Journal of Development Economics Vol. 68 (2002) 137 156 www.elsevier.

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Will trade sanctions reduce child labour? The role of credit markets
Saqib Jafarey a, Sajal Lahiri b,*
a

Department of Economics and Accounting, University of Liverpool, Liverpool L69 7ZA, UK b Department of Economics, University of Essex, Colchester CO4 3SQ, UK Received 30 September 2000; accepted 30 June 2001

Abstract We examine the interaction between credit markets, trade sanctions and the incidence of child labour in a two-good, two-period model with unequally wealthy households. Both poverty and poor education quality, inter alia, are important determinants of child labour. The incidence of child labour decreases as we move from the case of borrowing constraints to the case in which poor households can borrow freely from rich ones and then to the case of perfect international credit markets. Trade sanctions can increase child labour, especially among poor households, a possibility that decreases as their access to credit improves. D 2002 Elsevier Science B.V. All rights reserved.
JEL classification: O10; O16; F16 Keywords: Child labour; Education; Skill; Borrowing; Lending; Trade sanction

1. Introduction There are about 120 million full-time and another 130 million part-time child labourers in the world (see Ashagrie, 1993; Grootaert and Kanbur, 1995; ILO, 1996).1 Child labour is not a new phenomenon and there is a substantial literature dealing with it albeit with a focus that has shifted over the years (see Basu, 1999 for an extensive survey).2 The theoretical and empirical (micro-econometric) studies that have resurfaced with a vengeance in recent years have focused directly on the issue of child labour and on policies for
Corresponding author. Fax: +44-1206-8727-24. E-mail addresses: sjafarey@liverpool.ac.uk (S. Jafarey), lahiri@essex.ac.uk (S. Lahiri). 1 According to ILO convention, a person of age less than 15 years of age is treated as a child, and a child is deemed economically active if he or she does work on a regular basis for which he or she is remunerated or which results in output which reaches a market (see Basu, 1999, p. 1085). 2 For example, the classic study by Cain (1977) for the village Char Gopalpur in Bangladesh was an attempt to explain high fertility rates among the poor families of that village. 0304-3878/02/$ - see front matter D 2002 Elsevier Science B.V. All rights reserved. PII: S 0 3 0 4 - 3 8 7 8 ( 0 2 ) 0 0 0 0 9 - 3
*

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dealing with it.3 This is somewhat surprising as, although the absolute number of child workers is quite high, the participation rate of children has in fact been declining quite steadily. Over the last 45 years or so, participation rates among children aged 10 14 years have come down from about 27% to 13% (see ILO, 1996). One reason why in recent years there has been an increase in concern over child workers while the problem itself has steadily declined is the globalisation of the international economy and, in particular, agreements reached at the Uruguay Round of the GATT. It is possible that protectionist forces are hijacking the genuine concerns of the altruistic individuals. The increase in academic research on the subject is to a great extent a reaction to efforts by the United States of America and the European Union to addallegedly after intense lobbying from the protectionist forcesinternational labour standards and a social clause in the World Trade Organisation charter (see Bhagwati, 1995; Fields, 1994; Maskus and Holman, 1996; Rodrik, 1996; Srinivasan, 1996; Basu, 1999). Researchers are concerned that, in the absence of proper research and analysis, pressure groups in developed countries might force through policy measures not properly thought through. In fact, trade instruments are already being used extensively, albeit informally. For example, in the United Kingdom, several NGOs are involved in the naming and shaming of stores that sell products produced in the developing countries with the use of child labour. It is therefore important to have a close look at trade sanctions as a means of reducing child labour. Empirical studies point to two broad reasons for why children work. First, because of abject poverty, many households find it necessary to send their children to work, and thereby, stop them from receiving education (see Bhalotra, 1999; Ray, 1999 for empirical evidence). Second, there is very strong empirical evidence that the rate of return to basic, primary-level education as provided to poor children in many developing countries is very low, not only because of high rates of time discount but also due to the poor quality of education.4 That in such situations, poor families sending any child to school must be a testimony to the fact that those poor families gain some satisfaction purely from educating their children.5
Some of the theoretical contributions are from Basu and Van (1998), Basu (2000), Baland and Robinson (2000), Dessy (2000) and Ranjan (1999, 2001). Micro-econometric studies include the works of Bhalotra (1999), Cockburn (2000), Emerson and de Souza (2000), Ilahi (1999), Ravallion and Wodon (2000) and Ray (1999, 2000). 4 The rate of return to education is defined as the ratio of additional income to income foregone. It has been estimated that primary education in India raises future wage rates by factors of about 20 100% (see The Probe team, 1999, p. 21). If we assume that primary education lasts for 5 years and the higher wages are received over an indefinite time period after the completion of primary education, then it is easy to show that education will be profitable from a purely pecuniary point of view if and only if the discount rate, r, and the wage premium, wp, satisfy the following inequality: r V (1 + wp)0.2 1. Hence, if the wage premium is 20%, the discount rate has to be less than 3.7% to make education profitable. Even if the wage premium is 100%, a discount factor of less than 14.9% is required to make education profitable. Saha and Sarkar (1999) and Cohen and House (1994) provided additional evidence supporting low rates of return on primary education in individual developing countries. On the other hand, effective interest rates (including implicit charges) facing poor borrowers in many developing countries can vary from 16% to over 200% (see Basu, 1997, p. 267). Ray (2000) has found a significant negative relationship between the supply of child labour and quality of schooling in Ghana. 5 A recent survey conducted in Indian villages found that economic motives are not the only reasons why poor families want their children to go to school (see The Probe team, 1999, Chaps. 2 and 3).
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In addition, since decisions on child labour are inherently intertemporal ones, credit markets play a significant role in influencing them. Even if returns to education were significantly high, sending a child to school instead of to work entails a sacrifice of current income in favour of future earnings. If the family has access to credit at reasonable terms, then it may not have to forego present consumption significantly, and the decision to send a child to school may not be a painful one. The working of credit markets should therefore be an important element in the analysis of child labour.6 Given the facts, as outlined above, we develop an intertemporal model of child labour versus child education in which low value-added of schooling, subjective parental attitudes towards education and the nature of credit markets all play a role. To be precise, we develop a two-period, two-good model in which there are two types of families: rich and poor. Each family decides how many of its children should go to school in the first period. The children who do not go to school, work and receive income.7 By going to school, a child becomes skilled and earns a higher wage in the second period. The purpose of the paper is two-fold. First, we consider the child labour decisions taken in equilibrium by poor households. Second, we consider the effects of a trade sanction against child labour products on these decisions. The intertemporal nature of decision-making means that child labour will not only be directly affected by credit markets, but also be affected via the response of credit market outcomes to trade sanctions. We account for the role of credit markets by studying the results for both exercises from three alternative credit market scenarios. The three scenarios are: (i) all households can borrow or lend freely in a perfect international capital market at an exogenous interest rate (the country is small); (ii) borrowing is subject to quantitative restrictions; (iii) all households can participate in a domestic credit market, but cannot borrow from or invest in foreign capital markets. The first case represents the first-best scenario in which credit markets are perfect globally. While far from realistic, it represents a benchmark for policy makers at the international level to aspire to. It will also serve as a stepping stone for the analysis of the other two cases. The case of quantity-constrained borrowing is more realistic, since it depicts a situation in which poor borrowers in developing countries lack easy access to credit markets.8 The third scenario represents a goal which domestic policy makers should aspire to. Moreover, evidence suggests that credit opportunities in rural parts of the developing world take the form of informal loans from rich to poor households (see
6 In the 1982 Annual Report, the International Fund for Agricultural Development (IFAD) states: Credit is the most important single weapon against poverty. 7 In reality, there is often a third possibility, viz. leisure (see Ravallion and Wodon, 2000 for evidence from Bangladesh). However, others have found a negative correlation between child labour and school enrollment (see ` ze and Gandhi-Kingdon, 2001). Dre 8 The supply of credit in the developing countries is typically subject to restrictions. Policies such as government-imposed interest rate ceilings, which were a common phenomenon until fairly recently, have discouraged the growth of a commercial banking network that could intermediate funds between the ultimate lenders and poor borrowers, especially those living in the rural areas (see, for example, Gillis et al., 1996, for a discussion of this and other factors). Such supply-side inadequacies can lead to quantitative rationing even if it is not optimal for lenders. In addition, moral hazard and adverse selection, which can independently generate credit rationing as an optimal response by lenders (see, for example, Stiglitz and Weiss, 1981), are likely to be more severe in poorer countries, where the relative cost of gathering information is likely to be higher. Our concern is not with the reasons for such rationing to exist, but with its implications for education and child labour.

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Besley, 1995). In this sense, the third case possibly comes closest to reality, although we formally consider the normative benchmark of a perfectly competitive domestic credit market while the reality might include various imperfections and monopolistic practises.9 On the nature of equilibrium, we show that the incidence of child labour is likely to fall as borrowing opportunities improve, from binding borrowing constraints to a domestic loan market in which the poor can freely borrow from the rich to a world capital market on which the country can freely borrow. On the effects of trade sanctions on child labour, we break them down into three components: (a) a substitution effect, i.e. a reduction in the opportunity cost of sending a child to school, (b) an income effect, i.e. a reduction in the parents marginal utility from educating children, and (c) a discount rate effect which affects the present value of the wage premium from attending school. The first effect encourages schooling while the second discourages it. While both of these are independent of the exact credit scenario, the third effect is crucially dependent on it. Clearly, this effect is absent under a perfect international credit market (scenario (i)). However, it unambiguously discourages schooling under a binding borrowing constraint (scenario (ii)) and, with plausible restrictions, also discourages schooling under a domestic credit market (scenario (iii)), but by less than under borrowing constraints. Overall then, a trade sanction can induce a perverse effect on child labour (via the negative income effect) even in the first-best case of perfect access to world capital markets, but the possibility of a perverse effect rises (due to the additional discount rate effect) as access to credit weakens. The notion that credit opportunities may influence child labour has also been pursued by other authors. Jacoby and Skoufias (1997) argued that while trading on Arrow-Debreu markets might allow households to perfectly smooth consumption in the face of uncertain income, financial autarky, at the other extreme, would lead them to use child labour as an instrument of self-insurance.10 These authors, however, do not study the role of trade policy in influencing child labour, nor do they examine the interaction of policy instruments with domestic credit markets. In a paper which analyses the dynamics of long-run wealth distributions and the incidence of child labour, Ranjan (2001) has established the possibility that trade sanctions may not always reduce the incidence of child labour. Ranjan (2001) is therefore the first to suggest that negative income effects consequent upon trade sanctions may discourage families from seeking greater education for their children. His analysis, however, stops short of establishing that trade sanctions can actually increase child labour. Secondly, in Ranjan (2001), the framework is such that household decisions on child education are based solely on pecuniary factors. This implies that under perfect access to credit, households will either send all children to school or none, and there will be no marginal impact of trade sanctions. In our analysis, subjective parental attitudes play a role in addition to pecuniary factors, implying not only that child labour and education can coexist under perfect credit markets, but also that trade sanctions can have counter-productive income effects even in this case. Finally, our analysis studies the general equilibrium effects that can affect child labour in a domestic credit market based on heterogeneous households, a scenario which is not considered by Ranjan (2001).
None of the qualitative results would change if the domestic credit market was assumed to be monopolistic on the supply side. See footnote 25. 10 For some empirical evidence related to this argument, see Ilahi (1999).
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The model is spelt out in Section 2. Section 3 examines how the working of credit markets affects the incidence of child labour. Section 4 examines the effects of trade sanction on child labour under the two scenarios about the credit market. Section 5 concludes.

2. The basic framework of analysis We consider a small open economy. It has a two-period horizon, indexed by t = 1 and 2, respectively. The economy produces two goods per period. Goods labelled 1 and 2 are produced during t = 1 while goods labelled 3 and 4 are produced during t = 2. Pi denotes the world price of good i (i = 1, 2, 3, 4). Choosing good 1 as the numeraire, we set P1 = 1. Goods are produced with fixed-coefficient technologies in which labour is the only input. Workers are either skilled or unskilled and cannot substitute for each other in production.11 Goods 1 and 3 are produced by skilled labour, goods 2 and 4 by unskilled. Units are normalised so that one unit of each good requires one unit of the relevant labour. Perfect competition in production ensures that workers are paid their marginal revenue product; hence, the wage rate of skilled workers is P1 = 1 at t = 1 and P3 at t = 2; the corresponding wage rates of unskilled workers are P2 and P4. Skilled workers receive higher wages than unskilled ones, so 1 z P2, P3 z P4. In each period, the economy is a net exporter of the good produced by unskilled workers.12 The economy is made up of a collection of households, each headed by a single parent. The parent in each household may be either skilled or unskilled, a status which is exogenous. Accordingly, two classes of households exist: rich and poor, with the former headed by skilled parents and the latter by unskilled ones. Whenever necessary, rich and poor households will be indexed by superscripts s and u, respectively. Without loss of generality, we assume that there are an identical number, N, of children per household. Each child is born unskilled but can receive training during t = 1. Children who do not receive training work full-time during t = 1 as child labourers and earn P2; upon becoming adults, they remain unskilled and earn P4.13
11 This simplifying assumption can be relaxed without affecting the qualitative results of the paper. See footnote 31 below. 12 One assumption that follows is that children, being unskilled, are only employed in the export sector. In other words, we ignore child labour in other parts of the economy. This simplifying assumption is made to focus our attention on the effects of trade sanctions. Clearly, insofar as trade sanctions have an impact on non-export sectors, this will not involve the direct substitution effect which reduces the opportunity cost of sending a child to school. In this sense, as we shall see, the model is stacked in favour of the effectiveness of trade sanctions in reducing child labour. 13 In the literature on child labour, one finds two approaches to intertemporal modeling. We follow Ranjan (1999) and Baland and Robinson (2000) and consider a two-period model. In contrast, Dessy (2000) and Ranjan (2001) have adopted an overlapping generation framework. As a referee has pointed out, some issues arise explicitly in the OLG framework. For one, while the parent controls the child and decides his educational level when the child is young, once the child grows up, he starts his own household. Unless there is mutual altruism between parents and children, this can lead to parents not fully internalising the future benefits of child education and this alone can contribute to the existence of child labour. Also, fertility decisions could be endogenous and linked across generations, leading, as shown by Dessy (2000), to a vicious circle of low parental income, high fertility and high child labour participation rates.

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Children who receive training at t = 1 do so full-time but become eligible for employment in the skilled-goods sector at t = 2. Upon completing training, each child acquires a skill level equal to that of a skilled adult. The training decision is made for each child by the parent. Each households training decision can be characterised by a fraction, e, with Ne children receiving an education, and N(1 e) having to work as child labourers. Each parents preferences are represented by a utility function over the four consumption goods and a measure of the educational level of children. v wc1 ,c2 ,c3 ,c4 gNe: 1

where v is the utility level, ci is the consumption of good i (i = 1,. . .,4) and e is the proportion of children receiving an education in a household. The goods are assumed to be non-rivalrous within a household, but rivalrous across households. This allows us to abstract from the intra-household distribution of resources.14 The sub-utility functions w and g are both increasing and concave in their respective arguments. The inclusion of education in the utility function can be interpreted as asserting either that parents receive utility from seeing their children educated or that they receive disutility from subjecting their children to labour. The concavity of g with respect to education reflects decreasing marginal utility of education and/or increasing marginal disutility of child labour. The separability of utility between consumption and education is a matter of analytical and expositional convenience. Indeed, some of the main points of this paper could be made more forcefully if, for example, complementarity were to be allowed between education and the consumption of skill-intensive goods (see Appendix E in Jafarey and Lahiri, 1999). Employing the expenditure minimisation approach, the intertemporal budget constraint can be written as: Y N 1 e P 2 Z P3 P4 Ne N 1 e r r r   P3 P4 E P1 ,P2 ; , ,v gNe : r r

The variables not defined previously are: Y, which denotes the parents wage at t = 1. For skilled families, Y is equal to 1 and for unskilled families, it is P2; Z, which denotes the parents wage at t = 2, is P3 for the skilled families and P4 for the unskilled. r is the discount rate.15 E is an expenditure function which increases in all five arguments, has a negative second derivative with respect to the first four arguments and a nonnegative
14 By this abstraction, we do not mean to say that intra-household issues are not relevant for the understanding of child labour. For an analysis of these issues, see, for example, Baland and Robinson (2000) and Basu (1999). 15 It is one plus the interest rate.

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second derivative with respect to the fifth.16 The first and the third terms on the left-hand side give the present value of parents income; the second term is the income of the children; the fourth and the fifth terms are the present value of income by the educated and non-educated children, respectively. The right-hand side is the present value of total family expenditure.17 Throughout the paper, we assume non-increasing marginal utility of income and normality of all goods, i.e. E55 z0, E5i z0, i 1, . . . ,4: 3

We first study each households educational choice as a function of prices and a given discount rate, r. We then study the determination of the discount factor itself. Unless necessary for making comparisons, household indices will be suppressed. Needless to say that actual values of the households choice variable will be different, depending on the differences in household characteristics. Assuming price-taking behaviour for households in a credit market, the optimal choice of education, e, is found by maximising v (for a given r) subject to Eq. (2). Assuming a positive choice of e, the first-order condition is: P3 P4 zP2 , r

E5 gVNe

with a strict inequality if e = 1. E5 is the inverse of the marginal utility of income (shadow price of wealth): it represents the extra income needed to increase utility by one unit. The condition states that given an interior choice, the marginal benefit of more children going to school must equal the marginal cost. An increase in e leads to a marginal utility gain of gV(Ne), resulting in a gain equal to E5gV(Ne) in units of income. It also leads to a direct increase in second-period income by the amount of the skill premium P3 P4, which is then discounted back to period 1. On the other hand, an increase in e results in a loss of first-period income, due to the foregone wages of a child worker, P2. The right-hand side of Eq. (4) represents this cost. An interior choice results only if the discounted pecuniary returns to education are negative. This is balanced at the margin by the subjective utility that parents derive from

The expenditure function represents the minimum level of income or expenditure that can possibly attain a given level of utility. The partial derivative of an expenditure function with respect to the price of a good gives the Hicksian demand for that good. Moreover, the matrix of second-order partial derivatives of the prices is negative semi-definite. For this and other properties of expenditure function, see, for example, Dixit and Norman (1980). 17 ` ze and Gandhi-Kingdon (2001) have shown, there are costs of educating a child other than the As Dre opportunity costs (lost wages) considered here. For expositional simplicity, we have omitted such costs. As long as such costs are exogenous, including them would simply lead to a higher incidence of child labour in equilibrium. The comparisons of the effect of trade sanctions across different credit market scenarios would not be affected.

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having educated children.18 Note that the subjective influence is captured by the term, E5gV(Ne), which represents marginal expenditure on the additional utility that is associated with a small increase in childrens education. Lower parental income implies lower E5 (due to a higher marginal utility of income) and, given identical preferences, poor households will choose a lower e than rich ones.19 For this reason, unless specifically noted otherwise, we shall assume that rich households send all their children to school, while the poor send only a fraction. Given r, Eqs. (2) and (4) jointly determine v and e. In order to study the dependence of e on r (assuming an interior solution), Eqs. (2) and (4) can be totally differentiated for e and v. After the appropriate manipulations, we find dv b dr rE5 de g V P3 E53 P4 E54 rbE55 =E5 P3 P4 , dr r2 N E5 gW gV2 E55 where the borrowing/lending decision of each household may be expressed as: rb Z NeP3 N 1 eP4 P3 E3 P4 E4 , 7 5 6

since Ei = DE/DPi = ci (i = 1,. . .,4) (see footnote 16). Eq. (5) reflects the well-known notion that the welfare of a lender rises and that of a borrower falls with an increase in the interest rate. Given the first assumption in Eq. (3), the denominator of Eq. (6) is negative.20 Under the second assumption, the terms E53 and E54 in the numerator are positive. ( P3 P4) captures the skill premium facing children and is also positive. Hence, b z 0 is a sufficient condition for an increase in the interest rate to lower the educational level. Intuitively, an increase in r reduces the pecuniary returns to education. Also, for given e, it reduces welfare (and raises the marginal utility of income) for a household that borrows. Both of these tend to reduce the marginal benefits of education and induce a lower choice of e. Note that for a lender, the welfare effect of an increase in r is positive and works against the effect of a decline in pecuniary returns to education. This makes it theoretically possible for e to increase with r for a household that lends. However, this

In this respect, perfect credit markets (i.e. an exogenous interest rate) can be consistent with an interior solution for child labour. The possibility that perfect credit markets might coexist with child labour is also present in Parsons and Goldin (1989) and Baland and Robinson (2000). Both papers show that, even if parents are altruistic towards children (but not vice versa), the fact that the former cannot force the latter to help in repaying family debts once they have grown up, means that families might not make full use of borrowing opportunities in order to promote child education even if credit markets were perfect. 19 In reality, there may be other factors pushing educational choice to be greater for rich families. One would be differences in subjective discount rates in scenarios where credit flows are subject to quantity constraints. Another would be that poor families may not have access to the same quality of schooling as rich families. 20 The denominator of Eq. (6), which is negative, guarantees the second-order condition for an optimal choice of e.

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possibility is somewhat irrelevant to our analysis since we focus on households who are likely to be borrowers in the credit market. In order to study the dependence of b on r, Eq. (7) is differentiated: r3 db de r2 N P3 P4 P3 E35 P4 E45 Ng V dr dr 2 3 4 2 b1 cy cy r P3 E33 2P3 P4 E34 P4 2 E44 ,

i ( u PiEi5/(rE5)) is the value of marginal propensity to consume good i (i = 3, 4). where cy The term in square brackets captures the standard income and substitution effects of a 3 4 2 change in r upon b. The income effect is captured by b(1 cy cy )r and is negative 2 for a borrower. The substitution effect is negative if ( P3) E33 + 2P3P4E34+( P4)2E44 < 0, which we henceforth assume.21 In addition, there is an induced effect arising from the effect of an increase in r upon e. An increase in r reduces e and this reduces the demand for loans by a borrower. Hence, starting from an initial equilibrium in which b z 0, db/dr is negative.

3. Credit markets and child labour We consider three different credit market scenarios. Case 1. All households can borrow or lend freely in a perfect credit market, linked to international capital markets, where the interest factor is exogenous and equal to the world interest factor rw , i.e. r rw : Case 2. Borrowing is subject to a quantitative constraint, i.e. bu b: 10 9

Case 3. All households can participate in a domestic credit market, but cannot borrow from or invest in foreign capital markets, i.e. M s bs M u bu 0, where Mh denotes the number of households of type h (h = s, u). In Case 1, the interest rate is exogenously given as rw and the decisions of rich and poor households are entirely independent of each other. We shall concentrate only on those of the latter. Eqs. (2) and (4) determine the education decision and utility level of poor households as functions of the world interest rate, rw , while their borrowing from world markets follows residually from Eq. (7).
21

11

Noting that E3 and E4 are homogeneous of degree zero in the four prices and using Eulers equation, we can write the expression as ( P3/r)(E31 + P2E32) ( P4/r)(E41 + P2E42), which is negative assuming intertemporal substitutability in consumption.

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In Case 2, the discount rate for poor households is influenced by subjective factors along with the quantity constraint on borrowing. It is again independent of rich households. Eqs. (2), (4) and (7) (with the left-hand side set equal to b) jointly determine the educational decision, utility levels and subjective discount rates of poor households. In Case 3, where the two types of households can exchange loans in a perfectly competitive domestic credit market, each households discount rate will equal the equilibrium interest rate, denoted by rc. The general equilibrium of the system is described as follows. Eqs. (2), (4) and (7) applied to poor households determine eu, vu and bu. Eqs. (2) and (7) applied to rich households along with the condition that es = 1 determine vs and bs. The interest rate, rc , is determined by Eq. (11). Fig. 1 below depicts the general equilibrium of the system. The northeast panel depicts the credit market scenario. The locus BB depicts the demand for loans by poor households (M ubu), which is relevant for all credit scenarios. SS depicts the supply of loans by rich

Fig. 1. The equilibria.

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ones (M sbs), relevant for the case of a domestic credit market. Unlike the demand curve, the supply of loans could theoretically bend backwards.22 This possibility is well known and so are its implications.23 Since nothing novel can be added by accommodating it in the present context, we have drawn SS as upward sloping. The northwest panel depicts the relationship between eu and r. Since only the educational choice of poor households is being considered, household superscripts will be suppressed henceforth so that, unless noted otherwise, e will be used when referring to eu. The relationship between e and r is downward sloping as suggested by Eq. (6). The southwest panel, which will be useful in the next section for decomposing the total effects of trade sanctions, shows the (partial equilibrium) combinations of e and bu that coincide at given values of r (locus CC). It therefore combines points from AA and BB. The relationship between e and bu is upward sloping; a decrease in r causes e to increase but also leads to an increase in the demand for credit by the poor. Focusing on the northeast panel, the vertical intercept of BB, the demand for loans by poor households, lies above that of SS, the supply of loans by the rich. These vertical intercepts represent the marginal rates of intertemporal substitution in the case no credit flow takes h u s place. Denoting the latter by ra , h = s, u, the panel depicts the case ra > ra , i.e. the poor are ex ante more impatient so if any credit is allowed, loans will flow from rich to poor.24 This case has interesting policy implications when combined with the educational outcome, es = 1. Such a combination suggests that any attempt by rich households to increase their savings (broadly defined) at t = 1 will be channeled entirely through lending in the credit market, since the alternative asset, i.e. childrens education, cannot be increased. This situation can, as we shall see, help make trade sanctions more effective in reducing child labour among the poor. In the competitive equilibrium, equilibrium is at Ec with an interest rate of rc , a borrowing level, bc and the corresponding educational choice of poor households as depicted in the northwest panel is ec. Fig. 1 can be used to address the question of how educational choice by poor households might be affected by the presence of a borrowing constraint. Consider the case of the constraint, b (Eq. (10); Case 2). This is represented by a line bb in Fig. 1. Obviously, for this constraint, to make a difference, it must be binding, so we assume that b is small relative to bc. In the case of the constraint, the discount rate, u rb , determines educational choice by poor households, which is at eb in the northwest u panel. Hence, given that the constraint binds, rb >rc and eb < ec. Opening a domestic credit

bs < 0 implies that the income effect of an increase in r on savings is negative es = 1 implies that des/dr = 0. Both effects can contribute to making the sign of dbs/dr negative. 23 See, e.g. Romer (1996, p. 75). The main implication is that multiple equilibria may arise, with stable equilibria alternating with unstable ones. The qualitative results of this paper would remain valid for each stable equilibrium. 24 While rich parents have higher incomes than the poor at t = 1, they also have higher incomes at t = 2, hence, the overall effect of parental incomes on autarky discount factors is inconclusive. However, we have abstracted from the non-labour wealth of the two types of households. Adding such wealth, i.e. land, livestock, machinery, s etc., to total resources at t = 1 would make it more likely that ru a >ra.

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market therefore allows the discount rate of poor households to fall and results in a higher educational choice ec.25 Now suppose that, instead of a credit market in which flows are solely domestic, there were an international credit market on which all households could participate. It is reasonable to assume that for a developing country rc z rw . It is clear from Fig. 1 that in this case, we shall have ew z ec.
u >r s Proposition 1. Provided that r a a , equilibrium in a competitive domestic credit market involves borrowing by poor households from skilled ones. If a binding quantity constraint, V bc , were to restrict borrowing by poor households, the educational choices of poor b households would satisfy eb V ec . If, at the other extreme, poor households could directly borrow from the world market at an interest rate, rw , then rw V rc would be a necessary and sufficient condition for ew z ec .26

Heterogeneity is important for credit markets to play a role. If all households were identical, opening a domestic credit market would lead to no actual trade and equilibrium choices would not be affected. While previous work (see, for example, Ranjan, 2001; Galor and Zeira, 1993) has stressed the negative impact of an unequal wealth distribution on education, this argument has been made on the basis of models which rule out domestic credit markets. Our result suggests a somewhat different insight: an unequal wealth distribution creates potential gains from trade due to the different educational investments of households with different levels of parental income; opening a credit market helps realise these gains.27

4. Trade sanctions and child labour Having analysed the equilibrium, in this section, we shall study the effect of a temporary trade sanction on the incidence of child labour. Since the goods produced by unskilled workers are exported, the impact of a trade sanction in the first period would

Instead of a competitive market, one could imagine that, if the rich households were small in number, they would form a cartel and engage in monopoly lending. In this case, the supply curve of loanable funds would s disappear, but so long as r u a >r a , the rich would still lend to the poor along the latters demand curve. The discount rate of the poor would still be lower than under autarky or an appropriately tight borrowing constraint. This suggests that even an imperfectly competitive credit market can help lower the discount rate of poor households (relative to binding quantity constraints), thereby encouraging child education and reducing the incidence of child labour. 26 For the borrowing constraint regime, we derived deb/db (the detailed expression is not reported) and found it to be unambiguously positive for any non-negative value of b. This suggests that, within a borrowing constraint regime, the shadow cost of the constraint in terms of foregone educational choice is strictly positive; a marginal relaxation of the constraint lowers child labour. This is in keeping with the spirit of Proposition 1, which suggests that moving from a borrowing constraint regime to a freer regime lowers child labour. 27 In Jafarey and Lahiri (1999, Appendix A), we have shown that if the preferences are quasi-linear, i.e. there is no income effect, then educational decisions end up being equalised between rich and poor households once a competitive credit market is opened between them.

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Fig. 2. Comparative statics.

entail a reduction in the relative price of the unskilled good, P2.28 Thus, we shall examine the sign of de/dP2. The analysis will proceed by deriving the shifts in the relationships described in Fig. 1. These shifts will be depicted in Fig. 2. The new relationships are identified by, for example, AVAV, BVBV, and so on.

There could be other reasons for a reduction in P2. For example, an exogenous increase in the world supply of good 2 in period 1 would reduce P2. Our analysis therefore applies to all scenarios, and not just trade sanctions, that result in a reduction in P2.

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We assume that the equilibrium value of e is strictly in the interior of the interval [0,1] so that Eq. (4) is satisfied with equality. Totally differentiating Eqs. (2) and (4), we first obtain:29 E5 dv f1 N 1 eg E2 dP2 b=rdr: 12 Since, with es = 1, the skilled families do not produce any of the unskilled good, 1 + N (1 e) is the output of the unskilled good in period 1 per unskilled family, and E2 is its consumption of that good. The economy is also a net exporter of good 2 by assumption. These jointly imply that the coefficient of dP2 in Eq. (12) is positive. That is, a reduction in P2 reduces the welfare of the unskilled family. This effect is akin to the standard temporal terms-of-trade effect in international trade. The second term on the right-hand side of Eq. (12) gives the intertemporal terms-of-trade effect: an increase in the discount rate is bad for a borrower. Turning to the effects on e and b, we get a1 de a2 dP2 a3 dr, rdbu b1 dr b2 de b3 dP2 , 13 14

E52)gV E55[{1 + N(1e)}E2]/E5, r2a3 = where a1= NE5gW+ N( gV)2E55 > 0, a2 = (1gV 2 2 4 gV P3E53 + gV P4E54 + P3P4 > 0, r b1 = ( P3) E332P3P4E34 ( P4)2E44+br2(1c 3 y c y ) > 0, 3 4 b2=N ( P 3P4 +P3 gV E 35+P 4gV E45 )>0, b3=P 3E 32+P 4E 42+r ( cy + cy ) [{1+N (1e)} E2]>0, i where cy = PiEi5/(rE5), as defined before, is the value of marginal propensity to consume good i (i=3, 4). Note that the coefficient of de in Eq. (13) is negative. The first term on the right-hand side of Eq. (13), a2, gives the sum of the price and price-induced income effects, at a given value for the discount rate. A decrease in the price of the exportable, for a given level of real income, reduces the opportunity cost of education (a substitution effect) and therefore increases e.30 An increase in real income would have the same effect. However, since a decrease in P2 will decrease real income (see Eq. (12)), this will encourage a decrease in e (the income effect). Hence, the two terms in a2 are opposite in sign. The second term, a3, in Eq. (13) captures changes in e via those in r (the discount rate effect). This term represents the effect derived in Section 3, i.e. an increase in r reduces e. What Eq. (13) suggests is that even in the first-best case of internationally perfect credit markets, a decrease in P2 has the potential to decrease e (increase child labour) if the income effect dominates the substitution effect.31 We shall elaborate on the circumstances under which this may happen a bit further on.
Note that a term involving de in Eq. (2) drops out due to the envelope condition. 2 2 Using Eq. (8), we can write 1gVE52=(1c2 y) + c y ( P3P4)/( P2r). Noting that c y is the value of marginal propensity to consume good 2 and is less than unity, it is easy to see from the above equation that 1 gV E52>0. 31 As mentioned in footnote 11, this possibility will arise even if we allowed for substitution of child labour between goods 1 and 2. For example, we could assume a Heckscher Ohlin framework in which both types of labour are substitutes in production and are perfectly mobile between the two sectors. In this case, what we would need to assume is that good 2 uses unskilled labour more intensively. Using the Stolper Samuelson theorem in international trade theory, we could then show that a decrease in P2 will unambiguously reduce the real unskilled wage rate and increase the skilled wage rate. In this extended framework, we shall have the same qualitative income effects.
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To complete the analysis for the cases in which the discount rate is endogenous, we need to study how it is affected by a decrease in P2. Even if a decline in P2 raises e for given values of r, if r were to rise in the new equilibrium, this could induce a negative effect, given the negative relationship that holds between e and r for a non-lending household. Eq. (14) represents the households demand for loans. The coefficient of the first term captures the slope of the demand function and is negative. The third term captures the shift in demand due to changes in P2. A decrease in P2 increases demand for consumption in period 1 relative to period 2 (assuming goods to be intertemporal substitutes) and also reduces the income of unskilled families at t = 1. This induces a direct effect shifting outwards the demand for loan schedule. Similarly, an increase in the level of schooling (if it occurs) increases future income and therefore the demand for loans, and indirectly raises the interest rate. In Fig. 2, the distance DJ captures the direct effect and the distance CJ captures the indirect effect of a decrease in P2 on the overall demand for loans.32 We now perform an analogous exercise for rich households, taking into account the assumption that es = 1. Differentiating Eq. (7) for rich households, taking into account the effects on dvs via Eq. (2): rdbs c1 dr c2 dP2 , 15

s s s 3s 4s where r 2c1 = ( P3) 2E33 2 E34 P3 P4 ( P4) 2 E 44 + bsr2 (1 cy cy ), c 2= s s s 3s 4s ( P3E32 +P4E42)E2r(cy +cy ). Eq. (15) reflects the properties of the supply function of loans. For reasons mentioned before, we shall assume that c1 is positive, signifying (locally) an upward sloping supply function of loans, under an analogous restriction to the one that was invoked to ensure a downward sloping demand by poor households. The sign of c2 indicates the direction of shift in the supply function. c2<0 implies that a decrease in P2 increases the supply of loans. In principle, this need not occur.33 We shall leave aside for the moment whether or not it will. Given the shifts in the demand and supply functions, the rest of the analysis can proceed with reference to Fig. 2. Note that the precise comparative static effect of a trade sanction depends on the initial equilibrium, which in turn depends on the assumed credit market scenario. We, therefore, do not analytically compare the effects of trade sanctions under the pure cases studied in the previous section.34

32 Of course, in the new equilibrium, as depicted, e has fallen so in Fig. 2, the overall increase in the demand for loans is smaller than suggested by the direct effect alone. 33 A decrease in P2 increases the real income of the skilled families at t = 1 as they do not take part in the production of good 2. This income effect would increase the supply of loans. However, a reduction in P2 also has possible intertemporal substitution effects, which may reduce the demand for goods 3 and 4, reducing the supply of loans. An increase in the supply of loans therefore requires that the income effect is bigger than the substitution effects. 34 For expositional simplicity, we do not compare the case of perfect international credit markets to the other two cases. It should be clear from Eq. (13) above and the analysis below that trade sanctions are least likely to increase child labour in this scenario.

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As an alternative, we shall assume that a credit market exists initially and that the borrowing constraint is set such that it binds exactly at the equilibrium of this market.35 We then compare the effects of a trade sanction under two scenarios: (i) the borrowing constraint prevents loans from adjusting in response to any increase in the demand or supply of funds; (ii) the market freely adjusts to a new equilibrium. The first case can be thought of as marginal autarky. The northeast panel of Fig. 2 represents the situation described above: a binding borrowing constraint exists such that, prior to a trade sanction being imposed, the level of borrowing in competitive equilibrium barely meets this constraint. A decrease in P2 raises the demand for loans and shifts BB outward. The decrease in P2 also shifts the e r locus in the northwest panel. The exact nature of this shift depends on the sign and magnitude of a2 in Eq. (14). As drawn, the new e r locus, AV AV , intersects the old one, AA, from the left. This suggests that, for given r, e increases with a fall in P2 if e is large initially, but decreases if it is small initially.36 Heuristically, a low value of e is associated with a high marginal utility of both income (E5) and education ( gV). Both of these tend to make a2 negative. A low initial value of e is in turn associated, all else equal, with low parental income in our model. As drawn, therefore, the northwest panel suggests that a trade sanction could cause a decline in childrens education (at given values of r) at least for households that are poor and educate few children to begin with. In Jafarey and Lahiri (1999), pp. 19 20 and Appendix C), we have shown by numerical simulation that such a perverse outcome is indeed possible. There is also a considerable body of empirical literature which reports that decreases in family income have a significant positive effect on the incidence of child labour.37 In other words, it is precisely those families which are poor and send a large proportion of children to work who are likely to suffer large income effects as a result of trade sanctions. Combining the northeast and the northwest panels, note that in the presence of a borrowing constraint that binds at the initial equilibrium, the poor households discount factor ru b rises unambiguously. This ensures that, whatever the shift in e at given r, the interest rate change contributes a perverse influence to the effect of trade sanctions. Hence, in Fig. 2, the overall effect on e consists of distances QT (due to a decrease in P2 for a given r) and TU (due to higher r), respectively. Proposition 2 summarises this result. Proposition 2. In the presence of a borrowing constraint, a trade sanction increases a poor households discount rate, which negatively affects its childrens education. One implication of Proposition 2 is that, if a trade sanction induces a perverse effect in the hypothetical situation of constant interest rates, then it will contribute a stronger perverse effect if the household cannot increase borrowing at the margin. Hence, if to the existing poverty of households (which, as we argued above, can lead to large income
35 Exhaustive numerical solutions indicate, however, that the comparisons made between various credit scenarios remain qualitatively valid even when the initial equilibria differ across them (see Appendices C, D and E in Jafarey and Lahiri, 1999). 36 The intersection of AA with AV AVis only illustrative. The cautionary nature of our results concerning trade sanctions is strengthened by (but not dependent on) AV AVlying to the right of AA. If this happened over the entire range of the two curves, it would lend further support to our conclusions. 37 For example, Ray (1999) has found that the negative effect of household income on the supply of child labour is statistically significant at a 1% level of significance.

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effects from a trade sanction) we were to add a quantitative scarcity of borrowing opportunities (a possible consequence of a lack of collateral), this would further increase the severity of the perverse effects from a trade sanction. Turning to the case where the supply of funds adjusts, note that the relative shifts in BB and SS determine how the comparative static effects will differ from the case of no adjustment. As drawn, SS shifts down as BB shifts up and, at the new equilibrium, r goes up nonetheless. Hence, the interest rate effect on child labour may still be negative. However, the relevant comparison is that, as drawn, this influence is smaller if there is a borrowing constraint. Indeed, the diagrammatic analysis suggests that this comparison would be valid even if SVSV were to shift up (i.e. if the substitution effect dominates the income effect on the supply side), so long as the upward shift was less than that of BVBV. We summarise this result in Proposition 3.38 Proposition 3. Provided that rbuV>rbsVat the initial value of borrowing and lending, the trade sanction is less likely to lead to perverse effects on child labour if the supply of loans can adjust in a competitive domestic credit market than if it cannot. A corollary of Proposition 3 is that even if a perverse effect were to arise in both cases, it would be smaller if poor households had access to credit at the margin than if they did not. V sV Proposition 3 is based on the premise that ru b > rb after a trade sanction. Relaxing this assumption would imply that a trade sanction, despite lowering the current income of borrowers and raising that of lenders, nonetheless leads to a decline in credit flows from rich to poor. This appears implausible and several benchmark scenarios explicitly rule it out. First, if skilled families do not consume goods produced by unskilled labour, a trade sanction will have no effect on the supply curve of loans while shifting upwards the demand curve. Second, if the assumption of no domestic link to world capital markets was replaced by the assumption that rich households (alone) can borrow from world markets, at a given interest rate, rw , and intermediate these funds (perhaps in a monopolistic fashion), to the poor a decrease in P2 might have little or no effect on rw (and therefore on the marginal cost curve of obtaining funds facing rich households) if the world market for good 2 is small relative to other goods. In this case, the marginal willingness to lend would remain unaffected while the demand for borrowing would increase. Third, if Ms = Mu and, initially, P1 = P2, P3 = P4 (for the purposes of this particular case, we would have to suspend the assumption that es = 1). The original equilibrium would lead to no borrowing or lending. Now, if P2 falls, unskilled households will be made poorer at t = 1 and under the income effect will increase their demand for loans, while skilled households will become richer and under the income effect would increase their supply. The substitution effect would have the same magnitude for both households and will cancel out. In the new equilibrium, the premise under which Proposition 3 holds will be satisfied. To summarise, the analysis of this section suggests that the discount rate of poor households rises more strongly under borrowing constraints and rises less strongly or even falls under a domestic credit market. This implies that a perverse effect from trade sanctions to child labour in poor households is less likely if credit is available at the margin.
38

This is analysed more formally in Jafarey and Lahiri (1999, Propositions 4 and 5).

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5. Conclusion In this paper, we have studied child labour in the context of intertemporal decisionmaking by families which are subject to different scenarios concerning the credit market. We have shown that under fairly general and plausible circumstances, the development of domestic credit markets is likely to induce poor households to reduce child labour and allocate more of their childrens time to education. At the same time, even perfect credits markets, on their own, may not eliminate child labour altogether. We have also shown that trade sanctions that reduce the wage of working children may, given the pressure they place on already low parental incomes, induce very poor families to increase the amount of childrens time spent in labour and reduce that spent in education. At the same time, greater access to credit may reduce the possibility of this unintended effect. We would like to emphasise that it has not been an intention of this paper to make a general case for or against trade instruments as tools for solving the problem of child labour. We assume that the presence of child labour has, rightly or wrongly, led to the use of trade sanctions against many of the countries where children work in large numbers. The purpose of this paper has been to identify circumstances under which a policy of trade sanctions might not have the intended effects. In this regard, we have identified two distinct sources through which a perverse effect might arise: (i) low parental incomes and (ii) lack of access to credit. It seems fair to point out that there is a considerable body of evidence suggesting not only that child labour is directly associated with poverty, both across countries and within each country, but that access to credit is particularly difficult for the poor. These observations suggest that the perverse effects of trade sanctions are most likely to arise in precisely those sections of the population where the empirical incidence of child labour is most severe. To summarise the main results, it is very important that the poor households have access to credit markets at reasonable rates of interest if we want a serious reduction in the incidence of child labour. However, credit on its own is unlikely to eliminate child labour. One also needs to improve the economic conditions of the poor households and to provide their children with better quality primary education. Moreover, properly functional credits markets are also important for the effectiveness of other policies to reduce child labour. For example, the impact of trade sanctions on child labour is likely to be more favourable when the poor families have better access to credit. Trade sanctions can in fact be counterproductive if credit markets are completely absent.

Acknowledgements ` ze, Nadeem Ilahi, The authors are grateful to Alison Booth, Craig Brett, Jean Dre Arvind Panagariya and two anonymous referees for the helpful comments. An earlier version of the paper was presented at seminars at the University of Cyprus and the University of East Anglia and at an international conference on International Trade, Industrial Organization and Asia, held at the City University of Hong Kong during 2 6

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August, 1999. Comments from seminar and conference participants are also gratefully acknowledged.

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