ABSTRACT- Impact of globalisation on wage inequality and unemployment is one of theleading issues in the present scenario of world economy. The conventional wisdom suggeststhat globalisation leads to increase in wage inequality. The present paper attempts toexamine this issue in terms of a three-sector general equilibrium model with Harris-Todaro(1970) migration and urban unemployment of unskilled labour. Contrary to the conventionalwisdom the model shows that foreign direct investment may lead to reduction in wageinequality and unambiguously increases urban unemployment rate. The results are thusinteresting from the point of view of the fact that even without educational expansion there isa reduction in skilled-unskilled inequality in a developing economy.3Key Words:Globalisation, Foreign Capital, Skilled-Unskilled Wage Gap, Unemployment,JEL Classification:J30, J64, F11, F63AN INQUIRY ON IMPACT OF FDI ON WAGE INEQUALITY4AND URBAN UNEMPLOMENT1. INTRODUCTIONGlobalisation is a process through which businesses or other organisations start operating onan international scale .In other words; it refers to the integration of markets through freemovement of goods, capital, services, people, technology and information across differentcountries. There can be two aspects of globalisation- tariff liberalization and investmentliberalization. Tariff liberalization implies a decrease in the tariff rate. On the other hand,investment liberalisation means allowing foreign capital inflow in the form of foreign directinvestment (FDI) in developing countries. In our paper, we would like to focus on investmentliberalisation.Inequality, on the other hand is a complex phenomenon which refers to the difference foundin various measures of economic well-being among different groups or countries. Economicinequality can be of various forms, say income inequality, wage inequality or wage gap andso on. In our model, we mainly focus on the problem of increasing wage inequality or wagegap between skilled and unskilled labour.There are alternative explanations for rise in wage inequality. The wage-gap can increase dueto international trade i.e. globalisation and liberalisation is one of the main causes of wageinequality. This is known as the Trade View. Inequality can also increase due to skill biasedtechnological change. There are various numerical indices for measuring economicinequality. A widely used index is the Gini coefficient, but there are also many othermethods.The issue of the impact of globalisation on wage inequality have drawn attention of manyacademicians. Given the empirical evidence, the wage gap has widely increased across theworld during 1980s and 1990s. In the Latin American countries (Mexico, Cuba etc.),globalisation had caused an increase in wage inequality while on the other hand; East Asiancountries(China, Hong Kong, Japan, Korea, Taiwan etc.) revealed exactly the oppositepicture by experiencing a fall in wage inequality as the result of globalisation.5However, the fall in wage inequality in those countries is more due to educational expansionthan due to globalisation. Recent surveys showed that the share of national income accruingto the top 1% income earners were less than 21% of total income in the late 1930s,dropped to6% in the early 1980s and rose to 22% in 2017.A widening wage-gap is experienced both in the north and south. The developed countrieslike USA and Europe are relatively well endowed with skilled labour compared to thedeveloping countries and therefore exports skilled intensive goods. As a result, as trade opensup, the country specialises in favour of the export sector and the factor intensively used in theexporting sector gains to the expense of other factors. Therefore, the skilled wage relative tothe unskilled wage increases which leads to an increase in the degree of inequality in thedeveloped countries. On the other hand, the developing countries in south are endowed withan excess supply of labour (skilled or unskilled) and therefore trade liberalisation regimeshould bring down the inequality in the south. This is a typical Heckscher-Ohlin or theStolper-Samuelson type outcome which should be the case. But except for a few cases, all theavailable evidence so far indicates that the degree of wage inequality in the south is on a riseas well. 1 The reduction in wage gap as a result of globalisation in East Asia, as alreadymentioned earlier, can be explained mainly due to the expansion of education in East Asiancountries. On the contrary, the Latin American countries have been experiencing an increasein wage gap due to globalisation.The existing literature have revealed the upward trend of wage gap all over the world exceptthat it has fallen in East Asian countries mainly due to development of skill, expansion ofeducation etc. The basic purpose of our paper is that we try to explain this reduction in wagegap with the help of the impact of globalisation.We attempt to examine in terms of a general equilibrium model that whether FDI alwaysincreases wage inequality in developing countries. We would like to find out conditionsunder which we may have results which are opposite to the conventional wisdom. Moreover1 The high inequality in the south is prompting new theories. Outsourcing can be a valid reason for risinginequality. Contrary to popular belief, multinationals may often employ skilled workers in developing countriesand pay high wages. Refer to the website http://www.economist.com/blogs/economist-explains/2014/09/economist-explains- 0 accessed on 09/09/2017.6we would like to take into account of Harris-Todaro(1970) type migration and urbanunemployment of unskilled labour in our model. This makes our paper something new in thecontext of the literature. Our purpose is to examine the impact of foreign direct investment onskilled-unskilled wage inequality and urban unemployment rate in a developing economy.The paper employs a three-sector general equilibrium model to achieve the results.The rest of the paper is organised as follows. In section 2, we present the empirical evidencesof increasing wage gap and its relation with globalisation and an overall literature review.Section 3 describes the basic three sector general equilibrium model. Section 4 deals with thecomparative statics. Concluding remarks are made in section 5.2. REVIEW OF LITERATUREThere are many empirical facts on globalisation although only a few attempts have beenmade to justify them at the theoretical level. The existing conventional theories and models(2×2 Heckscher-Ohlin- Samuelson (HOS) structure, Stolper-Samuelson ) show gradualeradication of income inequality in the developing countries. However, Acharyya and Marjit(2000) have argued that theoretically as well as empirically Heckscher-Ohlin- Samuelsonmodel of trade, with the Stolper-Samuelson result at its core, fails to explain the widening ofwage gap between skilled and unskilled labour particularly in the south. 2 They have discussedfew alternative variants of the specific factor model accounting for the diverse trade pattern,informal factor markets and existence of non-traded goods for explaining the wage gapphenomenon. Woods (1997) has also pointed out that the straightforward application of thismodel fails to explain the open trade regime in the developing countries.Beladi, Chakraborty and Marjit (1997) have introduced a simple general equilibrium modelto analyse the effects of trade liberalization and fragmentation on employment and theskilled-unskilled wage differential in the South. In particular, they have shown that whilefragmentation necessarily improves the unskilled wage and the skilled wage, more lucrativeglobal opportunities for the skilled final product, in the absence of fragmentation, can reducethe rural wage and increase urban unemployment.Marjit and Kar (2005) have shown the unskilled emigration may worsen the wage-gapwhereas skill emigration can reduce the wage inequality although wages increase withemigration.7On the other hand, Yabuuchi and Chaudhuri (2007) have developed a three-sector generalequilibrium structure to show that an emigration (immigration) of either type of labour islikely to produce a favourable (an unfavourable) effect on the wage inequality. In particular,the result of emigration (immigration) of skilled labour on the relative wage inequality iscounterintuitive.Chaudhuri(2005) have shown using a reasonable production structure for a developingeconomy that a brain drain of skilled labour may raise the welfare of the economy while anemigration of unskilled labour is welfare reducing. Also an emigration of skilled/unskilledlabour lowers the urban unemployment of unskilled labour and widens the skilled-unskilledwage-gap. The paper provides an alternative explanation for the increasing wage inequality inmany less developed countries in the regime of liberalized trade and investment in terms ofhigher international mobility of skilled and unskilled labour during this period using a Harris-Todaro (1970) framework where the central principle of the Stolper-Samuelson theoremholds.Most of the existing conventional literature attempts to explain a rise in wage inequality as aresult of globalisation whereas in this paper we have depicted the case where investmentliberalisation may reduce skilled unskilled wage inequality and the conventional wisdom getschallenged. Therefore there can be a possibility of reduction in wage gap due to globalisationand here lies the significance of the paper. Our work differs from the works available in thecontext of wage inequality in the sense that we have considered Harris-Todaro(1970)migration and urban unemployment of unskilled labour. One can refer to the work of Ghoshand Gupta (2001) in this context where the authors have considered Harris-Todaro(1970)migration mechanism and urban unemployment of unskilled workers. However, our work iswidely different from the work of Ghosh and Gupta (2001). Our paper is based on a three-sector model whereas Ghosh and Gupta’s(2001) model is based on four sectors. Ghosh andGupta (2001) has focused on terms of trade in the context of wage inequality whereas wehave focused mainly on wage inequality and urban unemployment rate in our paper.The present work thus attempts to incorporate the existence of unemployment of unskilledworkers in a trade model for the developing economies. Our analysis shows that in thepresence of unemployment of unskilled workers, a more investment liberalisation and foreign8capital inflow may reduce the problem of skilled-unskilled wage gap and also lead to a fall inthe rate of unemployment prevailing in the economy.3. MODELWe consider a three sector small open economy consisting of sectorsX, Mand sectorZ.The economy is thus a price taker in the world market and we have competitive commodityand factor markets. Production function in each sector exhibits constant returns to scale(CRS). Sector Xproduces output with the help of skilled labour and domestic capital. SectorMproduces output with the help of unskilled labour and foreign capital and sector Zproduces output with the help of unskilled labour and domestic capital. Sector Xis skill-based service sector (like the Information Technology sector), Mis manufacturing sector andZis agricultural sector. We consider foreign capital to be specific toM . Skilled labour isused by both sectors XandM.The manufacturing sector (assumed to be located in the urban area) uses both unskilled andskilled workers to produce its product. The unskilled workers are employed on a contractualbasis at a fixed institutional wage rate.2 The skilled workers enjoy the market wage rate. Theagricultural sector (assumed to be located in the rural area) employs unskilled labour anddomestic capital to produce its product. The unskilled workers migrate from the rural(agricultural) sector to the urban (manufacturing) sector on the basis of Harris-Todaro (1970)(HT hereafter) migration mechanism. In this economy X and Zare the exportable sectorsand Mis the import-competing sector.3We assume, for simplicity that only in sector X we have variable coefficient technology andfor the other two sectors the technology is of the fixed coefficient type . This can be justifiedon the basis of the fact that in agricultural sectors workers are employed on the basis of agiven ratio of capital and labour. This is because in case of Indian agriculture where we havemainly family farming the use of capital is pre-designed in the sense that how much of capitalthat can be used by a given amount of work force is fixed implying that we treat the capital-2 The unskilled workers may be employed only to build the factory sheds. The production process is operatedby the skilled workers along with foreign capital.3 Developing country like India is an exporter of both rice and software.9labour ratio as fixed or we have L-shaped isoquant. Again for the manufacturing sector it canbe easily assumed that unskilled worker is employed on a contractual basis per unit of output.In fact it is also reasonable to assume foreign capital and also skilled labour to be employedper unit of output on the basis of a pre-designed target. It is only the service sector which isthe highest employer (apart from the informal agricultural sector) in a developing economylike India we have variable input-output coefficients so that there is a degree ofsubstitutability between skilled labour and domestic capital. The product of sector Zisconsidered as the numeraire and its price has been set equal to unity.The following notations will be used in our model –*jP- world price for the product of jth sector, with j= X, Mand Zija- quantity of i-th input required to produce one unit of j in sector jS- Stock of skilled labourL -Stock of unskilled labourDK- Stock of domestic capitalFK-Stock of foreign capital?- rate of urban unemployment of unskilled workersUL-level of urban unemployment of unskilled workersSw-wage rate of skilled labourFr – Rate of return of domestic capitalDr- Rate of return of foreign capitalw- Institutionally fixed wage rate of the unskilled labour used in sector M.w- wage rate of unskilled labour.t – tariff imposed on importing sectorZMX,, are used to denote output levels of the three sectorsWe now consider the equational structure of the model. The competitive equilibriumconditions are given by the following equations (1) to (3). HT migration equilibriumcondition implies the equality between the expected urban wage rate and actual rural wagerate of the unskilled workers. Thus we have equation (4). Factor market equilibrium gives usequations (5) to (8).10KXDSXSXarawP??*(1)SMSKMFLMMawarawtP????)1(*(2)KZDLZaraw??1(3)ww)1(???(4)SMaXaSMSX??(5)DZKKXKZaXa??(6)FKMKMa? (7)LZaMaLZLM???)1(? (8)Where?is defined as (MULL).Equations (5) to (8) ensure full employment of the factors of production in the economy,except for the market of unskilled workers. Our model consists of 8 equations with 8endogenous variables- MXwrrwLZDFS,,,,,,?and Z.The working of the model can be explained in the following manner.From equation (1) since*XP is given, Drcan be expressed as a function of Sw. From equation (3), we find wis afunction of Drso that it is a function of Swas well.From (4) we can write ?as a function of wand thus it is a function ofSw. When Swrises,Drfalls. As a result wincreases and?falls. It implies an increase in skilled wage rate results infall of urban unemployment rate.Using equations (7) and (5) we can rewrite equation (6) asDZKFKMSMSSXSKXKZaKaaSwawa???)()((6.1)11From equation (6.1) we can see asSwrisesKXarises andSXafalls, so SXKXaarises and thusZfalls. So equation (6.1) implies the locus ofSwand Zsuch that the domestic capital market isin equilibrium and it is negatively sloped.Using equation (4) we can rewrite equation (8) asLZaKaawLZFKMLMS???)(1?(8.1)Again from (8.1) we can find that asSwrises, ?falls thus Z rises. Locus of Swand Z are suchthat the labour market is in equilibrium and is positively slopped.FIG. 1From figure 1, we can determine Sw. So, once we knowSw, Dr,wand?are also known.Also from equation (2) ,Fris known asSwis known.For givenFK, Mis known .Since Z is known from (6),X is also known.124. COMPARATIVE STATICSIn this model we are interested to examine the effects of investment liberalisation in terms offoreign direct investment (FDI) in the economy concerned. This FDI is captured in the modelin terms of inflow of foreign capital. We want to examine the effects of FDI on skilled-unskilled wage inequality and urban unemployment rate.As there is inflow of foreign capital in the economy, for given Swwe have an increase in Z(as per equation 6.1). It leads to a rightward shift of DDKKlocus.Again for an rise in FK, from equation (8.1) we find, for given Sw, there is a fall in Z,leading to a leftward shift of LLlocus.FIG. 2From figure (2) we find that as a result of the shift of the two curves,Swincreases but theeffect on Z is ambiguous. It depends on the relative increase and decrease of the two curves.Thus, FDI causes an increase in skilled wage rage which ultimately results in fall of urbanunemployment rate. We have thus the following proposition13Proposition 1: Investment liberalisation in the form of FDI raises skilled wage rate andreduces urban unemployment rate.From the competitive equilibrium conditions using the envelope conditions we getKXDSXSrw??ˆˆ0??(1.1)KMFSMSrw??ˆˆ0??(2.1)KZDLZrw??ˆˆ0?? (3.1)Finding the value of Drˆ from (3.1) and replacing it in (1.1) we can derive,KXLZKZSXSww????ˆˆ?After some routine algebraic manipulations it can be shown thatˆˆˆˆˆLZKZSXKXKXFSXSFSKwKww?????????Thus,0ˆˆˆ????FSKwwaccording as LZKZSXKX???????.Highly skilled sector and mechanized agriculture leads to a possibility that LZKZSXKX?????.This implies0ˆˆˆ??FSKwwThis is quite reasonable from the point of view of a developing economy like India. In Indiaagriculture is not at its primitive stage so that there is quite a good use of capital inputs. Theservice sector on the other hand is highly skill-intensive and the proportion of skilled labourdominates over the use of capital. Under this condition we thus find that contrary to theconventional wisdom, skilled-unskilled wage inequality falls as a result of FDI. Thefollowing proposition is thus immediate.Proposition 2: Contrary to the conventional wisdom, investment liberalisation may reduceskilled-unskilled wage inequality under some reasonable conditions.145. CONCLUDING REMARKSWe have shown in our paper that FDI results in fall in unemployment reduce. It may reduceskilled unskilled wage inequality which is against the conventional wisdom. In LatinAmerican countries it has been empirically observed that that globalisation has widened theskilled-unskilled wage gap whereas in the East Asian countries there has been a reduction inthe skilled-unskilled wage gap and it has been mainly due to educational expansion ratherthan globalisation. Our paper shows that unlike East Asian countries, there is a possibility ofreduction in skilled –unskilled wage gap due to globalisation (or more specifically due toinvestment liberalization) rather than educational expansion.Our paper is thus important to the researchers and the policy makers in the sense that it showsa result related to skilled-unskilled wage inequality which is against the conventionalwisdom. Moreover, our paper is an important contribution from the point of view of FDI indeveloping countries in the sense that it reduces the urban unemployment rate. The maincontribution of the present paper is that it takes into account of skilled unskilled wageinequality on one hand and unskilled unemployment of workforce on the other hand. Ourfuture research agenda will be confined to incorporate features like skill formation (theeducational issue) and effects of tariff liberalisation in such a model.