On (Im)Perfect Subsitution

Another Econ 101 mistake people make, especially with regard to immigration and international trade, is some form of “foreigners (immigrants) can do all the work we do but for much lower prices!  Without subsidies/tariffs/minimum wage, they’re just going to take all our jobs!”  Other versions of this include “if a bunch of immigrants enter the nation, they’ll drive down wages!  Law of Supply and Demand!”

Both the above arguments make the same mistake, namely they assume foreign labor is a perfect substitute for domestic labor.  They treat all labor (or all low-skilled labor) as a homogeneous blob, one part easily replaceable with another.  But, alas, that is not the case, as price theory can show us.

Looking simply at the wages of laborers, we should ask the question “why do immigrants/foreigners command lower prices than domestic workers?” The fact that there hasn’t been wholesale replacement of domestic labor with foreign means we can rule out any cultural/biological/cost-of-living reasons such as “lower cost of living in 3rd world” or “they have a lower standard of life and thus demand lower pay” etc.  If this were indeed the case, domestic companies could just pack everything up and ship it overseas (that is, stuff that can’t be staffed by immigrants) and make tons of profits (while I have no doubt some people believe that is what is happening, the data say otherwise).

What’s more likely is that foreign workers and immigrants are simply less productive than domestic workers.  Immigrants coming into the country, legal or otherwise, face major barriers, not the least of which is the language barrier.  The manager at McDonalds cannot simply fire an American order-taker making minimum wage and hire a foreign worker for half the cost. The foreigner, simply by virtue of not knowing the language, will be less productive, thus his lower salary.  A similar argument for offshoring can be made: foreign workers, by virtue of less capital augmentation, will be less productive and thus command lower salaries.

In short, foreign workers/immigrants are not perfect substitutions for domestic labor!

It may make sense for some firms to replace/augment domestic labor with foreign labor, but the mere fact it is cheaper is not the reason why.  David Ricardo’s powerful idea shows there are times it is prudent to replace more productive resources with less productive resources, but to do so on a large scale with disregard to opportunity cost is a recipe for disaster, and why firms and individuals do not do it.

4 thoughts on “On (Im)Perfect Subsitution

  1. Jon, this is an excellent post! I have been surprised by the many commenters who have fallen for the emotionally popular, but incorrect, view that all jobs can be outsourced to India or immigrants from Mexico are going to take them all. Thanks for keeping things intellectually honest and for mentioning David Ricardo’s ideas about comparative advantage. Don Boudreaux had it right when he said that you have to repeat the lessons of basic economics all the time because falling for these incorrect, emotion-laden ideas happens all too frequently.

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  2. It doesn’t matter at all they they aren’t perfect substitutes. No two goods are ever perfect substitutes for one another. (If they were then they wouldn’t actually be two different goods by definition). Different goods can be substitutes for one another without being perfect substitutes.

    Any time a lower priced substitute for a good enters the market (even if it ‘s not a perfect substitute), it will put downward pressure on the price of that good and will be substituted to some degree by buyers. There is absolutely no need for them to be PERFECT substitutes in order for some substitution to occur. But then, no one is even actually claims that they are perfect substitutes anyway, so this whole post is kind of a strawman right form the get go.

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    • No. The vast majority of immigrants do not know the language or the customs necessary to make their labor worthwhile for many employers. You are right in saying that substitutes do not have to be perfect, but when dealing with human beings, they need to understand the language, know the customs, be able to drive and have reliable transportation, etc.

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