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Globalization, Profits and Salaries

Globalization, Profits and Salaries

Maurizio Franzini

Published in “Globalization, Institutions and Social Cohesion” edited by M. Franzini and R.F. Pizzuti, Springer, 2001

Introduction

One of the main causes of concern in the advanced countries over the past few years has been the slide of unskilled workers on the income ladder. This slide was due on the one hand to globalization and on the other to the technological progress which made it possible to dispense with unskilled workers.

The assessment of the impact of globalization has obviously been affected by the way it is deemed to act. In particular, emphasis has been placed on imports from developing countries while other possible significant influences have been neglected.

Therefore, in order to illustrate the connections between globalization and income distribution it seems necessary to identify first of all the peculiar features of this end-of-the-century phenomenon. Consistent with some recent contributions, this paper will underscore the role of the localization abroad of some production stages and it will be shown how this is founded on important changes in the benefits related to the way production is organized. This means that globalization cannot simply be regarded as the consequence of a liberalization process that has materialized thanks to the progressive lowering of the natural and legal barriers to the movement of goods and factors.

Following this line of reasoning, the pressure on unskilled workers’ salaries can be explained by the disequilibrium resulting from the greater profit opportunities associated with the relocation abroad of production and the related attempt by firms to gain access to such profit opportunities.

A comparison with the globalization which took place approximately one century ago will show how now, as then, there are forces at work which tend to narrow the differential between the salaries of unskilled workers in advanced countries and those of the same types of worker in countries that are lagging behind. This difference concerns the manner in which such forces take shape; migration then, localization today.

The possible reactions of those who suffer from globalization and the more general quest for corrective measures to improve the position of unskilled workers will be discussed in the final part of the article. It will be seen that there are no easy solutions, nor can the old solutions be guaranteed to work. This is not surprising, however. In an age of innovations it would be rather strange if old solutions were to apply. Thus, it is necessary to find new alternatives. Especially if good old laissez faire is not included among the new policy prescriptions.

Globalization, barriers and frictions

It is well known that globalization has many -perhaps too many – meanings. The identification of an element common to the different conceptions by scholars in the different fields is a tall order but, if an attempt were to be made, perhaps there would not be much progress with respect to the vague, though useful, “end of geography” referred to recently by Bauman (1999, p. 15).

Economists have embraced the notion that globalization means the “end of geography” (or, at least, its rapid decline). This can be proved by providing a brief review of their positions on the causes of globalization, how the latter takes shape and its consequences.

The starting point is a drastic decrease of the legal and natural barriers to the international movement of goods and factors. Due mainly to technological developments, as far as natural barriers are concerned, and to important political changes, as far as legal barriers are concerned, this decrease is considered the cause of globalization, namely of the acceleration of trade and the transfer of production factors (in addition to technologies). Several consequences are associated with these globalization phenomena, which concern mainly economic growth, the power of national states , the degree of equality in income distribution. This last is the question which concerns us the most.

In this review, the “end-of-geography” idea appears in the causes (the fall of barriers that separate the worlds), in the signs (the speed of travel, the mobility of goods and factors) and perhaps even in the consequences (the uniformity of the “political landscape”, the impracticability of diversity).

Let us leave behind the idea of the “end of geography” and let us concentrate on the problem we are interested in: the relationship between globalization and income distribution in the advanced countries. Conventional theories lead to expect a significant worsening for unskilled workers. This is not surprising if we consider that lower barriers brought about such an economic integration with less developed countries, with their abundance of unskilled workers, as to have an effect similar to a sudden increase in the supply of this resource. However, the channels through which this effect can materialize are many and not all equally beneficial to the decision-makers involved. Thus, in performing empirical tests, the role of the selected channel will be paramount.

In the wide debate held recently on the relationship between globalization and income distribution the prevailing opinion was that, so far at least, the effects of globalization have been rather weak; in fact, many consider the responsibilities of technological progress as much more significant in determining the unquestionable worsening of the position of unskilled workers in a large number of advanced countries. Without delving into the content of a far-reaching debate , what has already been stated should be reiterated, namely that the results are definitely influenced by the way globalization takes shape. If, as it happened, this is identified solely with the imports of finished goods from less developed countries there is the risk to underestimate the strength of the changes propelled by the “end of geography”.

Some recent studies, particularly those by Feenstra and Hanson (1996), Feenstra (1998), have called the attention on the remarkable development of the international trade in intermediate products. This increase is likely to represent extensive outsourcing and relocation abroad of some “backward” stages of the production process. If attention were paid to these developments, and if they were considered as the expression of the globalization process, then there would be serious reasons to consider the latter much more detrimental to the income of unskilled workers than what emerges from the consideration on finished goods.

However, before dealing with this problem it is worthwhile to take some preliminary steps. First, the benefits accruing from an interpretation of globalization which takes into account the importance of localization phenomena should be recognized.

The importance attributed by economists to lower barriers was already mentioned. Obviously, no one can dispute the occurrence of such reduction and that it was a substantial one; however, it is difficult to agree with those who talk about “frictionless economy” as a feature of the global economy , basically to present this as an unprecedented age in history. Actually, as Rodrik remarked recently: ” per ragioni che non sono del tutto chiare, i confini nazionali continuano ad agire come barriere agli scambi economici anche in assenza di restrizioni formali” (Rodrik 1998, p. 5).

If localization were attributed the importance it deserves, our age would acquire a peculiarity of its own, without the need to state that frictionless and costless markets are becoming a reality at exactly the moment when – perhaps due to one of history’s ruses – the most enthusiast boosters of such markets, economics textbooks, are turning away from them.

Pinpointing any novelty in our age without any reference to localization is actually rather hard. This is shown for instance by the founded criticism leveled at those who regard as unprecedented the present international factor movement and trade of finished goods. Data on the other historical period characterized by a strong international economic integration, namely that included between 1870 and the first world war, reveal in fact that international trade in finished goods, foreign direct investments and, most of all, migration were much more substantial in those years. If what is occurring today were an exact replica of the above phenomena then there would be good reasons to be wary of the claim that “nothing of the kind has ever been seen”.

One of the objections usually raised to this seems inadequate. In fact, for purposes of comparison between the two historical periods, it is argued that the enormous expansion of the service sector (services by nature are not exportable) makes an indicator such as the ratio between international trade and Gross Domestic Product meaningless. A direct comparison would require to adjust the Gross Domestic Product to account for services; if this were done the situation would drastically change in favor of the present globalization.

This objection might lead one to wonder why the growing dependence of individuals, and their welfare, on immobile services cannot be considered a new and powerful obstacle to globalization. It seems rather unusual that the service expansion argument is used exclusively to support the globalization thesis and not also to weaken it.

It is this writer’s opinion that if no attention is paid to localization it is hard to characterize this end-of-the-century globalization as really peculiar.

But there is a question that needs to be answered. In what way is localization a manifestation of globalization? Can it be identified with the acknowledged cause of globalization, namely the reduction of legal and natural barriers to the international movement of goods and factors? Is it not perhaps necessary to look for localization causes, part of them at least, in the production sphere and in the most advantageous ways to organize it?

The following section will try to show that localization can occur also regardless of the changes in the height of international barriers. This does not mean that their reduction did not play a role; rather it intends to show how localization – and all it means for globalization – might be the consequence of developments that fall entirely within the production sphere. Thus, the objective is to correct the overwhelming tendency to establish very close links between globalization and liberalization. Actually, adding the classical liberalization perspective to the one outlined above – which refers, in part at least, to the crisis of fordism and to vertically integrated factories – provides a greater insight into today’s globalization, thus making it possible to give a fuller account of highly significant phenomena such as the worsening position of unskilled workers.

Localization and Governance Costs

In order to examine the problem of relocation abroad of some manufacturing phases I will follow the approach adopted by the neo-institutionalist economic analysis, with special reference to Transaction Cost Economics. Oliver Williamson, the main initiator of this type of analysis in the wake of Coase’s very well-known work, summarizes one of the key issues with the following penetrating questions: “why can a large firm not do what a large number of small firms do, and more?” (Williamson 1985, p. 161). He provides an answer based essentially on the progressive weakening of the incentives that size entails.

For our purposes the crucial question is actually different: “Why do firms not “disintegrate” production into different production units located in such a way as to take full advantage of the cost opportunities, after allowing for any productivity difference, made available by the different areas in terms of production factors,?”

As can be seen, this question is different from Williamson’s, particularly because it starts from the differences that characterize national territories. In reality, it could be rephrased as follows: “If territorial differences count why do firms do not implement systematically what Krugman (1995, p. 333) called the slicing up of the value chain?”

In an international economy perspective, this question could be answered immediately: because there are barriers, namely because internationalization does have a cost. There are reasons, however, to doubt whether the costs of the disintegration approach are only those related to the crossing of national borders. This would be reasonable, for instance, in light of the consideration that for a long time the breakdown of production was not even carried out within national territories. Actually, in line with Transaction Cost Economics, it can be assumed that the decentralized approach does have some costs regardless of the international dimension of localization. High costs, vis-à-vis the centralized and integrated solution, may be key to answering the question at hand. These, which I shall term governance costs, should be considered as paramount for analyzing localization.

Actually, a suitable analytical approach for such a complex problem should take into account at the same time the governance costs, the internationalization costs and the production costs related to the different alternatives available to our representative firm. The following is an extremely simplified way to do so.

First of all, let us suppose that the production process consists of two technologically distinct phases, the first unskilled-labor intensive and the second skilled-labor intensive. The firm has a higher number of organizational alternatives available than the traditional make or buy considered by neo-institutionalists, namely either vertical integration or purchase of first-phase output in the open market.

First, the clear consideration on the territory introduces the “where” question. That means that it is important to ask where to produce (all or part) and where, if this is the case, to buy the intermediate product.

Moreover, it is necessary to consider the possibility that production (make) might be organized in manufacturing units in geographically distant areas. In fact, it is possible that even though there are no purchasing arrangements (buy) the firm might disintegrate production. The international dimension of localization attributes a special importance to this alternative which concerns the so-called how of production (make).

Taking into account all the possible combinations among the where, how, make and buy there would be at least nine organizational alternatives. As far as we are concerned, the five most important are the following:

1. Integration of the two phases within the national territory (integrated national production: INP)
2. Integration of the two phases within a foreign territory (IFP);
3.Localize part of production within the national territory (localized production within national territory: LNP)
4. Localize part of production in a foreign territory (LFP)
5.Buy abroad intermediate products related to first phase (Foreign buying – FB)

In order to further simplify the analysis, we can neglect the LNP alternative on the one hand and consider the last two (LFP and FB) as completely equivalent and a depiction of outsourcing, though only initially, on the other. This will make it much easier for me to explain what I consider the most important point.

In order to establish which of the three remaining solutions (INP, IFP and Outsourcing) is more beneficial to our firm, we should determine the costs of each. As already noted, these costs involve production, governance and internationalization. Let us review them briefly.

Since skilled workers available within the national territory are less expensive, not including productivity, while the opposite is true for unskilled workers, the best solution in terms of costs seems to be outsourcing. In other words, the breaking down production in different phases would seem to represent the most beneficial solution; however, it is necessary to consider the influence of the other two types of cost.

Naturally, internationalization costs put a nationally integrated solution in a favorable light. These costs include both legal and natural barriers; the latter in turn include not only transportation costs but also all the risks related to international relations (starting from those arising from the reliability, institutional and otherwise, of the foreign country).

Finally, governance costs are those that arise from the way production is organized and should considered as depending on several factors: from the technological ones to those that determine the size of the incentives. For instance, as already noted, Oliver Williamson argued that in a large vertically-integrated firm the costs related to lower incentives play a significant role. In the interpretation that will be outlined shortly the way these costs change is key.

If there is not much of as difference between the two “foreign” solution, and if production costs of the two integrated solutions are more or less the same, the problem is as follows: production costs push toward localization, internationalization costs toward a nationally integrated solution. Governance costs are then key. While not denying the importance of lower barriers, I will argue that to explain localization it is enough to assume that governance costs be significantly lower for the decentralized solution than for the integrated one.

Chart 1 shows the prevailing situation in the presence of high decentralized-governance costs; in our model, this is the starting position. In the profit-cost internationalization plane there are three straight lines. The horizontal one, which shows a profit independent of international barriers, refers to the profit that can be achieved through the INP solution. The downward sloping solid line concerns instead IFP: the profit associated with this alternative decreases as internationalization costs increase. Finally, the downward sloping broken curve represents profits that can be made by outsourcing production. If the differential in governance costs is sufficiently high in favor of the integrated solution, this curve will lie below that which depicts the profits obtainable through the IFP solution, as indicated by the chart.

In the initial situation barriers are sufficiently high (for instance at level C*) so that the highest profit can be earned through the INP strategy. It should be noted that, based on the assumptions on governance costs, lowering barriers would tilt the scale in favor of the IFP solution and not outsourcing: this should prove that lower barriers are not a sufficient condition for localization. They are not even a necessary condition, as will be seen shortly.

Let us suppose now that governance costs change significantly and that, given the same internationalization and production costs, this causes profits associated with INP and IFP to fall on the one hand and profits related to outsourcing to rise on the other. The situation that would be determined under these assumptions is that depicted in chart 2: outsourcing is more profitable and firms will prefer that approach.

It should be noted that the profits the firm can achieve are much more substantial than the decrease in governance costs: the disappearance of the barrier represented by those costs makes it possible to gain access to much higher profits. Thus arise the conditions that lead firms to break the manufacturing process down into different phases and localize each of them according to the principle of comparative advantage. In particular, firms will try to localize abroad unskilled-labor-intensive production phases.

All this does not require lower international barriers, as was shown. If such reduction takes place, the localization phenomenon can gather strength, as indicated by our charts. However, according to what was already stated, this short analysis intends to give due recognition to the changes occurring within the sphere of production organization, which were overshadowed by the excessive emphasis on the liberalization processes.

Before ending this section, it seems appropriate to draw a short comparison between the two possible alternatives of localization abroad: make or buy. Up to now it has been assumed that the two alternatives are interchangeable, but this is very doubtful. If we are dealing with backwardness and thin markets, the risks associated with purchasing can be rather significant as the firm would depend on a single supplier that cannot be easily replaced. Of course, as market and development consolidate the situation changes. Following the Transaction Cost Economics approach, and adapting it to our case, it might be said that expanding markets reduce the risks related to specificity; this makes it increasingly beneficial to resort to the marketplace.

Profit pressures on unskilled workers.

In the previous section we analyzed what could be defined as the impact effect of globalization, the latter to be intended as a drive toward localization. The change in governance costs, possibly strengthened by the reduction of internationalization costs, alters the priorities of firms in terms of production organization and opens up an imbalance phase.

Firms undertake to achieve those profits that seem to be within their reach now; however, it would be wrong to assume, on the one hand, that localization is the only way for them to achieve this objective and, on the other, that firms almost automatically converge toward those solutions that guarantee a greater profit. Both questions are affected by the workings of the labor market of the country of origin.

Let us consider some possibilities.

If in the labor market there are rigidities, namely that it is difficult for firms to “terminate” their workers, the possibility to take advantage of profit opportunities through localization abroad will be significantly lower. Obviously, this does not apply to new investments. Thus, in this case the effects of globalization will show up much more slowly, though they will not fail to take shape in the long run.

If, instead, there is no such rigidity but there is a low downward flexibility of unskilled workers’ wages, firms will take advantage of the new profit opportunities by localizing. In the short run unskilled workers will pay the price of globalization, while in the longer run it is highly likely that there will be effects on salaries as well.

The third possibility refers to the case whereby there is a full salary flexibility and firms can obtain the reduction required by simply threatening to localize abroad. In this case, higher profits are achieved without the need to localize, thus without triggering an additional stream of international trade. The exit threat is sufficient. This shows that at the foundation of the phenomenon there is a change in the relative positions of firms and unskilled workers: the most advantageous option available to firms improves their bargaining power and, in a market characterized by high salary flexibility, this translates rapidly into a different allocation of the surplus generated by cooperation.

Besides the differences highlighted above, it is out of the question that the unbalance created by the higher profit opportunities made available by localization will end up exercising strong pressures on unskilled workers and that many firms will actually localize production. The road to a new equilibrium is in fact characterized by these phenomena, thus by the trend of the gap between the income of unskilled workers in advanced countries and those in developing countries to narrow.

Taking account of these considerations, one cannot help but agree with Feenstra (1998) when he criticized the approach most frequently utilized to determine empirically the effects of both globalization and technological progress on unskilled workers’ income. Overlooking the outsourcing phenomenon may cause the role of globalization, or in other words the opportunities made available by world markets, to be underestimated and the impact of unskilled-labor-saving technologies to be overestimated. In fact:

· If the aspect of globalization examined is only that of the international trade in finished products and, in particular, imports coming from developing countries, while the trade of intermediate products is neglected, its effects on the unskilled workers’ income will certainly be underestimated;
· if, as it happened, every reduction of unskilled workers within specific industries is attributed to technological progress, forgetting that localization can be another cause of this phenomenon, then there may be an error in overestimating the impact of technological progress.

Thus, evidence of the pressures globalization exerts on unskilled workers can be found also if account is taken of trade in intermediate products. Furthermore, if pressures arise regardless of actual localization, as might happen in some cases according to what was said above, then the overall impact might even be greater. There seems to be no doubt then that there are sufficiently strong forces to narrow the differential between the unskilled workers of advanced countries and those of developing countries, especially in absence of correctives or new obstacles.

Surely, this type of convergence is not a new development; Jeffrey Williamson showed that the same thing happened in the previous globalization phase (Williamson J.1998). Then, according to Williamson, the main mechanism that would have ensured this convergence was the mass migration from the old to the new world, namely from countries with an abundant pool of unskilled labor to countries that had a shortage of this resource. In particular, migration flows made it possible for the income of unskilled workers in Norway, Denmark, Sweden and Italy to rise, reducing income disparities in such countries. The opposite took place where these immigrants settled in countries such as the United States and Canada. In Spain and Portugal, which tried to steer clear of globalization, income inequality remained right where it was (Williamson J., 1998, p. 62). There is a lot to learn from this historical experience, as we will see in the next section.

Reactions, correctives and conflicts

This section hinges on the following questions: can there be any reaction to the trends that will arise following the imbalance determined by the higher profits that can be achieved through localization? If governments wanted to intervene to prevent the conditions of unskilled workers from worsening excessively, what would the best measures to be adopted be?

Regarding the first question, reference should be made to the above-mentioned work by Jeffrey Williamson. During the other globalization, governments intervened as a result of the pressures by those who suffered from globalization in order to place a lid on the transmission channel whence the negative impulses were flowing. Thus, the United States introduced some restrictions on immigration while Continental Europe resorted to import tariffs.

Williamson blames measures of this kind for the de-globalization that characterized the years between 1914 and 1950; however, in concluding his essay, he maintains, though cautiously, that today the conditions for those events to occur once again are lacking. His views are based on three elements: the lower importance of the sector that produces tradable goods, the limited share of the agricultural sector (thereby limiting its importance, despite its being generously subsidized) and the incomparably lower importance of migration flows from developing to developed countries than that which took place in the period prior to the first world war (Williamson 1998, p. 69).

The considerations on localization outlined above, however, do not point to the same direction as Williamson’s cautious optimism. The absence of significant migration flows does not guarantee a lack of significant pressures on the unskilled workers’ income, so that if the reactions originate from a persistent and prolonged worsening there are good reasons not to share Williamson’s conclusion. Actually, localization is different from immigration simply because companies go where cheaper unskilled workers are, instead of waiting for them in their countries of origin. This does not make much of a difference, even though these workers are very much likely to prefer localization over migration by far.

Thus, strong pressures to introduce protectionist measures cannot be ruled out. These measures can include outright brakes on international mobility or also the introduction of frictions in the labor market that might operate as the above obstacles to firm exits. Actually, some authors think that globalization will create a greater rigidity (Agell, 1999). As already mentioned, these types of measure alone are likely to do nothing more than delay the effects of globalization.

Obviously, in assessing the possibility that these interventions are carried out, it is necessary to consider also the interests of the beneficiaries and their lobbying ability. Beneficiaries do include firms, probably consumers (which is not an independent group and, in part, overlaps with unskilled workers) and probably skilled workers who might be interested in localization because, by increasing the price competitiveness of the firms they work for may make their jobs safer and better paid. In reality, as we will see presently, there is a risk that the interests of skilled and unskilled workers may clash also for other reasons.

From the standpoint of the unskilled workers in the advanced countries, one popular corrective action is to increase the cost of labor in developing countries. This result can be achieved by “exporting”, as they would have it, a set of institutions, beginning from those related to social insurance and Welfare. The debate on labor standards for instance is headed in that direction. What was said before about the beneficiaries of localization can be applied also to this case. Contrary to what is normally stated, firms in developing countries are not the only ones whose interests run counter to these kinds of measure; anybody in the advanced countries that can benefit from localization are exactly in the same situation. Obviously, interests alone do not move people to action; it may be interesting, however, to know which way they drive them.

Another type of intervention is the attempt to change all workers into skilled workers. The emphasis placed on the formation of human capital in the debates on development strategies should be set within this context. Besides its unquestioned desirability, this intervention poses some problems: how long does it take to carry it out? Will there be actual job opportunities for all skilled workers commensurate with the investment made and the expectations raised? Who will finance this massive investment in human capital? This last problem is crucial and involves also the other interventions proposed.

Another corrective action is trying to raise in a selective and specific manner the productivity of unskilled workers, assuming that this could be done without investments in human capital, otherwise it would be the same as the intervention considered before.

In order to increase this productivity either private or public investments are necessary. As far as the former are concerned one wonders why firms should do it if they can reduce their costs simply by localizing. As to public investments, the question of financing them looms large. The pressure by unskilled workers to make these investments is likely to increase over time: these investments may be highly effective in protecting their incomes.

The last type of intervention is that designed to support workers’ income through supplements ex post. In this case, the danger of adopting solutions that might turn into permanent obstacles to change – also and especially to the development of human capital in future generations – should not be underestimated. Actually, these types of experiment in the past did not yield appreciable results. I am referring, for instance, to the harm done recently to farmers by the economic integration in Europe. However, there are some interesting proposals that might significantly mitigate these risks. Noteworthy among these is that which calls for an income supplement to unskilled workers, which is strongly supported by Phelps (1997).

One of the main problems with this intervention – actually present in all the other interventions considered – is where to find the financial resources. Who should bear the cost of measures intended to protect unskilled workers?

In this respect, the situation is rather clear. Cutting into profits by way of taxation – and in particular doing it in a way that unskilled labor is not exempted – risks precipitating the localization processes. Thus, there is a catch-22 with this solution as it would generate the very problem it is trying to solve. This argument leads us to look into another direction to find those that will have to bear the costs to protect unskilled workers. These might be those who benefit from the services of the Welfare State, or even skilled workers through the fiscal system.

Thus, the conflict between skilled and unskilled workers – which can be set against a larger backdrop involving the redistribution of income for salaried workers, beneficiaries of the Welfare State, firms and investors – may become sharper. Its roots may reach down even further than those of the generational conflict, which is a matter of deep concern for many in our country today.

Thus, it is not easy to devise corrective actions that do not have serious drawbacks, though the combination of some observations set forth in this section may indicate a practicable way out. A policy capable of preventing the most negative effects should, in any case, be coordinated at the international level, cast over the long term and structured along such a high number of issues as to limit the paralyzing burden of many, splintered, personal interests. Surely, it is not an easy task.

Conclusions

This paper has argued that in order to understand fully some of the most significant changes taking place now and, most of all, to identify the reasons why the situation of unskilled workers in industrialized countries is worsening, it is necessary to focus first and foremost on the extensive localization of manufacture under way. It was shown that the main cause of such change is the relative reduction of governance costs associated with the disintegration approach.

Taking localization into account makes for an easier identification of the effects of globalization on unskilled workers. These effects stem essentially from the much higher profits that firms can achieve by localizing production and replacing domestic unskilled workers with other, less expensive, workers; contrary to what happened in the preceding globalization, the use of this labor force does not require large migration flows but simply the relocation of whole production phases.

It was seen how the rigidities of labor markets can have a significant influence on the immediate and delayed effects of the localization thrust. In any case there will be substantial pressures, calling for an adequate policy response to the likely reactions and to prevent the less socially desirable effects of globalization.

The analysis conducted in this respect indicated that there might be possible conflicts between skilled and unskilled workers within a wider context of income redistribution from salaries to profits. It was also underlined that a short-sighted redistribution policy and, especially, with little coordination at the international level can meet with some difficulties.

It is probable, to cite a well-known expression, that Rome’s salaries are not set in Beijing. But surely a major political effort is necessary for them not to be affected too heavily by what happens in areas much closer to us, without causing harm of a different kind.

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