Economic Reform and Labor Unions: A General-Equilibrium Analysis Applied to Bangladesh and Indonesia

Noting the trend toward more independent trade unions in developing countries, this article examines whether the presence of unions strengthens or weakens the benefits to be gained from economic policy reform. We show that the presence of “passive” unions—ones that choose their wage-employment contract given the firm’s cost-minimizing strategy—increases the welfare gains from trade liberalization, because trade reform lowers the wage premium enjoyed by the unionized sector, reducing a distortion in the labor market. These gains are amplified when the unions are “active,” namely, when they negotiate a contract with the firm that is off its labor demand curve. Such a contract results in featherbedding—paying workers more than their marginal product—and trade reform reduces the amount of featherbedding. The policy implication for Bangladesh—a country with strong trade unions and a protected unionized sector—is that the benefits of further trade liberalization may be greater than otherwise predicted. In Indonesia, where both unionization and import tariffs are low, allowing greater independence to unions may preserve flexibility and reward workers better than the current minimum-wage policy.