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Why Are Wages Low in Developing Countries?

Mises Daily: Monday, December 01, 2008 by

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Low wages in developing countries are among the many sins allegedly committed by global capitalism, but few of those making the charge really stop to think about why wages are so low in some developing countries.

In his 2007 book The Myth of the Rational Voter, economist Bryan Caplan proposes an interesting thought experiment which suggests that people implicitly accept the results of competitive markets. Caplan asks if those who criticize companies that pay low wages overseas feel that they could get rich quick by investing all of their resources in overseas enterprises — specifically, enterprises in poor countries. After all, it stands to reason that if workers in developing countries are underpaid and exploited, a profit-seeking businessperson would be able to reap immediate profits by hiring the workers away from their current occupations and re-employing them elsewhere.

If people pass on the opportunity, Caplan argues, then they implicitly accept the tragic-but-nonetheless-real fact that workers in very poor countries simply are not very productive. Low wages, then, are not the product of exploitative multinational corporations but of extremely low productivity. The relevant question for those concerned about the very poor is not "how do we convince (or force) multinational corporations to pay more" but "how can we improve the productivity of the world's poorest workers?"

This is where there is room for improvement, and this improvement should come by improving contracting institutions in poor countries. I don't have the specific local or cultural knowledge to know exactly how these institutions will evolve, but socially conscious investors or activists should try to encourage the development of institutions that constrain coercion and limit fraud.

Suffice it to say that the strategy of blocking overseas investment is ineffective at its best and positively harmful at its worst. I'm willing to grant the possibility that global labor markets are monopsonistic rather than competitive, but international capital flows suggest that this is not the case.

In a study of wages and working conditions in developing countries, economists Benjamin Powell and David Skarbek found that the textile sweatshops derided by rich westerners offer higher wages and better working conditions than the alternatives in very poor countries. People in developing countries need more sweatshops rather than fewer.

On the domestic front, people have argued that they are for "free trade" but that environmental standards should be improved so as to ensure that workers in poor countries are not exploited and their environments pillaged. But this eliminates poor workers' competitive advantage, reduces the possible gains from trade, and relegates them to an underground labor market of prostitution or picking through garbage dumps.

Regulation also will not change the productivity of very poor workers. It will only change the incentives, and this will likely produce unwanted consequences. Environmental regulation and onerous labor laws will alter the incentives in such a way as to increase the relative profitability of evading the law, tilting the competitive balance in favor of the relatively unscrupulous.

"That might be true," people might respond, "but can't multibillion-dollar multinational corporations afford to pay more? Isn't it unconscionable that CEOs are able to take home millions while workers in underdeveloped countries earn mere cents per hour?"

Is it sad? Yes. Is it unconscionable? No. Can companies "afford to pay more?" Again, the answer is no. Firms might be able to pay above-market wages in the short run, but in addition to operating in internationally competitive labor markets they also operate in internationally competitive capital markets and internationally competitive goods markets. Firms that sacrifice profits in order to pay higher wages will reduce their ability to earn profits, attract capital, and expand in the future. In the short run, we can improve standards of living for some people. In the long run, this illusory prosperity comes at the cost of increasing future poverty.

The current crisis faced by American automakers provides a useful and tragic case in point. For years, they were able to pay some workers at union pay scales with union benefits. Over time, however, they were undercut by competitors who were unhampered by these costly restrictions and they were themselves sharply restricted in their ability to expand. Now, apparently, there isn't anything left to loot.

"People in developing countries need more sweatshops rather than fewer."

Finally, when it comes to a firm's production decisions, wages are not all that matters. Firms will invest in inputs — say "unskilled labor" and "skilled labor" — until the ratio of the marginal products of the factors to the prices of the factors are equal for all inputs. If an American worker earns $30 per hour while a Chinese worker earns $1 per hour, this is not by itself sufficient to show that investing in China is in a firm's best interests. If the American worker can produce 120 units of output in an hour while the Chinese worker can only produce two, then producing the good in the United States is actually cheaper. Each unit produced in the United States costs twenty-five cents, while each unit produced in China costs fifty cents.

The idea that expanding and integrating the global marketplace exploits the poor is a myth that causes avoidable misery. Protesting and trying to slow the advance of international capitalism is not the solution. Encouraging the development of institutions in which the world's poor can increase their productivity is.