What impact does trade between a developing and a developed country have on inequality in the developing country?

A plausible version of the canonical Hecksher-Olin model of trade would say that inequality decreases in the developing country. The Hecksher-Olin model studies the impact of different factor endowments on trade, taking technology as given across countries.  Suppose there is only one consumer good and suppose the ratio of skilled to unskilled labor is higher in the developed country.  Then the wage of skilled workers in the developing country is higher than that of skilled workers in the developed country and the wage of unskilled workers is higher in the developed country vs the developing country.  Allow trade in factors of production so factor prices are equalized across countries. Skilled workers will migrate from the developed to the developing country and unskilled workers the reverse.  The wages of skilled workers in the developing country will go down and the wage of unskilled workers will go up.  Inequality in the developing country – where developing is identified with a particular ratio of factor endowment – will go down with trade.

Apparently, the stylized facts on trade and inequality do not fit this story.  Kremer and Maskin offer a different theory based on complementarities in worker skill levels in production.  Suppose the only consumer good is produced by  a manager and a worker.  The skill level of the manager has a bigger impact on output than the skill level of the worker: output is the square of the skill of the manager times the skill of the worker.  Hence it is more efficient to assign a high quality worker to the manager’s task than the worker’s task.  Suppose there are skill levels A and B in the developed country and C and D in the developing country where we assume A>B>C>D.  Suppose there is an abundance of C workers in the developing country.  Before globalization, some C workers are matched with each other producing CCC and some are matched with D workers producing CCD.  The wage of the C-workers must be CCC/2 to maintain zero profits and this pattern of matching in equilibrium.

Now allow movement of labor across countries or equivalently production across borders.  Then the following is possible: C workers move to the developed country for a higher wage w’.  The D workers who are low skill and hence unattractive partners for production in the developed country, stay in the developing country.  They may still be matched with C workers but getting lower wages CCD-w’ as C workers now must earn more to stop them working for the developed country. Or if all C workers now work for the developed county, D workers end up matched with each other producing and splitting only DDD and hence with lower wages.  In either case, globalization increases inequality in the developing country.

This is the main idea.  Many extension and other parameter configurations are discussed. A useful literature review identifies Hecksher-Olin models where globalization can also increases inequality.

It was really fun to read this paper.  It is simple and clever.  It generates externalities in wages from matching patterns.  The implications are subtle and have provocative implications.

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