Recent empirical work on the US auto and steel industries indicates persistence of inter-industry wage differentials, which imply that workers' marginal product is higher in some industries than in others and hence that too little labour is employed in these `wage-premia' sectors. Some argue that wage subsidies would be an appropriate policy to increase employment in these sectors and so to correct the misallocation of labour. Given the existence of wage distortions, however, imposing an export subsidy or an import tariff on a wage-premia sector might be a suitable second-best if the production and consumption distortions due to the subsidy or tariff are outweighed by the gains from a reduced misallocation of labour. Industrial policy may also be more relevant empirically than strategic trade policy in shifting profits towards domestic producers in imperfectly competitive markets, on account of the size of the labour market compared with the volume of trade.

In Discussion Paper No. 435, Research Fellow Jaime de Melo and David Tarr evaluate the relative importance of labour- and product-market misallocation in the US steel and auto industries in 1984, when the VER on autos negotiated with Japan was in full force and the VERs had been negotiated with foreign governments for imports of carbon and alloy steel products. The VERs in that year are estimated to have resulted in premia accruing to foreigners of 32% on auto imports and 7% on steel. The welfare cost to the US therefore arises from both resource misallocation and rent transfer to foreigners.

De Melo and Tarr estimate the importance of scale economies in both industries by explicitly comparing under constant and increasing returns to scale, assuming first that wage premia are exogenous and second more plausibly that they result from union monopoly power. They also consider the case where domestic auto producers behave as monopolistic competitors, to allow for the importance of product differentiation. They also account for the effects of income and real-wage changes on labour supply in general equilibrium simulations.

Under constant returns to scale and with exogenous wage premia, optimal trade policy yields tariff rates of 5% in steel and 1% in autos, for a total welfare gain of $4 million, but with endogenous wage premia the welfare gain is almost zero. Under increasing returns to scale and with exogenous wage premia, a contestable market in steel and monopolistic competition in autos, the corresponding tariff rates are 10% in steel and 3% in autos, for a total welfare gain of $145 million, which reduces to $7 million once. De Melo and Tarr conclude that protection can not be justified on account of the rent transfer and that for most market structures considered the extent of resource misallocation is too small to justify protection in either industry. For a contestable market in steel with exogenous wage distortion, however, removing protection reduces scale economies and increases labour misallocation sufficiently to outweigh the distortionary costs of protection. Finally, de Melo and Tarr compute `optimal' protection levels in the two sectors and show that quite apart from the difficulties of implementing such interventions in practice, the welfare gains from them would be very small.

Industrial Policy in the Presence of Wage Distortions: The Case of the US Auto and Steel Industries
Jaime de Melo and David Tarr

Discussion Paper No. 435, July 1990 (IT)