Trade and inequality: From theory to estimation

by Elhanan Helpman, Oleg Itskhoki, Marc Muendler and Stephen Redding

Vox
May 20, 2012

What is the effect of trade on inequality? This column presents a unique study examining wage inequality in Brazil after liberalisation. Starting from a closed economy, the column finds that wage inequality will initially rise as only some firms take advantage of the new opportunities. But as trade costs continue to fall and more firms start to trade, wage inequality peaks and begins to fall back.

Until recently, research on the labour market effects of international trade has been heavily influenced by traditional theories such as the Heckscher-Ohlin and Specific Factors models. Those theories provide predictions about relative wages across skill groups or across occupations and sectors. In contrast to predictions of those theories, empirical studies find increased wage inequality in both developed and developing countries, growing residual wage dispersion among workers with similar observed characteristics, and increased wage dispersion across plants and firms within sectors. In a large part due to this disconnect, previous studies have concluded that the contribution of international trade to growing wage inequality is modest at best (see for example the survey by Goldberg and Pavcnik 2007).

We argue that these apparently discordant empirical findings are in fact consistent with a trade-based explanation for wage inequality, but one rooted in recent models of firm heterogeneity and trade. In Helpman et al. (2012) we begin by documenting a number of stylised facts about the level and growth of wage inequality in Brazil that provide support for these recent theories.

• First, much of overall wage inequality occurs within sectors and occupations rather than between sectors and occupations. We document this fact with a decomposition of the variance of the log wage into the variance within sector-occupations and the variance between sector-occupations. We find that the within sector-occupation component of wage inequality accounts for over two-thirds of both the level and growth of wage inequality in Brazil between 1986 and 1995, as illustrated for the growth of wage inequality in Figure 1.
• Second, a large share of the wage inequality within sectors and occupations is driven by wage inequality between rather than within firms.
• Third, both prior findings are robust to controlling for observed worker characteristics. This robustness suggests that wage inequality between firms within sector-occupations is largely residual wage inequality.

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