How labor markets and imperfect competition affect tariff policy

Protection may be a second-best policy when the domestic sector is imperfectly competitive. But the optimal tariff depends on labor market institutions too. The author considers two theoretical settings. The first is fully centralized wage bargaining, where all workers are unionized and wage differentials are redistributed among workers (the Scandinavia case). The second is negotiation at the firm level, where workers are unionized in imperfectly competitive sectors only, and wages may differ from sector to sector (the Latin America case). He uses the case of the competitive labor market as a benchmark. In Scandinavia, free trade maximized welfare. The central trade union internalizes the consequences of imperfect competition in the domestic sector. Since prices in this sector are a mark-up over labor costs, there is a wedge between the sectoral productivities of labor and, therefore, an inefficient allocation of manpower. By choosing a moderate wage, the central trade union replicates the effects of a subsidy to the imperfectly competitive sector so that no government intervention is required. In Latin America, decentralized wage bargaining increases the wedge between the sectoral productivities of labor. While wages in the export sector are constrained by harsh competition in world markets, trade unions in the domestic sector can get higher wages without completely squeezing labor demand. An import tariff improves manpower allocation by reorienting demand toward the domestic sector. Since the second-best tariff is strictly positive, opening the economy leads to a drop in welfare. The author's analysis sheds some light on the political economy of protection. Particularly, it suggests that trade liberalization is more likely to raise welfare in the Latin America case when its accompanied by changes in labor market institutions.