Trade liberalisation and labour demand elasticities: Empirical evidence for Pakistan

Abstract

In this era of trade liberalisation, when most developing countries are following export-oriented policies, the impact of trade liberatisation on labour markets has become an important area to explore. The experience of trade liberalisation in developing countries is quite varied, but understanding the effects of openness on their labour markets is a complex and demanding task as these countries have undergone significant structural changes and adjustments from 1980s onward. In accordance with standard trade theory, developing countries should specialise in the production of labour-intensive goods, thus increasing the relative demand for this factor. Pakistan's trade policy has also declared exports as an important and leading sector for employment generation. However, so far, little evidence is available on the issue of trade liberalisation and labour markets which can help work out the trade-labour linkages for Pakistan. In that context, the present study is an attempt to investigate these linkages. Among various paths through which trade liberalisation is channelled to the labour market, one is that of labour demand elasticity. It is expected that trade openness might induce an increase in elasticity via a scale effect due to the increased competition in the output market, and via a substitution effect generated by expanding a firm's production possibility set to include additional input. The main hypothesis of this study is that trade liberalisation might lead to an increase in labour demand elasticity and is expected to have a favourable impact on the employment generation in Pakistan. The study is carried out for labour engaged in the manufacturing sector in Pakistan, using panel data approach for the years 1970-1995. A labour demand equation is obtained from the solution of a firm's cost minimisation problem. The impact of trade liberalisation on employment is not restricted to a wage elasticity effect; it also allows for a direct effect with globalisation acting as a demand shifter. Overall, we find a positive significant effect of trade liberalisation on labour demand elasticities. As Pakistan has adopted a stance in favor of trade liberalisation over time, and the effective rate of protection has reduced very sharply since the early 1990s, it is thus revealed from the results that there has been a consequential shift from capital-intensive production to more labour-intensive production that is in keeping with the perceived static comparative advantage, and in turn, is expected to lead to increased employment generation because of the greater incentives afforded to labour-intensive exports in particular.