A number of recent political developments have intensified the free movement of goods and labor. According to Hatton and Williamson (2005), over the last 30 years the ratio of exports of goods to GDP has doubled in many countries. Also, in terms of world population, immigrants’ proportion has increased. The United Nations estimates that international migrants constituted 3 percent of the world population in 2005. The tendency toward the international labor liberalization influences the human capital accumulation in any country, which in turn can change the dynamics of international trade in the world.
A new, but growing literature reports the importance of national institutional development on the pattern and effects of international trade. There are also plenty of theoretical and empirical papers that investigate the role of educational quality on the pattern of international labor movement. Moreover, there is a history of theoretical and empirical exploration into the existence of a relationship between international trade and international migration. However, researchers have not paid much attention to the effect of national institutional development on the pattern and consequences of international labor movement. We find it essential to focus on this gap in the literature for several reasons. First, not comprehending the effect of national institutional quality on the pattern and aftermath of international labor migration may lead to an underestimation of the benefits of a creation of a common labor market area. For instance, we find that international migration boosts international trade. This result is more profound when the country with the most developed institutions has the worst national early childhood care and educational system (henceforth, ECCE). Moreover, we find that a creation of a common labor market increases the intensity of human capital accumulation in the world.
This paper offers a theoretical understanding of the role that ECCE and the national institutional development play in a country’s accumulation and distribution of human capital in the presence of moral hazard under free movements of goods and labor. In this sense, we explore the existence of a mechanical linkage between immigration and trade. We treat national institutional quality and ECCE as exogenous.Footnote 1
Our paper presents a simple two-country-Ricardian-trade model under free trade and immigration. Countries export either a high-skill intensive (complex) good or a low-skill intensive (simple) good. Exogenous national institutional quality is complementary to agents’ training acquisitions because more developed national institutions are associated with lower monitoring costs, which attracts workers willing to provide relatively high productive efforts, which is more important in producing the complex good. This is the main force driving the sorting of agents in our model. Ultimately, since relatively higher national institutional quality attracts skilled immigrants, the country with the more developed institutions exports the complex good. The quality of the exogenous ECCE also generates the underlying individuals’ training distribution across countries. In two otherwise similar economies, the one with the best ECCE will export the complex good. When a country obtains relatively better ECCE such that individuals acquire high training levels, but national institutional quality is low such that agents’ training levels are underutilized, out-migration toward the country with better institutions occurs.
This paper is a generalization of Vogel (2007) to allow for immigration and ECCE. In order to motivate the international movement of labor, countries are given differential training endowments, which are endogenously determined by the existence of the exogenous national quality of institutions and ECCE. This drives the additional mechanism that departs from Vogel (2007). Our model shows that differences in relative national institutional quality and underlying training endowments will not straightforwardly drive migration. We find that because migration will be selective on individuals’ training levels, it will alter the pattern of comparative advantage in international trade.
Our approach presents an opportunity to understand international trade, immigration and education simultaneously in a single model. Each country has a large number of firms grouped into two industries, a simple and a complex one. There are two final goods produced using only labor. In the simple sector, individuals work alone and produce a simple good. In the other sector, production of a complex good is determined by collaboration between a worker and a manager. If a manager is able to measure perfectly a worker’s efforts, then the second has no incentive to provide unproductive efforts. But the manager is unable to identify perfectly worker’s efforts. The level of unproductive efforts depends not only on the worker’s wage that she receives, but also on the degree of imperfectability of the labor contracts. We assume that the latter is related to the development of national institutions. The more developed national institutions, the lower worker’s unproductive effort levels will be.
Individuals have the same homothetic preferences toward accumulation of human capital, but they possess different natural ability levels. The higher their ability, the lower their cost of acquiring high training levels. The more trained workers are, the less their unproductive effort levels. An individual knows that it is costly for her to acquire training subject to her natural ability and efforts subject to her training. However, a better trained manager under more developed national institutions is compensated more for her ability to reduce moral hazard in the complex sector. An efficient matching process takes place, where the most talented workers pair up with the most talented managers and enter in the complex sector. The least talented individuals enter in the simple sector.
In some sectors it is impossible for a manager of a firm to perfectly observe the productive efforts of her employees who engage in a team project during the production process. For example, in an interdisciplinary research project conducted from two researchers that are specialized in two distant academic subjects, if one of the researchers is the manager, and the other the worker, it is hard for the former to evaluate the latter because the manager can judge her part of the research but is unable to perfectly evaluate the part of the research conducted by the worker. She therefore cannot perfectly measure the value of their interdisciplinary research project. However, the manager has perfect information about the training levels of her employee but imperfect information about her productive efforts during the production process. She can design a wage contract that values her employee’s work subject to certain norms that are perfectly measured and verified such as the quality of her employees’ ideas and determination in the working process. Managers with higher training levels can better evaluate a performance measure of their employees.
No matter how skillful a manager is, there are still outside factors, such as the broad national institutional development that could encourage employees to increase their individual productive efforts in the team production. We assume that better developed national institutions provide a higher quality of the performance and verifiability measures of the firms that operate in the complex sector.
ECCE is another factor that influences individuals’ decision about their skill level. Two individuals who are born with the same natural ability, but live in countries with different ECCE, will acquire different skill levels. It is easier for the one who lives in the country with the best ECCE to accumulate more skills and, therefore, to exert more productive effort levels in the complex industry. One may imagine a different label for ECCE, such as a natural cultural identity that promotes ECCE independent of the evolution of the national institutional development. For example, Japan has better ECCE than the USA, at least according to the survival rate to grade 5,Footnote 2 but the USA has better national institutions than Japan, as proxied by the rule of law index taken from Kaufmann et al. (2010), which measures, among other factors, the quality of contract enforcement. In Table 1, we present the above indexes, where the ECCE index is taken from UNESCO EFA (2010) and the rule of law index is taken from Kaufmann et al. (2010).Footnote 3
In our model, countries are assumed to vary only in the development of their institutions and ECCE. Under free trade, the country with the best ECCE and the most developed institutions contains more highly skilled individuals who seek employment in the complex industry, and therefore, these countries export the complex good. In a common labor market regime, the country with the best developed institutions is the host country of immigrants. Only the most talented individuals prefer to emigrate toward the country with the best developed institutions because there they capture higher incomes for their training levels. National institutional quality acts as the sole determinant of the pattern of international labor movement.
We show that immigration promotes international trade especially in a scenario when the country with the most developed institutions has the worst ECCE. According to Table 1, one can find a plethora of countries that satisfy these conditions. For example, Croatia, Democratic Republic of Korea, Slovenia, Italy, Belarus, Spain, and Japan have better ECCE than USA, but the latter has more developed institutions than all the above countries. Thus, if these countries differ only in the development of their national level of institutions and ECCE, then according to our theory their autarky prices could quite possibly be the same, providing no incentives for international trade. However, under a common market area, we observe a movement of labor from the country with the least developed institutions (Italy) toward the country with the most developed ones (USA). Immigration changes the division of labor in both countries, giving unequivocal comparative advantage in the complex good to the country with the most developed institutions (USA). Thus, international labor movement creates international trade. This is true not only in the above scenario, but as long as there are national institutional differences, independent of the ECCE.
We also examine the effects of international students on trade, assuming that countries also differ in their national training systems. It follows that the country with the best ECCE, training system and more developed institutions exports the complex good. However, when international students must return to their country of origin after graduation, we show that it is possible that the host country will eventually export the simple good under the scenario that the latter has a better quality of institutions and training systems, but worse ECCE.
This paper contributes to the recent and growing literature on institutions and international trade. It argues that the quality of institutions and ECCE act as independent sources of comparative advantage in a country. This result is consistent with Vogel (2007); Costinot (2009); Grossman (2004); Levchenko (2007); Matsuyama (2005); and Nunn (2007). We follow Vogel (2007) by developing a simple theoretical game in which each individual chooses her sector of employment, training level, production team, and efforts. Our model differs from all of the above because we allow for immigration and ECCE. A distinct contribution of our model is to make ECCE the sole determinant of the pattern of international trade in the presence of moral hazard.
This paper adds to literature on international trade and the allocation of talent similar to Vogel (2007); Ohnsorge and Trefler (2007); Rosen (1981); and Lucas (1978). This paper is different from the above in the definition of talent, which is defined as something that an individual with given natural ability develops through the interaction of the national institutional development and ECCE.
This paper also contributes to the literature on economics of immigration. It shows that only the most skilled individuals immigrate in the country with the most developed institutions. This is consistent with Abowd and Freeman (1991); Blanchard and Katz (1992); Borjas (1987, 1992, 1993); Freeman (1993); and Jensen (1988). Our paper differs notably in terms of the mechanism through which the incentives of individuals to emigrate are determined. It sheds light on a separate channel, the national institutional development, which resolves the pattern of international labor migration.Footnote 4
Finally, this paper adds to the literature that explores the linkage between immigration and international trade. In a classical paper, Mundell (1957), using a basic Heckscher-Ohlin model, shows that international trade and immigration are substitutes. Markusen (1983) claims that there exists complementarity between immigration and trade for low barriers’ costs using a typical Heckscher-Ohlin framework. However, if the barriers’ costs related to international trade or/and international factor movements are too large, his conclusions are reversed.Footnote 5 The result of our model is consistent with Markusen in that immigration promotes international trade, but we use a Ricardian trade model. Our paper differs from Markusen (1983) when barrier costs are too large. In such a case, our model predicts that international trade and immigration still complement each other because individuals with the highest natural ability find it beneficial to emigrate toward the country with the most developed institutions, since they will be rewarded for reducing moral hazard. To the best of our knowledge, this work is the first one that links immigration and trade using a simple Ricardian model in the presence of moral hazard.
The rest of the paper is organized into seven sections. In Section II, we describe a five-stage theoretical game in a two sector economy. In Section III, we solve the five-stage theoretical game for a symmetric subgame perfect equilibrium in a closed economy in the presence of moral hazard. Section IV investigates the pattern of international trade. Section V explores human capital accumulation in both countries under a common labor market area. Section VI allows for temporary or permanent migration of individuals in purse of their studies, and section VII concludes. The proofs of all propositions and corollaries are provided in Appendix C. See Additional file 1: Appendix C.