Trade and Income Inequality in Developed and Developing country

Submitted by Priyanta Ghosh

Introduction:Global income inequality has for long been a subject of much interest

to economists. In U.S.A after 1970’s and in most of the developed

countries after 1980’s wage inequality ha increases. Several

economists started researching over income inequality. It was because

of the perception that income inequality among nations and within

nations has been growing rapidly over the last two decades. The

perception derives from the well known fact that gap in per capita

income between richest and poorest country increased substantially in

the recent year. The income gap between the fifth of the world people

living in the richest countries and fifth of the poorest was 74 to 1

in 1997 which has increases from 60 to 1 in 1990 and 30 to 1 in 1960(

UNDP 1999).

What is Income inequality?

We can think of three different notion of income inequality.

Inter-country income inequality:

Here each of the country is considered as an individual and the

relevant inequality is that of the distribution of the per capita GDP

among countries. So in a more explicit way we can say here inequality

means gap in the per capita GDP between developed and underdeveloped

countries. But the weakness of this measure is population of

countries is does not take into consideration under this measure. For

example China and Madagascar have same per capita GDP but since China

has a larger population than Madagascar from the point of view of

inequality China should be in a better position than Madagascar. But

this measure does not consider this fact.

International Income Inequality:

Under this notion we consider the distribution per capita GDP among

the world population. This measure provides necessary importance to

the population size of the country but assumes all individuals in a

given country receive the same income which equals the per capita GDP

of that country.

Intra Country Income Inequality:Previous measure assumes all individuals in a country earn same

income. So it ignores inequality within country. Intra country

inequality captures inequality in distribution of income among

individuals within a country. Therefore if income gap between less

skilled and more skilled workers increases then intra country

inequality increases and if the gap fall then intra country

inequality fall.

Trend in Income Inequality:

Here we discussed about the trend in different notion of inequality.

Trend in inter-country income inequality

A.K Ghose (2004) in his paper finds trend in inter country inequality

by taking data on initial per capita GDP(1981 ) and average annual

GDP growth rate of 96 economies over the period 1981-1997. He

excludes the countries which had a population of less than 0.5

million in 1981 as well as transitional economies. He found a

positive correlation between initial level of per capita GDP and GDP

growth rate and conclude a country having higher per capita GDP have

higher growth rate. Therefore inter-country inequality increased

during the period under consideration. In the following the figure 1

relationship between initial level of GDP and GDP growth rate has

been shown.

Figure 1

Trend in International Inequality

In the same paper A.K Ghose also looks at the trend in

international inequality over the sane period under consideration

i.e. 1981-1997. In order to capture international income inequality

he calculate population weighted Gini coefficient for each of the

period between 1981-1997.He also calculated unweighted Gini

coefficient for the same period. After fitting the trend equation he

found trend line for unweighted Gini coefficient increases steadily

at a rate of 0.4% per annum while the trend line for population

weighted Gini coefficient declined at a rate of 0.7% per annum. This

suggests during the given period inter-country inequality rises but

international inequality fall. Schultz(1998) did a similar kind of

study considering a group of 120 countries during the period 1960 to

1989. He found international inequality increased between 1960-1973

and slowly declined thereafter. Figure 2 shows the trend line for the

population weighted Gini coefficient

Figure 2

Trend in intra country inequality

In U.S.A wage inequality increased after 1970 onwards. Between

1979 to 1995 real wage of those with 12 year of education fell by

13.4% and real wages of those with less than 12 years of education

fell by 20.2%, while real wages of workers with 16 or more year of

education rose by 3.4%. So clearly wage gap between skilled labor and

unskilled labor increased dramatically in U.S.A. Feenstra and

Hanson(2001) showed by figure 3 that relative wages of nonproduction

to production workers in U.S manufacturing sector has increased

steadily after 1980’s where non production and production workers

considered as proxy of skilled and unskilled labor respectively.

After 1980’s wage inequality has also increases in Australia, Canada,

Japan and United Kingdom.(Freeman and Katz 1994)

Figure 3

In a paper Wei Lu and Ben Xu(2003) said according to Chinese

official statistics the Gini coefficient of China rose from a low

level of 0.33 in 1980 to 0.40 in 1994 and to 0.46 in 2000. China’s

wage inequality increases by an average rate of 11% per year from

1997 to 2000. Fig 4 shows the changes in china’s wage inequality as

represented by Wei Lu and Ben Xu.

Figure 4

Hanson and Harrison(1999) in paper discussed about the wage

inequality in Mexico. Considering data on large number of

manufacturing plants from SECOFI sample data he found relative wages

of white collar to Blue Collar workers increased from 1.930 in 1984

to 2.545 in1990. He has also shown from industry census data of

Mexico that from 1985 onwards ratio of white collar to blue collar

average wages increased steadily (fig 5)

Figure 5

A study on India’s wage inequality has been carried out by

Kunal Sen(2007). From that study we see that in India’s

manufacturing sector after a period of falling wage inequality in the

early 1970’s and then a period of sharply rising wage inequality in

the late 1970’s, there has been a period of slow but steady increase

in wage inequality since the mid 1980’s.

Reasons for such kind of trends

Most popular and well known theory that talks about inter-country

inequality is convergence hypothesis. This states that less developed

countries and regions should be expected to grow faster than more

developed countries, so that we should expect inter-country

inequality to decline over time. Three main arguments in support of

this hypothesis are Firstly, Since less developed countries are

late comers in the world of modern economic growth they can simply

adopt the technology invented by the developed country and therefore

can avoid the cost of inventing and time lags associated with the

development of new technologies. Secondly, One standard assumption

in the growth theory is diminishing return to factor inputs. Since

less developed countries are capital scarce country compared to

developed countries productivity of capital is higher in less

developed countries than developed countries. Thus for equivalent

rate of investment, the less developed countries should be able to

achieve higher growth. Thirdly, Workers in the less developed

economies initially confined in low productivity agricultural

activities, as growth occurs workers move to high productivity

manufacturing and service activities. So there has been a structural

change in employment level in less developed economies which raises

the growth of labor productivity.

But we have seen that inter- country inequality actually

increases over time. So there must be some short comings in the

arguments of convergence hypothesis. In the theoretical levels there

are some problems with the above arguments Firstly, There is no

reasons to believe that developed economies will stick to their

previously invented technology, rather they will invent more

advanced technologies and will always try to keep a gap in technology

with less developed countries. There is no reason to why the pioneer

cannot derive advantages from their accumulated experience of

developing leading-edge technologies. Secondly, Diminishing return

to the factor is not always the case, because of the scope for

learning by doing there may actually be constant or even increasing

returns to factor inputs. Thirdly, Since the developing country

try to catching up developed economies they have a tendency of

premature adoption of technologies in the sense that they may adopt a

technology which less skilled laborer of less developed countries are

unable to use, so the process of labor transfer (from low

productivity to high productivities) tends in reality to be extremely

slow.

But surprisingly we have seen that though inter-country

inequality has increases over time, international inequality falls.

Now this is possible if and only if first, there exist a group of

under developed countries which experiences higher growth rate per

capita GDP than the developed economies and, second, this group

accounts for the majority of the population living in less developed

countries. In the study A.K Ghose(2004) find in 17 developing

countries per capita GDP increases among them 10 are populous less

developed countries of the world. For example per capita GDP

increases in China and India which constitute a major portion of

world population.

Now comes the most important part that explains the

reasons for rise in intra- country wage inequality or in other words

reasons for rise in skilled unskilled wage gap which directly links

wage inequality with liberalization of trade. There are mainly two

theories that explain intra-country wage inequality.

-----Trade theoretic argument

----- Skilled biased technological change

Trade- Wage linkages

The link that standard trade theory identifies between trade and

wages is embodied in the Stolper Samuelson Theorem (1941). Consider

two regions , Developed country and Developing countries, two factor

of production( low skilled and High Skilled workers). High skilled

workers are abundant in developed country; low skilled workers are

abundant in developed country. There are two goods, high skill

intensive and low skilled intensive. Heckscher- Ohlin-Samuelson

theory predicts that with opening up of trade between developed and

developing country , developed country will export high skilled

intensive good and developing country will export low skilled

intensive good . Consequently relative price of high intensive

product will increase in developing country. Now following Stolper

Samuelson theorem a rise in the relative price of good will rise the

relative and real reward of the factor which has been used

intensively in the production of that good. So trade liberalization

causes the price of skilled intensive goods to rise relative to non-

skilled intensive goods in developed country and vice versa for

developing countries. For developed countries price changes reduces

the demand for labor in the unskilled industries and increase the

demand for labor in skilled intensive industries. Therefore in

developed country employment shift toward skilled intensive sector by

raising the demand for skilled labor. Rise in the demand for skilled

labor raises the wages of skilled labor relative to those of

unskilled labor. Following the same logic in developing country

relative wage of less skilled workers will increase. Hence if we

follow the Stolper Samuelson argument of linkage between trade and

wage inequality wage inequality will rise in developed country while

it will fall in less developed country.

But we have already seen that though wage inequality has

fall in East-Asian countries it has actually increases in lain

American country. So data does not support that wage inequality fall

in less developed countries. So there are two possibilities (i) trade

is responsible for rise in wage inequality but not through the

channel proposed by Stolper Samuelson theorem but through some other

channel and there are some shortcomings of Stolper Samuelson theorem

argument.(ii) trade plays a minor role in explaining rise in wage

inequality. Problems with Stolper Samuelson arguments are following.

a) The Stolper Samuelson argument for explaining wage inequalti is

based on the assumption of one to one relationship between

output price and factor rewards. This one to one relationship

between output price and relative wages does not hold for the

more complex model(e.g more goods than factors)

b) Trade can reduce the relative wages of unskilled labor even

without reducing the relative price of low skilled intensive

goods.

Example: Suppose U.S low skilled intensive firms opens up

branches in developing country, produce low skill intensive

product at a lower price using cheap laborer of developing

countries and then re export it in U.S. This shift in the

production of low skilled intensive product increases

unemployment among low skilled labor in developed country and

this will reduce the wage rate low skilled labor in developed

country. But since total production of unskilled intensive goods

does not fall, it just a shift in the place of production

relative price of unskilled intensive goods remains unchanged.

c) Stolper Samuelson theorem has been criticized on the ground

of its extreme assumptions such as (i) perfect competition

in all markets. In reality there are very few perfectly

competitive markets (ii) Perfect mobility of factors across

sectors. Then trade liberalization will affect economy-wide

wage inequality and not sector specific wag inequality

since under perfect factor mobility across countries factor

returns are equalized across sectors. But wage inequality

changes even within sectors (iii) there are technological

differences between countries. (iv) Trading country

produces homogeneous products.(v) constant returns to scale

in all sectors.

Brati shankar chakrobarty and Abhirup Sarkar in a paper shown

if there are constant return to scale in one sector and

increasing return to scale in another sector trade can actually

increase wage inequality in both developed and developing

country which goes against the prediction of Stolper Samuelson

theorem.

Trade plays minor role in explaining wage inequality

According to some economist trade plays minor role in explaining

rise in wage inequality in U.S.A. Their arguments are like

following

(I) The magnitude of U.S trade inflow and outflow with

developing country is too small to leads to the observed

wage changes. Trade to GDP ratio increases with trade

liberalization but it was not as high to conclude larger

trade contributes in rising inequality. In the U.S value of

trade was 6.1% of GDP in 1913 that rises to 8.8 % of GDP.

Moreover trade to GDP ratio started rising from 1980,s

onwards while wage inequality started increasing from

1970’s in most of the industrialised countries , therefore

trade expansion cannot explain rise in wage inequality from

the periods 1970;s o 1980’s in those countries( Krugman

1995)

(II) Movements of price across contries seem to

contradict the movements of relative wages. When relative

wage of unskilled labor fall relative price of less skilled

intensive goods should fall, but data shows it remains

stable or increases. (Lawrence and slaughter 1993).

relative price of apparel goods fell in the 1970’s, they

were stable in 1970’s(Leamer 1980’s)

(III) If shift in the employment and wags is due to the

international trade then larger shift should takes place

between industries since trade leads to expansion or

contractor of industries in response to foreign

competition. On the othr hand if changes are due to the

technological progress then larger shift should take place

within industries since all the industries shifts toward

higher technology that require skilled labor. Berman, Bound

and Grilichas(1994) shows that more shifts has taken place

within industries.

Other channels that explain trade-wage linkages

Outsourcing :

Outsourcing means imports of intermediate inputs from

abroad. Suppose developed country produces a good (Ym) which

requiraes two intermediate inputs one is skilled intensive (Y2)

and another is unskilled labor intensive (Y1). Now since

unskilled laborers are cheaper in developing country developed

country can actually import less skilled intensive intermediate

input from developing country. This will reduce the domestic

demand for unskilled labor in that industries which will reduce

the wage rate unskilled labor not only in those industries but

in all industries. Therefore outsourcing can leads to rise in

inequality.(Feenstra and Hanson 2001)

Feenstra and Hanson argues that once we take into

consideration outsourcing (the termed as Global production

sharing) then above arguments against trade can be reviewed.

Against the Krugman argument he said trade to GDP ratio was

lower because growth of service sector was included in GDP while

there was no trade in service sector. To make a better

comparison of trade with overall production we should the

merchandise trade to merchandise value added. When this done we

found merchandise trade has indeed indeed grown substantially

relative to the production of this commodities in many advanced

countries. Against the Lawrence and Slaughter argument he said

if we consider trade in intermediate goods then importing

intermediate goods from developing country should reduce the

import price relative to the domestic price. Lawrence and

Slaughter data support this. Larger rise in the skill unskilled

wage gap within industry can easily be explained by outsourcing.

Mobility of factor in explaining wage inequality

Suppose there are two sectors, skilled intensive and unskilled

intensive sectors, and three factors of production skilled

labor, unskilled labor and capital. Capital is being used in

both the sectors but it is used more in skilled intensive

sectors. Under such a framework if there is a inflow of capital

in developing country marginal productivity of both the skilled

and unskilled labor will increase. But since skill intensive

sector uses more capital marginal productivity of skilled labor

will increase more than marginal productivity of unskilled

labor. Therefore both the wage rate increases but skilled wage

increases more than unskilled wages and results in rising wage

inequality.

Empirical evidences

Empirical evidences of how trade impact on inter-country inequality and international wage

inequality:

Professor A.K Ghose (2005) tried to find out the effect of

trade liberalization on inter country and international inequality.

In doing so he estimated the relationship between trade performances

and annual GDP growth rate. He simply run a cross country regression

of average annual rate of GDP growth on average annual rate of change

in trade -GDP ratio (measure of trade performances) and found a

statistically significant positive relationship. He did the similar

exercise on several different sub-samples and the relationship is

found to be robust. He found impact of trade liberalization on tread

to GDP ratio has been rather similar for poor and rich countries.

Therefore impact of trade liberalization on GDP growth rate was also

similar for poor and rich countries. So rise in the inter-country

wage inequality cannot be explained by trade liberalization. He

argued though average growth performances showed no systematic

variation across countries since population growth is higher in poor

countries, per capita GDP is lower in poor countries. His regression

result shows

RGDP=3.198-0.737PCGDP adjusted R-square= -0.002

RGDP-annual rate of growth of GDP PCGDP-per capita GDP

He showed trade-GDP ratio increases more in more

populous country. He run a regression of change in trade to GDP ratio

(RTG) on population (POP) and found following result.

RTG= 0.949(4.062)+ 4.232(2.463)POP adjusted R-square-

0.054

This suggests that trade liberalization has more favorable effect on

the growth performances of populous countries than on that of small

countries since populous countries are low income countries trade

liberalization contributed to the decline in international

inequality.

Empirical evidences of impact of trade on intra-country wage inequality

Explaining developed country wage inequality:

Feenstra and Hanson(1996) in a paper tried to explain rise

in skill-unskilled wage gap in U.S through outsourcing. In that paper

he takes the import data and expenditure data for 435 industries in

USA for the years 1972-1988. He run a regression of Relative demand

for skilled labor on outsourcing where relative demand for skilled

labor has been measured by non production worker share of industry

wage bill and Outsourcing has been measured as a share of imported

intermediate inputs in the total purchase of non energy materials.

They have shown in the paper for the period 1972-1979 outsourcing

is insignificant but for the period 1979-1990 it found to

significant in impacting relative demand for skilled labor.

Coefficient of outsourcing entails outsourcing account for 30.9%

increase in the relative demand for skilled labor. According to them

contrast between the result for 1970’s and 1980’s is possibly

because of the fact that here outsourcing includes not only import of

intermediate inputs form less developed country but also from

advanced countries. They said once we exclude the imports from

advanced nations and do the similar exercise this problem of

discrepancy in result may not arise.

Feenstra and Hanson again in 2001 wrote a survey paper

where he has shown both outsourcing and technological up gradation

can explain rise in U.S wage inequality. In this paper they estimates

the following regression equation

∆s Hm = φ0 + φ K ∆ ln K m + φ Y ∆ ln Ym + φz ' ∆z m, m=1,…,M, Where ∆s Hm is changes in the wage share of skilled labor ∆ ln Km is changes in capital shipment ratio ∆ ln Ym is changes in shipments of industries(proxyof industry output) ∆z m vector of structural variables where the variables

are imported intermediate goods as a share of total material

purchases and share of capital and other high tech capital in total

capita stock.

He has taken the data for 447 manufacturing industries

within the U.S manufacturing sector between1979-1990. Three

regressions have been carried out considering three different

measures of the computers and the high technology share. In the

entire regressions outsourcing and computer share found to have a

positive impact on the wage share of skilled labor in total industry

wage bill. While later is being measured in terms of ex ante and ex post

rental prices respectively contribution of outsourcings founds to be

more than the contribution of computer share. When computers are

measured by their share of investment in total investment then

contribution of computer share founds to be larger. He showed

outsourcings account for 15-24% of the shift towards nonproduction

labor.

Explaining wage inequality in developing country:

Though large number of studies on International trade and wage

inequality has been carried over for developed countries there are

few studies for developing country as well. Most of the studies of

this kind are concentrated in Latin America. Hanson and Harrison

(1999) made a study on Mexican Manufacturing sector following the

trade reforms in the 1980,s. His study finds strong evidence of an

increase in wage gap between skilled and unskilled workers. He has

shown prior to the reforms, Mexico has extended trade protection

preferentially to the industries that makes relatively intensive use

on the unskilled workers, even though it had an abundance of

unskilled labor. Thus the trade liberalization has disproportionately

large impacts on the non skilled intensive sectors as the exposure to

China and other countries that have abundant unskilled labor

contributed to a decrease in relative wages of unskilled workers.

Therefore following Hanson Harrison trade reforms could be considered

to be the driving force behind the increasing wage inequality.

Beyar et al (1999) in a study on Chile finds after the trade

reforms in 1970’s and 1980’s wage inequality increases. He had shown

that trade liberalization leads to a change in the structure of

production in the country. But when he try to finds how this changes

are linked to the changes in the wage premium of skilled labor he did

not find any straight forward link.

A study on Mexico has been made by Feenstra and Hanson

(1997) where he try to find out effect of FDI on wage inequality. Ha

has obseved that a dramatic increase in FDI inflow in Mexico because

of the capital market deregulations of 1980’s. He takes region and

evaluate on the plants where FDI mostly flows in. They find increase

in the relative demand for skilled labor is positively correlated

with change in the number of such plants. Their analysis suggests

that greater wage inequality could also be linked to the increasing

flow of capital and not just to the flow of goods.

Robbins has made two studies one in 1995 and another in

1996 to explain wage inequality via trade in developing country. In

1995 study he took a group of East-Asian countries and finds greater

openness has led to the decreasing wage inequality between skilled

and unskilled workers in most of the East Asian countries in his

sample. While in 1996 he made a study over five Latin Americans

countries (Argentina, Chile, Colombia Costa Rica and Uruguay) and

finds the evidence of widening wage inequality associated with

greater openness. Adrian Woods (1997) said difference in the outcome

of East Asian countries and Latin American countries can be explained

by the different periods used in Robbins comparative studies. For

East Asian countries he takes 1960’s and 1970’s while for Latin

American countries 1980,s and 1990’s data. He argued in the latter

period large low income exporters such has china enters in the global

market and since such countries have a huge supply of unskilled labor

Latin American countries less skilled laborer can actually being hurt

by this.

Some of the studies on India have also been carried out.

Mishra and Kumar(2005) in a paper evaluates the impacts of the 1991

trade liberalization on the industry wage structure. He finds a

strong negative relationship between changes in the trade policy and

changes in the industry wage premium over time. Chamarbagwala (2006)

in a paper try to finds whether trade liberalization can explain the

widening skill gap and narrowing gender wage differential between

1983 and 2000 for the economy as a whole. He finds both trade

liberalization and other domestic sector reforms contributed in

increasing the within sector demand of skilled men and women. Kunal

Sen (2007) examine the effect of trade reform on wage inequality in

Indian manufacturing sector by taking industry level data for the

period 1973-1999. He finds significant negative relationship between

relative skill intensity(log ratio of skilled to unskilled labor) and

trade policy measures effective rate of protection(ERP) and Import

Penetration Ratio(IPR).therefore his results says trade

liberalization will increase the relative employment of skilled labor

and therefore relative wages of skilled labor. In the same paper he

had also made an interesting study of how trade induced skilled

biased technological changes impacted on rising Indians wage

inequality. Since theoretically technological changes can change

wages within industry he run a fixed effect regression of log of

ratio of skilled unskilled wages on ERP and IPR separately and he

finds as protection fall ratio of skilled wage to unskilled wages

rises. Hence his analysis also suggests that through trade reform

trade induced skilled biased technological change improves which in

turn increases within industry wage inequality.

Conclusion: Several studies have been made for developed countries to

explain wage inequality. Some of the economist argues competitions

with developing countries reduces the wage rate of unskilled labor

while some of the economist argued it is outsourcing that contributes

in raising wage inequality. Studies have been carried over for

developing countries also but it is limited in number. For India

lesser number of studies has been carried over. Therefore there is

still scope for explaining wage inequality in India.

ReferencesRobert C. Feenstra and Gordon H. Hanson (2001) “Global Production

Sharing and Rising Inequality: A Survey of Trade and Wages”

Gordon H. Hanson and Ann Harrison (1999) “Trade Liberalization and

Wage Inequality in Mexico”

Ajit K. Ghose (2004) “Global Inequality and International Trade”

Kunal Sen (2008) “Trade Policy and Wage Inequality”

Robert C Feenstra and Gordon H. Hanson (1996) “Globalization,

Outsourcing, and Wage Inequality”

Maosa Oda and Robert Stapp “Factor Mobility, Trade, and Wage

Inequality”

Jeffry D. Sach. and Howard J. Shatz (1996) “U.S Trade with Developing

Countries and Wage Inequality”

Brati S. Chakraborty and Abhirup Sarkar “Trade and Wage Inequality”

Beyar H, Rojas P. and Vergara, R. (1999) “Trade Liberalization and

Wage Inequality”

R Chamarbagwala (2006) “Economic Liberalization and Wage Inequality

in India”

R. Feenstra and G. Hanson(1997) “Foreign Direct Investment and

Relative Wages: Evidence from Mexico’s Maquiladoras”

P. Mishra and U. Kumar (2005) “Trade Liberalization and Wage

Inequality: Evidence from India”

D Robbins (1995) “Trade, Trade Liberalization and Inequality in Latin

America and East Asia: Synthesis of Seven Country Studies”

E Berman, J Bound, and Z. Griliches(1994) “Changes in Demand for

Skilled Labor within U.S Manufacturing: Evidence from the Annual

Survey of Manufactures”

Paul Krugman (1995) “Growing World Trade: Cause and Consequences”

R Lawrence and M. Slaughter (1993) “International Trade and American

Wages in the 1980’s: Giant Sucking Sound or Small Hiccup?”