Imperfect Mobility of Labor across Sectors: a Reappraisal of the Balassa-Samuelson Effect

This paper investigates the relative price and relative wage effects of a higher productivity in the traded sector compared with the non traded sector in a two-sector open economy model with imperfect substitutability in hours worked across sectors. The Balassa-Samuelson [1964] model predicts that a rise in the sectoral productivity ratio by 1% raises the relative price of non tradables by 1% while leaving unchanged the non traded wage-traded wage ratio. Applying cointegration methods to a panel of fourteen OECD countries over the period 1970-2007, our estimates show that the relative price rises by only 0.78% while the relative wage falls by 0.27%. Hence, our first set of empirical findings cast doubt on the quantitative predictions of the Balassa-Samuelson model. A second set of empirical findings highlights the role of imperfect labor mobility: interacting the ratio of sectoral labor share-adjusted total factor productivities with an index of labor mobility across sectors, we find that the relative price responds more to a productivity differential between tradables and non tradables while the reaction of the relative wage is more muted as the degree of labor mobility increases. We show that the ability of the two-sector model to account for our evidence quantitatively relies upon two ingredients: i) imperfect mobility of labor across sectors, and ii) physical capital accumulation. Finally, our numerical results are robust to the introduction of i) non-separability in preferences between consumption and labor, and ii) traded investment.