Complements or substitutes? Labor market effects of foreign inputs in developing economies

Abstract

This paper examines how import liberalization affects labor markets when labor and intermediate inputs can be complements or substitutes. We embed a constant-elasticity-of-substitution production function in a dynamic trade model, showing that labor market responses depend on sector-specific substitution elasticities. Empirically, we exploit tariff reductions in Colombia using a difference-in-differences design that decomposes trade shocks into import-competition and input channels. Import competition reduces the wage bill, while cheaper intermediate inputs increase it; these gains are driven by services, are imprecisely estimated in manufacturing, and reverse in agriculture. Combining the model with reduced-form estimates, we use indirect inference to recover sector-specific elasticities. We find substitution between labor and intermediates in agriculture and manufacturing, but complementarity in services. Allowing for this flexibility relative to a Cobb–Douglas benchmark amplifies worker reallocation toward services and away from agriculture. It also increases welfare in services and reduces it in manufacturing and agriculture.