Eastern Europe's economic transformation has highlighted the large gap between its living standards and those of the West. In principle, either capital flows to the East or a flow of labour to the West could equalize the living standards of Europe's two regions. Estimates that between 3 and 7 million workers will migrate to the West in the next decade including many from the former Soviet Union are now commonplace; such population flows would have major supply-side effects in both receiving and sending countries.

In Discussion Paper No. 614, Research Fellows Michael Burda and Charles Wyplosz assess the effects of migration on the composition and quality of labour forces in both regions. To highlight migration's effects on capital formation and aggregate supply, they ignore the private and social costs of migration per se, labour market imperfections, unemployment related to the business cycle, externalities in capital formation, and migration's effects on savings, intergenerational welfare and world interest rates, to compare the welfare effects of various policies in terms of productive efficiency alone.

They use a two-region model in which the East has an inferior endowment of physical capital and a lower average level of human capital. They study the costs and benefits of market-driven migration relative to the bench-mark optimal outcome achieved by a benevolent social planner who shifts population until average human capital levels and capital/labour ratios are equalized. While such a policy would reduce the size of the East European economy but also maximize Europe's aggregate social product, private decisions in the market solution cannot internalize migration's negative effect on total factor productivity. This may lead to a `Mezzogiorno' effect, and the market outcome cannot replicate the social optimum unless the government implements a tax and subsidy scheme.

Burda and Wyplosz also consider the (more likely) case where Eastern human capital levels exogenously catch up with those of the West. They still find a case for taxes and subsidies, but the superiority of the benevolent planner's outcome over that of the market disappears over time, since losses occur only during the transition. Finally, in the case where Eastern human capital evolves endogenously as a function of Western human and physical capital, investment in physical capital entails an externality that private decisions will not price correctly: the planner invests more and employs a lower discount rate than the market in evaluating the investment decision.

In Discussion Paper No. 615, Burda and Wyplosz focus on the effects of East-West migration within Germany after its rapid unification. The resulting massive unemployment and spectacular increase in real wages in the Eastern region triggered a debate on the possible role for interventionist economic policy. Incipient migration imposes a form of arbitrage relationship between Western and Eastern labour costs, but the social desirability of migration and its effects are unclear. For a series of examples addressing migration and congestion costs, real wage rigidity in the West, labour force heterogeneity and endogenous growth, they again contrast the social optimum with the market solution. Migration may imply externalities that call for government intervention, whose form depends on the source of the market's failure to price the externality correctly.

If Western German real wages are rigid, migrants balance the value of migrating to a job in the West against the expected value of remaining in the East, net of the amortized cost of migration; it may then be difficult to finance wage subsidies in the East if this requires taxation of Western wages. The two regions' different endowments of human capital may also affect their economic development. If all the gains from migration can be appropriated, the market solution will be optimal; but if migrants are largely the more highly-skilled and better-educated workers (which seems likely), this will impose deleterious effects on the East, and the West may also suffer in the short run. Policy should therefore aim to stem the flow of westward migration and encourage skilled Westerners to move east; such policies have in fact been pursued in the united Germany. Finally, if investment has external effects on the macroeconomic production function, as the recent literature on investment externalities suggests, wage subsidies are inappropriate, and capital subsidies are needed instead.
Burda and Wyplosz conclude that there is no justification for the common claim that the only policy intervention German unification requires is a subsidy to labour in the former GDR. There are labour market distortions that call for this, but it is not clear that these are main distortions, that correcting them is worth the deadweight losses that financing the recommended transfers would entail, or that such policies would be effective if pursued. Policy intervention may be desirable, but the choice of what to subsidize and what to tax is far less obvious than is often believed.

Human Capital, Investment and Migration in an Integrated Europe
Labour Mobility and German Integration: Some Vignettes
Michael Burda and Charles Wyplosz

Discussion Papers Nos. 614-15, December 1991 (IM)