Trade Liberalization, Firm Performance and Labour Market Outcomes in the Developing World: What Can We Learn from Micro-LevelData?

wages and employment to any exogenous shock to labor demand; 3) a reduced bargaining power
of workers.

Given the relevance of the labor demand elasticity for the welfare of workers, it is useful to see
more formally how it can be influenced by trade liberalization. As shown by Hamermesh (1993)
and Slaughter (2001), an industry’s labor demand elasticity, η, can be decomposed as follows:

η = [1 — s]e + sσ

where s is the labor share of total industry revenue, e is the constant-output elasticity of substi-
tution between labor and all other factors of production, and σ is the industry product-demand
elasticity.²2 Equation (21) shows that η consists of two parts. The first, [1 — s]e, captures the
substitution effect. It tells, for a given level of output, how much the industry substitutes away
from labor towards other factors when wages rise. The second part, sσ, captures the output effect:
higher wages imply higher costs and thus a lower demand for an industry’s output, which translates
into a lower demand for labor. Thus, both the substitution and the output effects contribute to
reduce labor demand when wages rise. Finally, note that the higher the share s of labor in total
cost, the higher the relative importance of the product demand elasticity for the labor demand
elasticity.

Note that trade liberalization can influence the elasticities e and σ, and thus also the derived
labor demand elasticity η. First consider σ. As shown in Section 2, trade models based on imperfect
competition generally imply that trade liberalization increases the product-market demand elas-
ticity. Consider now the constant-output elasticity of substitution e between labor and all other
factors. Suppose that an industry is vertically integrated with a number of production stages.
With international trade, stages can move abroad either within firms by establishing multinational
corporations with foreign affiliates (as in Helpman, 1984), or by buying the output of those stages
from other firms (as in Feenstra and Hanson, 1996). Trade thus gives access to foreign production

²²In equation (21) all the elasticities are defined to be positive.

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