Sources of heterogeneous gains from trade: Income differences and non‐homothetic preferences

Abstract

Global wage inequality is tightly linked to productivity-and remoteness-related income differences within and across countries. These sources of heterogeneous effects of globalization on wages are customary in quantitative work in trade which aims at examining the link between trade and inequality. However, the second source of heterogeneous effects of trade on income difference around the globe-non-homotheticity in preferences-has been largely ignored. We explore the relative importance of these two factors in explaining the link between globalization and global wage inequality. Abstract This paper considers the interrelationship between a hierarchy of consumption needs of agricultural goods, manufactures, and services as a central feature of the demand side of economies and the demand for skilled and unskilled workers, whose incomes differ. The relationship is established as skilled and unskilled labor are used in conjunction with capital goods in a nested constant-elasticity-of-substitution (CES) production function, which features capital-skill complementarity and a substitutive relationship between the bundle of capital and skills on the one hand and unskilled labor on the other hand. Incomes differ across countries both within and between types of workers. As trade costs change, relative and absolute incomes of worker types change and so does the workertype-specific pattern of consumption. A calibration and simulation exercise documents that a consideration of the supply-and-demand-side linkage in this hierarchy-ofneeds model matters quantitatively for the role of trade liberalization in the world economy.