Elsevier

European Economic Review

Volume 42, Issue 8, 1 September 1998, Pages 1595-1612
European Economic Review

Why do rich countries prefer free trade over free migration? The role of the modern welfare state

https://doi.org/10.1016/S0014-2921(97)00084-6Get rights and content

Abstract

According to traditional trade theory (Heckscher–Ohlin), free trade and free migration are equivalent measures of economic integration leading both to an equalization of factor prices. This prediction is in sharp opposition to the observed preference of rich countries for free trade over free migration. We provide an explanation for this inconsistency: the redistribution policies in the countries. Social welfare in countries with a relatively small number of low-skilled native workers is higher with free trade than with free migration due to redistribution of income towards immigrating workers.

Introduction

There is a common procedure how economic integration of countries is undertaken. The first step is that countries liberalize trade flows among themselves by creating a free trade area. However, after this step, nearly all free trade areas are very reluctant to open their borders for a free movement of people.

One prominent example is the relationship between Turkey and the European Union (EU). The EU has always been very hesitant to handle the Turkish application for a full membership of Turkey in the EU. Most economists and politicians agree that the basic reason for this reluctant attitude is the fact that a full membership in the EU would imply a de jure freedom of movement for people, leading to an uncontrolled influx of unskilled Turkish workers into the richer EU countries. However, only recently the EU agreed to form a free trade area with Turkey.

The North American Free Trade Agreement (NAFTA) is a second example. One of the arguments in the US discussion about ratification of NAFTA has been that this agreement would eliminate the incentives for Mexican workers to move illegally to the US by increasing the wages in Mexico through trade. However, NAFTA does not even include a proposal for the transition from a free trade zone to a common market with free movement of workers among the signatory states.

This difference between the desired steps of integration seems to be rather surprising from the viewpoint of traditional trade theory. Many economists agree that trade between rich and poor countries can best be explained by the famous Heckscher–Ohlin model. Trade is traced back to different relative factor endowments. The model predicts that trade perfectly substitutes a direct movement of factors if relative factor endowments are not too different between countries. Hence, free trade has the same consequences for wages (and other factor returns) of rich countries as a direct movement of workers between poor and rich countries (see Mundell, 1957, and more recently Razin and Sadka, 1992). The question then arises why richer countries nevertheless prefer free trade over free migration.

Obviously, there must be other sources at work causing the difference. Several sources are mentioned in the general debate challenging the Heckscher–Ohlin trade model with factor price equalization as an appropriate vehicle for describing the real world.1 We do not follow this route and accept the neoclassical trade model with factor price equalization as a good approximation of the international allocation of markets. However, we argue that this model is missing one very important aspect of the world, namely the existence of the modern welfare state which engages in a wide variety of policies altering the outcome of free trade versus free migration.

In advanced economies, governments play much larger roles than half a century ago. This is most obviously indicated by government expenditure levels amounting now to 13 to 12 of national income. Much of the growth of the public sector in the present century can be attributed to the fact that countries conduct redistribution policies by transferring income from high- to low-income households.2 The basic difference between free trade and free migration is that the former integration regime does not change the international allocation of unskilled residents as recipients of welfare programs while the latter increases the number of unskilled residents in rich countries and lowers their number in poor countries. Hence, the costs of redistribution programs for rich countries are higher in the free migration case. It is therefore not surprising that rich countries prefer free trade over free migration.

To emphasize the importance of the modern welfare state for the choice of the integration regime, we set forth in Section 2a two-country Heckscher–Ohlin model with factor price equalization. In this setting we introduce government activities. Welfare maximizing governments pursue redistributive policies. Section 3depicts the situation where both countries perform deliberate redistribution policies and only free trade is allowed for. Section 4studies deliberate redistribution policies in both countries with free migration. Each country takes the effects of its policies on the international labor allocation as well as on the factor and good prices into account leading to strategic behavior. Even if strategic effects in national tax-transfer policies could be avoided by coordinating redistributive measures via intervention of a supranational institution (like the EU), the rich country would experience a welfare loss in a free migration situation compared to the free trade. Since unskilled immigrant workers cannot be excluded from welfare benefits, part of the national income is redistributed to foreigners. With uncoordinated redistribution policies, the outcome is even worse. The rich country definitively prefers free trade over free migration. Our analysis thus provides a strong explanation for the reluctance of rich countries to allow for a free movement of people. To focus as sharply as possible on the importance of redistribution policies for the desired integration regime, we compare free trade without migration with free migration without commodity trade.3

Section 5summarizes the basic findings and draws some parallels to the existing literature.

Section snippets

Production and consumption

We consider two countries, i=1, 2, which differ only in their endowment of potentially mobile unskilled labor. Both countries are equally endowed with a second factor of production which is immobile, say land. Let Ni denote country i's number of native unskilled workers, and let T1=T2=T stand for the countries' endowment with the immobile factor. The country with the larger native labor force, country 2, is interpreted as Turkey while country 1 is called Germany (i.e. N2>N1). We distinguish two

Free trade and deliberate redistribution policy

We now introduce redistribution policies in each country. Income is redistributed from the owners of the immobile factor to workers living in country i. There is no possibility to discriminate foreigners living in a country from receiving transfer payments. This is, for example, a very realistic scenario in the EU. EU member states have to guarantee the same fiscal treatment to all EU citizens (see Art. 48 and Art. 51b of the Treaty on the European Union).

With redistribution policies, the net

Coordinated redistribution policy

In the free migration equilibrium, Eq. (9)shows that the equilibrium in the markets of good x in both countries are independent of any redistribution measures. However, the equilibrium labor allocation and the equilibrium prices of good x are determined by solving Eq. (9)for both countries and the migration equilibrium condition (8) simultaneously. The latter changes in the presence of redistributive transfers toRL(p1,T,L1)+z1E(p1)=RL(p2,T,L−L1)+z2E(p2).With z1=z2, the migration equilibrium of

Conclusions

The basic purpose of this paper has been to show that the attainable level of social welfare for rich countries is smaller in the case of free migration than with free trade when countries engage in redistribution – even if factor prices are identical. Thereby, we contrasted the two extreme scenarios of free trade associated with prohibitive migration barriers and free migration in the absence of any commodity trade. In a related paper (Walz and Wellisch, 1996b), we show that the basic result

Acknowledgements

Earlier versions of this paper have been presented at the University of Munich as well as the Annual Meeting of the Verein für Socialpolitik. We would like to thank Michael Rauscher, seminar participants as well as two anonymous referees for very helpful suggestions and comments. Of course, any remaining errors are ours.

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