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Understanding the place premium, or; building the economic intuition behind open borders

There are plenty of misconceptions about the place premium — the arbitrary wage gap between different countries of the world. (The term “place premium” was introduced in a working paper titled The Place Premium: Wage Differences for Identical Workers across the U.S. Border – Working Paper 148 by Michael Clemens, Claudio E. Montenegro, and Lant Pritchett. See also our blog posts that mention the place premium). Some common ones include the mistaken beliefs that estimates of the place premium don’t account for purchasing power, or that the place premium doesn’t adjust for characteristics like job type or labour quality. But even if one avoids these missteps, it can be difficult to grasp the source of the place premium and the intuition around why labour mobility would erode the place premium by increasing real incomes worldwide.

Here’s the classic example of the place premium: the bus driver. You take the bus driver in Yemen and transplant him to the US. Same guy, doing the same job, driving the same bus, even. Just in a different place. You’ve just boosted that Yemeni’s income by about 15 times over, because now he’s ferrying highly-productive Americans instead of relatively unproductive Yemenis. He’s driving them between Boston and New York instead of between Sana’a and Aden. And yes, that 15x multiplier is real — it’s the actual point estimate from the seminal paper on the place premium, calculating the premium between Yemen and the US in terms of real wages, adjusted for all statistically-identifiable characteristics of the worker and the job.

Now, you might contend that the Yemeni bus driver isn’t himself being more productive. After all, he’s doing exactly the same job he was before. The extra income he earns now doesn’t represent any increase in his productivity; it just represents some income he’s siphoned away from Americans, who pay a Yemeni bus driver the wages of an American bus driver, even though he’s plainly less productive than the American who might otherwise drive that bus.

This intuition, I think, is related to why people make a couple of rather unintuitive (to me, anyway) conclusions about the place premium and its implications:

  1. Open borders erodes the place premium primarily, if not only, by redistributing the income of richer people to poorer people. The poor of the world do in fact benefit immensely from migration, but this is not because migration makes them more productive. They simply earn an economic “rent” by taking rich-world wages which are incommensurate with their actual poor-world productivity. World GDP does not actually increase from open borders, and rich-world GDP actually falls.
  2. People in poor countries are poor because they are innately unproductive. This is because of one or both of the following:
    1. Levels of productivity are endogenous to you as an individual, not the society you happen to be in. The value of your work is determined by you and you alone, not the society you live in.
    2. Levels of productivity are endogenous to your country of origin. The value of your work is determined by some combination of your personal qualities and the institutions you grew up in. The society you live in has little to no impact on your productivity.

These claims are incredibly unintuitive to me, because even if they might be true to some degree, there isn’t any economic theory or data to support the strong claim that where you live has no impact on productivity. The very fact that economists who study labour mobility consistently conclude that the gains from open borders would roughly double world GDP means that these conclusions are wrong. Moreover, there are plenty of reasons why your intuitions about the relationship between your environment and your productivity ought to run the exact opposite way.

If you lived in a society currently facing a civil war, or a natural disaster, you would be incredibly unproductive. An engineer isn’t of much use in a famine-ridden country; he has to spend most of his time looking for food, instead of designing bridges. The claim that the society you live in has no impact on your productivity is totally unintuitive; of course the engineer becomes less productive if you take him from his comfy home in an OECD country and plop him into somewhere like Somalia or the Congo. So vice-versa, if you find an engineer in Somalia or the Congo, and you take him with you to somewhere like France or Italy, you’ve immediately increased his productivity. He spends less time figuring out how to get food and shelter, and more time figuring out how to build bridges.

You might protest that this is a high-skilled immigrant, so let’s go back to the bus driver. Exactly the same intuition applies. Take an American bus driver and drop him down in Yemen. Would he still really deserve his American wages in Yemen? Sure, it’s no fault of his own that we’ve forced him to live and work in Yemen instead of the US. But the fact is that the Yemenis he’ll be driving around are less productive than his old American passengers. He used to drive software engineers and Starbucks baristas (you laugh, but baristas save productive doctors and executives plenty of time and money) in the US; in Yemen, he drives shepherds and hotel cooks. Given that the entire productivity of being a bus driver comes from ferrying valuable people around, it’s unsurprising that when the economic productivity of the people he transport drops, his productivity drops as well. So vice-versa, taking a Yemeni bus driver and giving him a bus in the US to drive makes him incredibly more productive. He used to support a small, relatively undeveloped economy; now he supports a much more prosperous economy. His taking that American job has directly lowered the transportation costs for quite a few highly-productive people.

You might protest that while this is true at the individual level, you couldn’t simply take every person from Yemen and put them in the US and expect to achieve the same result. You’d be right, which is why nobody that I know of seriously suggests forcing poor people to immigrate to the rich world. It’s the people who have a lot to gain from immigration — those whose potential productivity means they can reasonably expect a substantial wage hike from moving to a better society even just doing the same work they’re used to doing — that will migrate. People who aren’t productive enough to justify the large financial and non-financial costs of moving simply won’t move. Unless you subsidise migration, you won’t see unproductive people swarming highly-productive societies.

Still, on one level, it can seem intuitive to say that if you’re doing exactly the same job in two different places, your productivity doesn’t matter: you should earn the same wage for the same work wherever you are. But that’s actually incredibly unintuitive. Even if you’re just a farmer, your crop yields depend on where you are. If you can buy or rent land elsewhere that is more fertile, you can do the identical job on that piece of land and immediately become more productive. And that’s just the simplest scenario. If you’re a machinist, you are more productive working in a society with a functioning power supply than you are working in a society with frequent blackouts. If you’re a hairdresser, you are more productive working in a society where your clients are corporate executives instead of a society where your clients are subsistence wage-earners — because even if you save your clients exactly the same amount of time and effort, in one society your clients’ time is worth a lot, and in the other it is worth little.

It might be intuitive to conclude that open borders is simply redistribution, allowing unproductive people to claim wages meant for highly-productive people. But some basic economics suggests this can’t be true. If a Yemeni bus driver is 15 times less productive than a US bus driver, he basically will get his passengers lost or injured so often that the only way his employer can find it profitable to keep him on staff is if they slash his wages down to the levels he earned in Yemen — if they slash his high-productivity wages by 15 times. Something has to give: either he has to be productive enough to merit higher wages, or he has to go back to Yemen and back to his old job. Otherwise, he ends up jobless and destitute in the US.

Having travelled on public transport in different countries, I could swallow the claim that a bus driver from a poor country is only half as productive as a bus driver from a rich country (because of poorer driving habits, etc.), though I’d still be skeptical of it. But I’ve never met a bus or taxi driver who is so thoroughly incompetent that I would deem his driving skills worth 1/5th or 1/10th of his professional counterparts whom I’ve encountered in the rich world.

The place premium doesn’t actually mean all the gaps we see between rich and poor countries would disappear under open borders. Even in jurisdictions with open borders, such as between Guam or Puerto Rico and the mainland US, we observe a place premium where it seems the American bus driver earns 25% to 40% more than his statistically-identical counterpart in Guam or Puerto Rico. That probably is explained by true productivity differences (though some of it might also stem from xenophobia or other reasons making it difficult for a bus driver in Guam or Puerto Rico to undercut a bus driver on the mainland). But nowhere in the history of the world have wage gaps as big as the ones we see internationally today been observed. We can quite surely say that most of the place premium comes from arbitrarily coercing otherwise productive people into staying in unproductive regions or societies.

The intuition behind this is clear: your productivity does in fact depend on where you are. You produce more living in Australia than you do in Antarctica for a reason — just as you produce more living in South Africa than in Zimbabwe for a reason. Whether it’s a better geophysical climate or a better political climate, some places just make us more productive citizens and human beings than other places do. We need a damn good reason to arbitrarily force people to stay unproductive — especially when it means consigning them to a life of grinding poverty that would shock just about anyone reading these words.

The photograph featured in the header of this post depicts Italian immigrants laying tram tracks in Springfield, Massachusetts circa 1900.

John Lee is an administrator of the Open Borders website. Liberal immigration laws are a personal passion for him. See all blog posts by John.

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3 thoughts on “Understanding the place premium, or; building the economic intuition behind open borders”

  1. Interesting post.

    Productivity is a huge component of poverty, but it is easily misunderstood. One thing that is often overlooked is that productivity depends on the value of what you are creating. Value in the economy is determined by supply and demand (for the final product and for the labor).

    Putting aside the fact that the US has a minimum wage, I think the big reason workers in the US are more productive is that we have a higher demand for labor and a lower supply. In fact, we have a massive chronic labor shortage (to the extent that the idea of a labor shortage makes sense).

    The bus driver in the US is a component of the productivity of all the people he busses around, and they are willing to pay drivers a lot because they are doing really productive things and there are not a whole lot of people willing to do what he is doing for much less.

    So if we have such a massive labor shortage, why the unemployment rate? I would say two reasons. First, we have a minimum wage and unemployment insurance. Second, workers in the US tend to have a much higher reserve wage than in Yemen.

    When we have a sudden shock to the economy, we can’t simply adjust immediately to really low reserve wages and an economy that is ready to employ people with really low reserve wages.

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