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Trade and Wages - the Mechanism behind theRecent Rise in Inequality?
Dirk H. EhntsAugust 2008
Abstract
Rising inequality in developed as well as developing economies hasbrought the issue of trade and wages back to the agenda of the tradeeconomist. Ever since Heckscher and Ohlin proved that economic in-tegration between countries with different factor endowments wouldcreate winners and loser among the factor owners, trade is a primesuspect when it comes to explaining rising inequality inside countries.The recent episode of trade integration has been the integration of China, and with it, many other emerging economies. Also, the Eu-ropean Union has expanded eastwards, making cheap labor availableinside the European common market. However, it seems that tradein a Heckscher-Ohlin sense has not been the main driver of recent in-equality in developed countries. Still, the increase of markets couldhave turned trade into an indirect cause for increasing inequality.
JEL classification: F15Keywords: international trade, wages, offshoring, inequalityPreliminary draft. Do not cite. Do not distribute.
 
1 Introduction
US-American income inequality has risen steadily in the last decades.
1
Byevery measure of inequality, the poorest of society are farther away fromthe richest since the decades following the second world war. Apart fromthat, declining real wages for workers add to the concerns that the benefitsof globalization do not reach the majority of US-Americans.
2
In the ongoingdiscussion, many have trouble to disentangle these two points. A rise ininequality is not the same as a fall in real wages for workers. In order tostructure the discussion it is necessary to dig a little deeper into these issues.Economic inequality is an outcome of the market economy. As such, incomeinequality itself is mostly tolerated in society, and well-off people are oftencelebrated. Entrepreneurs succeed by taking risks, exposing themselves toSchumpeterian creative destruction. If they succeed, it pays them a premiumover average wages.
3
On the downside, their own businesses might fall preyto an innovation in the near future.Opportunities for entrepreneurs increase when a country joins the globaleconomy. The stakes are increased by stiffer competition on one side and alarger market on the other. Successful firms use more human and physicalcapital, which gives incentives to workers to invest in their human capital.
4
High-skilled workers then should be rewarded with higher wages than low-skilled workers. The successful firms can conquer foreign markets, expandtheir production and compete not so efficient firms out of the market. Thisis the quintessence of the Melitz (2003) model. It is assumed that duringtimes of economic integration wages for workers are rising, since the averageefficiency of firms increases through inefficient firms leaving of the market.However, the real wages of American and also most European workers have
1
see Huang and Stone (2008), Figure 1.
2
source?
3
See Knight (1921), chapter 1.
4
source?
2
 
been falling for some years now.
5
Measuring inequality 
Generally speaking, inequality can be measured by comparing real wages,income, wealth or consumption. Finding the right measure depends on howone thinks about inequality. If one wants to show that relatively poor peo-ple’s life gets better, consumption might be the relevant measure.
6
If oneis interested alternatively in whether it is possible to pursue the AmericanDream, it might be more insightful to look at the evolution of wealth in dif-ferent cohorts over time. For those valuing a society with a low variance of income, income might be the right measure.Whatever one’s view on the issue is, there is a quite simple relation betweenthe measures. Income, wealth and consumption all depend on (expected)real wages.
7
Even though this is about trade, let me use a macroeconomicidentity for clarification:
Y  
=
C 
+
S 
(1)Income
Y  
is spent on consumption
C 
and saving
S 
. Over time, wealth risesas savings are accumulated. Since social benefits depend on real wages of workers, even the income of the unemployed depends largely on real wages.This is why in the following the focus lies on real wages.
Trends in inequality 
Figure 1 shows that average income inequality in OECD countries has risenduring the period of 1994 till 2005. Apparently, income inequality has in-
5
source?
6
See Broda and Romalis (2008) and also Cox and Alm (2008). It should be interestingto see how consumption inequality develops with the on-going tightening of money.
7
It does not matter in this context whether you believe in the lifecycle consumptionhypothesis or in the Keynesian marginal propensity to consume. What is important isthat consumption depends on the income, which itself depends on the real wages. Eitherdirectly through labor income or indirectly through capital income from earlier incomethat had been saved.
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