Why does trade liberalisation raise wage inequality worldwide?

Paolo Epifani, Gino Gancia, 7 October 2008

a

A

Since the late 1970s, an unprecedented wave of trade liberalisations has taken place. The share of countries classified as open according to the Sachs-Warner (1995) criteria rose from 35% in 1980 to 95% in the late 1990s and the trade share of the average country rose from 59% of GDP to 74%. Over the same period, the skill premium – the difference between the wages of skilled and unskilled workers – rose on average by 8%.

Figure 1. Openness and skill premia

Figure 1 points to a strong positive association between openness and wage inequality. Analysing a sample of 35 developed and developing countries with available data, it shows the change in the openness ratio during the 1980s on the horizontal axis and the percentage change in the manufacturing skill premium on the vertical axis.1 The graph shows that countries such as Turkey, Mexico, Chile, Malaysia, which substantially increased their outward orientation, also experienced a concomitant increase in the skill premium. In contrast, countries such as Japan, Korea, Finland, Egypt, whose trade exposure fell, experienced a fall in the skill premium.

Figure 2. Openness and returns to education

The broad picture does not change when using a different proxy for the returns to skill. Figure 2 reports, for a sample of 40 countries observed for at least two years between the early 1960s and the late 1990s, the change in the openness ratio on the horizontal axis and the percentage change in the economy-wide private returns to education on the vertical axis.2 Again, countries such as Mexico, China, Korea, Philippines, Guatemala and Nicaragua experienced a substantial increase in the returns to education in periods of greater exposure to international trade. In contrast, other countries’ periods of falling trade exposure are associated with falling returns to education.

From the evidence to the theory: A puzzle

These data suggest that trade openness and wage inequality may be related, yet we do not clearly understand why. In fact, the canonical trade models cannot easily reconcile the theory with this evidence. Consider the Heckscher-Ohlin model first. In this model, trade stemming from endowment differences (inter-industry trade) should allow countries to export the services of the abundant factor in exchange for the services of the scarce factor, thereby raising the relative demand for skills in the skills-rich OECD countries and reducing it in the skills-poor developing countries. Yet, a striking feature of the latest wave of globalisation is the dramatic increase in wage inequality in those developing countries that have enthusiastically embraced it (e.g., China, Mexico, Chile, Colombia, Argentina, etc.). Moreover, recent estimates suggest that endowment-based comparative advantage can account for only a tiny fraction of world trade flows.

Consider now the so-called “new trade theory”. According to this analysis, similar countries trade in similar products (intra-industry trade) because firms produce differentiated goods under increasing returns to scale and consumers enjoy having access to a greater variety of goods. Intra-industry trade represents an overwhelming and growing share of world trade, and it is therefore a likely culprit for the increase in wage inequality. Yet its distributional implications have long been overlooked. The reason is that intra-industry trade is, by definition, trade in goods that are produced with similar factor intensities, implying that intra-industry specialisation should leave relative factor demand and relative factor prices, such as the skill premium, unaffected.

In recent work (Epifani and Gancia, 2008), we argue that this seemingly plausible conclusion is wrong. More precisely, we show that intra-industry trade between identical countries leaves relative factor rewards unchanged only under very special and counterfactual circumstances.

The skills bias of intra-industry trade

Our theory builds on the observation that tasks performed by high-skilled workers are different from those performed by low-skilled workers, not only because of their higher cognitive content, but also because they often have the nature of fixed costs (think, for instance, of R&D and marketing activities). This crucial feature of skills-intensive activities implies that they naturally generate economies of scale. To have an idea of how intrinsically related skills-intensive and scale-intensive activities are, it suffices to note that, in the empirical trade literature, an industry’s ratio of non-production to production workers is used to measure both skills intensity and economies of scale (e.g., Helpman, Melitz and Yeaple, 2005).3

Moreover, skills-intensive goods are typically highly differentiated, implying that the benefit from having a wider variety of products is stronger in the skills-intensive sector. Intuitively, having the option to choose between different types of electronic equipment (from the iPod to refrigerators, serving very different purposes) is more valuable than having access to a variety of garments (all serving similar purposes).

These observations allow us to look at the distributional implications of intra-industry trade from a new perspective. Trade liberalisation expands the size of markets, and this in turn increases the demand for skilled labour for two related reasons. First, market size boosts skilled workers’ productivity, because skills-intensive industries are subject to increasing returns to scale.

Second, larger international markets offer a wider variety of differentiated products, thereby inducing people to shift their consumption habits towards these goods. Given that differentiated products are skills-intensive, the demand for skills increases too. These simple mechanisms suggest that ability is more important in large markets. As globalisation is creating a huge world market, skilled workers benefit relatively more from this process.

We find big effects. Under plausible calibrations, our model suggests that a 50% fall in trade costs between two identical countries can increase the skill premium by 10%, whereas full integration can raise it by up to 30%. Moreover, if the skill bias of market size is strong enough, international trade can also widen wage differentials in developing countries.

In this respect, an interesting case study is Mexico’s drastic trade liberalisation in the mid-1980s, followed by an upsurge in the skill premium. In a simple numerical exercise, we show that trade integration between the skills-poor Mexico and its main trade partner, the skills-rich US, can account for a 15% rise in Mexico's skill premium, broadly matching actual data.

Our formal econometric analysis, using data for up to 68 countries observed between the early 1960s and the late 1990s, confirms these results. Countries that are larger and more open to trade tend to have a higher skill premium, and the effects are quantitatively similar to the predictions of the theoretical model. These findings suggest that a substantial fraction of the observed widening of wage inequality may be attributed to the growth of world markets due to globalisation.

References

Banerjee, A. V. and Duflo, E. (2005). "Growth Theory through the Lens of Development Economics," in (P. Aghion and S. Durlauf eds.), Handbook of Economic Growth, Vol. 1 A, Amsterdam: North Holland.

Epifani P. and Gancia, G. (2006). "Increasing Returns, Imperfect Competition and Factor Prices," Review of Economics and Statistics 88, 583-598.

Epifani P. and G. Gancia (2008). “The Skill Bias of World TradeEconomic Journal, 118, 927-960.

Helpman E., M. Melitz and S. Yeaple (2004) “Export versus FDI with Heterogeneous FirmsAmerican Economic Review, 94, 300-316.

Psacharopoulos, G. and Patrinos, H. A. (2004). "Returns to Investment in Education: A Further Update," Education Economics 12, 111-134.

Sachs, J.D. and A. Warner (1995)."Economic Reform and the Process of Global Integration," Brookings Papers on Economic Activity, Vol. 26 pages 1-118.

Footnotes

1 The skill premium is computed as the ratio of non-production to production wages in total manufacturing from the UN General Industrial Statistics database.

2 Returns to education are obtained as the coefficient of years of schooling in a regression of log wages on years of schooling. It captures the increase in wage associated with an additional year of schooling. Our data are drawn from Banerjee and Duflo (2005) and Psacharopoulos and Patrinos (2004).

3 In a related paper (Epifani and Gancia, 2006) we provide an alternative and deeper explanation for why skills-intensive sectors enjoy stronger increasing returns to scale together with supporting empirical evidence.

Topics: International trade, Poverty and income inequality
Tags: Inequality, skill premium, trade liberalisation

Associate Professor of Economics at Università Bocconi and Researcher at CESPRI and CSLd'A

Researcher at CREI, Assistant Professor at Universitat Pompeu Fabra and CEPR Research Affiliate

V