions o n fiscal policy. Changes i n taxes i n I r e l a n d or the U K can affect the price of l a b o u r i n I r e l a n d w i t h consequences for the competitiveness of t h e I r i s h t r a d a b l e sector. I f t h e I r i s h t a x rate rises t h e n I r i s h labour cost competitiveness vis-a-vis the U K w i l l deteriorate. I f U K tax rates fall i t w i l l lead to demands for increased wage rates i n I r e l a n d once again affecting competitiveness. T h i s r e s u l t is r a t h e r s i m i l a r to the findings of K a n b u r and Keen (1993) for i n d i r e c t tax competition between a large and a small country. F i n a l l y , t h e r e l a t i v e insignificance of the unemployment rate i n b o t h the closed a n d t h e open economy models has i m p o r t a n t implications for how the I r i s h economy reacts to shocks. I t means t h a t the t r a d i t i o n a l Phillips curve, a n i m p o r t a n t mechanism for reducing unemployment, is weak or missing i n t h e I r i s h economy. H o w e v e r , w i t h o u t t h e p o s s i b i l i t y of e m i g r a t i o n t h e economy m i g h t have behaved very differently i n t h e past w i t h labour costs r e s p o n d i n g to r i s i n g u n e m p l o y m e n t i n a manner more i n line w i t h the E U norm.

REFERENCES BARRO, R.J., 1991. "Economic Growth i n a Cross Section of Countries", Quarterly Journal of Economics, Vol. CVI, No. 2, May. BARRO, R.J., and X. Sala-i-Martin, 1991. "Convergence Across States and Regions", Brookings Papers on Economic Activity, No. 1. BOROOAH, V.K., and K.C. LEE, 1991. "The Regional Dimension of Competitiveness i n Manufacturing: Productivity, Employment and Wages i n Northern Ireland and the United Kingdom", Regional Studies, Vol. 25, No. 3. BRADLEY, J. and J. FITZ GERALD, 1988. "Industrial Output and Factor Input Determination i n an Econometric Model of a Small Open Economy", European Economic Review, Vol. 32, pp. 1,227-1,241. . BRADLEY, J., J. FITZ GERALD, D. HURLEY, L. O'SULLIVAN and A. STOREY, 1993. "HERMES: A Macrosectoral Model for the Irish Economy", i n Commission of the European Communities ed., HERMES: Harmonised Econometric Research for Modelling Systems, Amsterdam: North Holland, Amsterdam. BRADLEY, J., J. FITZ GERALD, and I . KEARNEY, 1993. "Modelling Supply i n an Open Economy", Economic Modelling, Volume 10, No. 1, January, pp. 11-21. BRADLEY, J., K. WHELAN and J. WRIGHT, 1993. Stabilization and Growth in the EC Periphery: A Study of the Irish Economy, Aldershot: Avebury. CALLAN, T., and J. FITZ GERALD, 1989. "Price Determination i n Ireland: Effects of Changes i n Exchange Rates and Exchange Rate Regimes", The Economic and Social Review, Vol. 20, No. 2, pp. 165-188. DAVIS, S.J., 1992. "Cross-Country Patterns of Change i n Relative Wages", National Bureau of Economic Research Macroeconomics Annual, 1992. DIEWERT, W.E., 1974. "Applications of Duality Theory", i n M.D. Intrilligator and D.A. Kendrick (eds.), Frontiers of Quantitative Economics, Vol I I , Amsterdam: North Holland. DREZE, J.H., and C.R. BEAN, 1990. Europe's Unemployment Problem, M I T Press. GEARY, P.T., and C. McC ARTHY, 1976. "Wage and Price Determination i n a LabourExporting Economy", European Economic Review, Vol. 8. HARRIS, J., and M . TODARO, 1970. "Migration, Unemployment and Development: A Two-Sector Analysis", American Economic Review, Vol. 60. HONOHAN, P., 1992. "The Link Between Irish and U K Unemployment", Quarterly Economic Commentary, Spring. KANBUR, R., and M . KEEN, 1993. "Jeux Sans Frontieres: Tax Competition and Tax Coordination When Countries Differ i n Size", American Economic Review, Vol. 83, No. 4, September, pp. 877-892. KENNEDY, K., 1991/1992. "Real Convergence, the European Community and Ireland", Journal of the Statistical and Social Inquiry Society of Ireland, Vol. XXVI, Part IV. KRUGMAN, P., 1995. "Growing World Trade: Causes and Consequences", Brookings Papers on Economic Activity, No. 1. LAYARD, R., S. NICKELL, and R. JACKMAN, 1991. Unemployment. Macroeconomic Performance and the Labour Market, Oxford University Press. MITCHELL, B.R., and P. DEANE, 1976. Abstract of British Historical Statistics, University of Cambridge, Department of Applied Economics, Monograph No. 17. MUNDELL, R.A., 1957, "International Trade and Factor Mobility", American Economic Review, Vol. 47, pp. 321-335.

CROURKE, K., 1994. "Did Labour Flow Uphill? International Migration and Wage Rates i n Twentieth Century Ireland", in G. Grantham and M . McKinnon (eds.), The Evolution of Labour Markets, London: Routledge, forthcoming. PAIN, N . , 1993. "An Econometric Analysis of Foreign Direct Investment i n the United Kingdom", Scottish Journal of Political Economy, Vol. 40, No. 1. ROCHE, B I L L , and JOE LARRAGY, 1993. "Data Series on Trade Unions", Depart­ ment of Industrial Relations, Dublin: University College. STATISTICAL OFFICE OF THE EUROPEAN COMMUNITIES, 1992. Labour Costs, 1988, Vol. 1, Luxembourg. WALSH, B., 1974. "Expectations, Information and Human Migration: Specifying an Econometric Model of Irish Migration", Journal of Regional Science, Vol. 14. WILLIAMSON, J.G., 1990. Coping with City Growth During the British Industrial Revolution, Cambridge: Cambridge University Press.

APPENDIX I The Data W; w

u

QQ z; z

w

u

Pi t;

t

u

Ui U

u

L;

Wage b i l l , i n c l u d i n g employers' social i n s u r a n c e costs, d i v i d e d by employment, industry, I r e l a n d , National Income and Expenditure. Wage b i l l , i n c l u d i n g employers' social i n s u r a n c e costs, d i v i d e d by employment, t o t a l economy, U n i t e d K i n g d o m , O E C D Economic Outlook database. V a l u e added i n t h e I n d u s t r i a l sector, constant 1985 prices, I r e l a n d National Income and Expenditure. V o l u m e o f manufacturing output, OECD, index. Consumer prices, I r e l a n d , value of consumption divided by volume at 1985 prices. National Income and Expenditure. Consumer prices, U n i t e d K i n g d o m , value of consumption d i v i d e d by volume at 1985 prices, O E C D Economic Outlook database. Price of m a n u f a c t u r i n g output, I r e l a n d , value of m a n u f a c t u r i n g o u t p u t divided by volume index, Census of Industrial Production. Wedge between I r i s h employers' labour costs and employees' after t a x earnings. I t is denned as the average direct t a x rate, i n c l u d i n g the social insurance costs of both employer and employee or one m i n u s the r a t i o of personal income to personal disposable income. Wedge between B r i t i s h employer's labour costs and employees' after t a x earnings, O E C D Economic Outlook database. Rate of Unemployment, I r e l a n d , labour force basis. Rate of U n e m p l o y m e n t , U n i t e d K i n g d o m , O E C D Economic Outlook database. E m p l o y m e n t i n I n d u s t r y , I r e l a n d , labour force.

N: e

Proportion of Labour Force Unionised, Stg£/IR£ exchange rate.

A l l variables come from either the E S R I - D e p a r t m e n t of Finance or t h e O E C D Economic Outlook databanks except for N w h i c h is from Roche a n d L a r r a g y (1993). The average a n n u a l earnings d a t a have been preferred i n e s t i m a t i o n over wage r a t e data as they include the other labour costs facing employers, chiefly l a b o u r taxes. The g r o w t h i n taxes on l a b o u r over t h e sample period has been an i m p o r t a n t factor i n the rise i n labour costs facing employers. ;

The sources of the data for Figure 2 are: Ireland: 1925-47, Wage b i l l i n transportable goods i n d u s t r y d i v i d e d by employment, Census of Industrial Production, CSO, Stationery Office, D u b l i n , various issues. 1947-53, W e e k l y wage index, transportable goods i n d u s t r i e s , Irish Trade Journal, CSO, Stationery Office, D u b l i n , various issues. 1953-90, Wage b i l l i n i n d u s t r y divided by employment i n i n d u s t r y , National Income and Expenditure, CSO, Stationery Office, various issues. United Kingdom: 1925-35, Weekly Money Wage Rates, M i t c h e l l and Deane (1976, p. 345). 1935-47, Index of W e e k l y Wages, U K Statistical Abstracts, H M S O various issues. 1947-90, Wage b i l l d i v i d e d by employment, U K N a t i o n a l Accounts, H M S O various issues. T h e 1953-90 average earnings series for I r e l a n d and the U K are extended backwards using the other sources cited above. The ratio of I r i s h to U K wages is t h e n scaled to be equal to 0.953 i n 1988, w h i c h is the r a t i o of relative wages for 1988 (SOEC, 1992). The p a t t e r n of convergence between 1960 and 1990 shown i n F i g u r e 2 for labour costs for the i n d u s t r i a l sector as a whole can be detected also a t t h e level of i n d i v i d u a l m a n u f a c t u r i n g sectors. The d a t a for the e a r l i e r period, w h i c h indicate a r e l a t i v e l y stable r e l a t i o n s h i p over t i m e , m a s k significant changes i n the composition of i n d u s t r i a l employment, changes w h i c h reflected the i n t r o d u c t i o n of protection i n the early 1930s. Thus O'Rourke (1994), u s i n g data for wage rates for selected occupations, finds a r a t h e r different p a t t e r n .

APPENDIX 2 D e r i v a t i o n of Open Economy Model

The demand for labour i n a n open economy is given by A l If - q

=d -rd (w -ew.J

w

0

1

(AI)

;

The supply of labour is defined as I f = D j - r b ( W ; -Z - r t ) - r b ( W 2

;

i

3

- Z„ -r t , } + b U - r DgN:

u

4

c

(A2)

T h e intersection of t h e firms' demand for labour and the unions labour supply function determines t h e wage rate. However, the r e s u l t i n g wage rate, w h i c h is the outcome o f a b a r g a i n i n g process, differs from the m a r k e t clearing wage w h i c h w o u l d correspond to f u l l employment. The p o i n t of i n t e r s e c t i o n is obtained by s u b t r a c t i n g E q u a t i o n A l from E q u a t i o n A 2 : Qw = ( b - d ) + ( b 1

0

- t ) + (b + d )w

- d )Wi -b2(z;

2

;

x

3

x

u

(A3) B

z

- 3< u - t ) +d e +b U u

1

4

+b N

u

5

;

R e a r r a n g i n g gives: w

=

(Pi-dp)

g

|

(b -dj)

w

t

bgCzj-tj)

(b -d )

2

2

(b +d )^ 3

(ba-di)

x

1

(b -dj) 2

(A4) ^ 3 _

(

(ba-di)

_

z

u

t

i _ _

}

"

b ^ r j

e

(ba-dj)

bj u