Working Paper: CEPR ID: DP12077
Authors: Justin Caron; Thibault Fally; James R. Markusen
Abstract: Almost all of the literature about the growth of income inequality and the relationship betweenskilled and unskilled wages approaches the issue from the production side of general equilibrium(skill-biased technical change, international trade). Here, we add a role for income-dependentdemand interacted with factor intensities in production. We explore how income growth andtrade liberalization influence the demand for skilled labor when preferences are non-homotheticand income-elastic goods are more intensive in skilled labor, an empirical regularity documented inCaron, Fally and Markusen (2014). In one experiment, counterfactual simulations show that sector neutralproductivity growth, which generates shifts in consumption towards skill-intensive goods,leads to significant increases in the skill premium: in developing countries, a one percent increasein productivity leads to a 0.1 to 0.25 percent increase in the skill premium. In several countries,including China and India, simulations suggest that the historical growth experienced in the last 25years may have led to an increase in the skill premium of more than 10%. In a second experiment,we show that trade cost reductions generate quantitatively very different outcomes once we accountfor non-homothetic preferences. These imply substantially less predicted net factor content of tradeand allow for a shift in consumption patterns caused by trade-induced income growth. Overall,the negative effect of trade cost reductions on the skill premium predicted for developing countriesunder homothetic preferences (Stolper-Samuelson) is strongly mitigated, and sometimes reversed.
Keywords: Non-homothetic preferences; Skill premium; Per capita income; International trade
JEL Codes: F10; O10; F16; J31
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Productivity increases (O49) | Skill premium (J24) |
| Income growth shifts consumption towards skill-intensive goods (F62) | Demand for skilled labor (J24) |
| Historical income growth (N12) | Skill premium (J24) |
| Trade cost reductions (F14) | Skill premium (J24) |
| Non-homothetic preferences (D11) | Consumption towards skill-intensive goods (E21) |
| Trade cost reductions (F14) | Outcomes compared to standard Stolper-Samuelson predictions (F11) |