The very low levels of wages and labor compensation common in emerging economies typically evoke two types of reaction in advanced countries. First, workers in developed countries worry that the huge gap in wage levels will cause their jobs to be sent offshore. Second, investors become excited at the seemingly unlimited opportunity to enjoy this cost advantage.

Both of these reactions are not only one-sided, but also, to a large extent, untrue. Pundits have written reams about the risks of job losses due to outsourcing. Yes, some low-skilled jobs are disappearing. But provided that advanced countries upgrade their economies to become more knowledge-intensive, further open their markets to produce and consume services, and modernize education to improve the human capital of the future workforce, they should be well equipped to play their own role in the value chain.

The other response—to cheer the low wages in Asia, South America and maybe even Africa—proves equally unjustified. A comparison of seven emerging economies shows that none pays over 15 percent of the U.S. level of labor compensation. On average, manufacturing sectors in the Czech Republic, Hungary, Poland and Mexico pay between 10 and 15 percent of wages offered in the United States. In Turkey, the number is closer to 5 percent. The manufacturing sectors in India and China pay an average of 2.5 to 3 percent of the U.S. compensation level. Large variations exist within countries, of course. Global companies are more likely to pay much higher wages than domestically owned plants in emerging economies. Vast differences also exist among industries and product groups. Still, the labor compensation gap is so large that, even with rapid wage increases, emerging economies will not lose their cost advantages for decades.

Productivity Pitfalls
But here is the snag: Wages do not show the entire picture of competitiveness. The important question is this: Why is compensation for labor in China and India so low in the first place? Because the skill levels of workers are lower, they use less machinery and technology, and firms in these countries have not adopted the best practices known around the world. In other words, wages are low because productivity is low. When workers produce little per capita, they also get paid less. Therefore, a better competitiveness indicator is one that takes into account wages and productivity. This measure is called the labor cost per unit of output, or the labor compensation gap adjusted for the productivity gap. The size of the unit labor cost gap depends on how these two gaps compare. Generally, the productivity gap for emerging economies is smaller than the wage gap. Companies in emerging economies operate at a low wage cost given the labor intensive character of the economy, but at the same time can benefit from better use of technologies due to their exposure to international competition.

But there are important differences across countries. As noted, China’s and India’s manufacturing industries have been successful in keeping compensation at the lowest possible levels. Granted, productivity is also far below the U.S. level. Nevertheless, productivity levels exceed compensation levels by a considerable margin. As a consequence, unit labor costs in China and India are, on average, 20 percent of unit labor costs in the U.S. This makes them, by far, the most competitive manufacturing nations in our sample. At the other extreme is Mexico, which had labor costs of 11 percent of U.S. levels in 2002. But this was matched by a similarly large productivity gap. As a result, unit labor costs are, surprisingly, almost equal to those in the United States.

The critical lesson for businesses in developed countries is clear: Firms that may benefit from one-time labor cost advantages when they invest in low-wage countries should be aware that wages will eventually rise, and might rise quickly. When they do, these countries must offer new technology or organizational tactics that will make these workers more productive—otherwise, the cost advantages gained by locating business in such countries will erode. This lesson forces government and business to focus on exploiting knowledge creation as a means to stay at the productivity frontier, not only at home, but also abroad, and to avoid a race to the bottom in terms of cost competition. These changes will create a win-win situation in international competition and ultimately make everyone better off.

Bart van Ark is director of international economic research at the Conference Board and a professor of economic development at the University of Groningen in the Netherlands.