This question is related to the findings in the following paper:

McCaig, Brian and Nina Pavcnik. (2018) “Export Markets and Labor Allocation in a Low-Income Country.” American Economic Review, 108(7): 1899–1941.

An excerpt of the abstract is copied below:

We study the effects of a positive export shock on labor allocation between the informal, microenterprise sector and the formal firm sector in a low-income country. The United States-Vietnam Bilateral Trade Agreement led to large reductions in US tariffs on Vietnamese exports. We find that the share of manufacturing workers in Vietnam in the formal sector increased by 5 percentage points in response to the US tariff reductions. ... We estimate the gap in labor productivity within manufacturing across the informal and formal sectors. This gap and the aggregate labor productivity gain from the export-induced reallocation of workers across the two sectors are reduced when we account for worker heterogeneity, measurement error, and differences in labor intensity of production.

Assume that the United States is a large country and answer the following:

(a) Explain what most-favoured-nation (MFN) tariffs mean. Demonstrate the welfare effects of large reductions in US tariffs on Vietnamese exports in the United States. (max. 300 words; 10 points)

(b) Suppose the United States always maximises social welfare, without considering any political economy motives. What would explain that the United States had signed a bilateral trade agreement with Vietnam? (max. 300 words; 10 points)

(c) Panel B of Table 2 in McCaig and Pavcnik (2018) showed that the aggregate decline of employment in household businesses can be explained by both between-industries (48%) and within-industries (52%) margins. Would we expect this split with the Heckscher-Ohlin model? Why or why not? (max. 250 words; 8 points)

(d) McCaig and Pavcnik (2018) also found that aggregate productivity improvements in Vietnamese manufacturing sector can be attributed by the reallocation of workers towards more productive firms. How can we explain that? (max. 300 words; 10 points)

(e) The central message of the paper is that trade liberalisation in Vietnam shifts workers from the informal sector (household enterprises) to the former sector (manufacturing), and it leads to a labour productivity gain in the short-run. With this in mind, what do you think labour productivity would change in the long-run? (max. 350 words; 12 points)

Answer to Question part (a)

The “Most Favored Nation” (MFN) or “MFN” rates are the tariffs that countries promise to impose on imports from other members of the World Trade Organisation unless the country is part of a preferential trade agreement. That means it receives the lowest tariffs, the fewest trade barriers, and the highest import quotas (or none at all). In effect, MFN rates are the highest (most restrictive) that WTO members charge one another.

A most-favored-nation (MFN) clause requires a country to provide any concessions, privileges, or immunities granted to one nation in a trade agreement to all other World Trade Organization member countries.

The most-favored-nation clause in two countries' free trade agreements confers that status. It means that interest rates on a subsequent loan won't be lower than on the primary one. The MFN clause is also used in loan agreements and commercial transactions. It means the seller won't offer a better deal to another buyer. In the U.S. the term "permanent normal trade relations" is used to refer to a country with MFN status.

In the U.S., it's more common to hear the term "permanent normal trade relations." This is simply another way to refer to a country with MFN status.

The welfare effects of large reductions in US tariffs on Vietnamese being a smaller and developing country are:

1. Vietnam receives the benefits of economies of scale because MFN lowers the cost of their exports since it lowers trade barriers as much as possible. That help increases their exports and their country's economic growth.

2. Vietnamese products become more competitive and businesses have more opportunities for growth.

3. MFN gives Vietnam access to the larger market.

Answer to Question part (b)

Granting MFN status to Vietnam causes tariff reductions. The tariff reductions on Vietnamese goods are expected to give the American consumer access to quality products at relatively low prices and enhance a mutually beneficial trade relationship with the rapidly developing economies.

By granting MFN status to Vietnam, the United States also gains from improved resource allocation, although some of the gains are offset by deterioration in its terms of trade.

Granting MFN status to Vietnam would improve Vietnam’s terms of trade and help improve the efficiency of resource allocation in Vietnam. Better market access would increase both the volume of Vietnamese exports to the United states and the prices received for them, while reducing their costs to U.S. users.

The study of Fukase and Martin using computable general equilibrium model suggest that Vietnam’s exports to the United States would more than double after a change to MFN status.

Lowering these high tariffs would improve U.S. consumer welfare by lowering prices, and increasing the volume of imports from Vietnam. The direct welfare gains in the United States are estimated to be significant. There are likely to be significant additional gains to both countries from the liberalization Vietnam will undertake as a result of the negotiations for MFN status and entry into the World Trade Organization

Global Trade Analysis (GTAP) model. The results revealed that the increased market access to the United States brings significant welfare gains to Vietnam.

The above   point to substantial benefits to both Vietnam and the United States.

Answer to Question part (c)

In the Heckscher-Ohlin (H-O) model, it is defined the ratio of the quantity of capital to the quantity of labor used in a production process as the capital-labor ratio capital-labor ratio indicative of Capital intensive and labor intensive.

The realistic characteristic of the world is that countries have different quantities—endowments—of capital and labor available for use in the production process. Thus, some countries like the United States are well endowed with physical capital relative to their labor force. In contrast, many less-developed countries like the Vietnam have much less physical capital but are well endowed with large labor forces. We use the ratio of the aggregate endowment of capital to the aggregate endowment of labor to define relative factor abundancy between countries. Thus if, for example, the United States has a larger ratio of aggregate capital per unit of labor than Vietnam’s ratio, we would say that the United States is capital abundant relative to Vietnam. By implication, Vietnam would have a larger ratio of aggregate labor per unit of capital and thus Vietnam would be labor abundant relative to the United States.

The H-O model assumes that the only differences between countries are these variations in the relative endowments of factors of production. It shows that (1) trade will occur, (2) trade will be nationally advantageous, and (3) trade will have characterizable effects on prices, wages, and rents when the nations differ in their relative factor endowments and when different industries use factors in different proportions.

Answer to Question part (d)

The reallocation was greater for workers in more internationally integrated provinces and for younger cohorts. We estimate the gap in labor productivity within manufacturing across the informal and formal sectors. This gap and the aggregate labor productivity gain from the export-induced reallocation of workers across the two sectors are reduced when we account for worker heterogeneity, measurement error, and differences in labor intensity of production.

McCaig and Pavcnik also found that the reallocation of labor from household businesses to employers in the enterprise sector provides an important margin of adjustment to new exporting opportunities. The estimated magnitudes imply that expanded export opportunities increased employment in the enterprise sector in manufacturing by 15% during the period of the study. The aggregate share of workers in household businesses declined in Vietnam during the early 2000s, with approximately half of this decline attributed to the reallocation of labor from household businesses to employers in the enterprise sector within industries. The within-industry component is particularly pronounced in manufacturing. Importantly, workers in industries that experience larger declines in tariffs on Vietnamese exports to the U.S. observe a greater decrease in household business employment. Their findings are robust to several robustness and falsification checks. The findings do not reflect pre-existing or concurrent global demand shocks affecting Vietnamese products and we find no effects of the Bilateral Trade Agreement (BTA) prior to its implementation. Moreover, the results are robust to controls for sorting of workers that differ in observable and time-invariant unobservable worker characteristics.

Answer to Question part (e)

McCaig and Pavcnik studied the impact of Viet Nam’s exports on informality. They find that, individuals moved from employment in small, informal enterprises to employment in large, formal firms. Over the first 2 years after the start of the bilateral trade. They also find that industries with bigger US tariff cuts experience larger reductions in informality. This movement contributes to aggregate productivity growth of about 1.5%–2.8% annually and economic development.

They find that not all individuals are affected equally by exporting opportunities. Individuals living in more internationally integrated provinces and younger workers are more likely to reallocate from household businesses toward employers in the enterprise sector in response to lower export costs. This heterogeneity is consistent with lower adjustment costs to trade shocks among the young and with lower geographic trade costs. Their analysis, most generally, suggests that demand-side policies such as declines in export costs, which are expected to disproportionately benefit initially more productive firms provide a potentially important policy impetus for the relative contraction of employment in the less productive household-business sector and expansion of jobs in the registered enterprise sector in low-income countries. Existing trade literature has found limited or no industry employment adjustment in response to tariff declines in the short run. The inclusion of workers in the household business sector in the analysis provides new insights on this employment response. Their study does not find shifts in the structure of total industry employment with declines in export costs. However, employment shifts toward industries with greater declines in export costs among Vietnamese employers in the enterprise sector, a sector with employers most directly impacted by the agreement. Their analysis includes data on employers in both sectors, shows that this expansion of the employment in the formal sector occurs through the reallocation of workers previously employed in household businesses (rather than from out of the workforce or unemployed). Analysis covering only formal enterprise sector could not detect such reallocation.