Special articles

Globalisation and Inequality

An Analytical Perspective
With the possible exception of the east Asian countries, increased foreign trade and investment
have increased wage inequality in almost all parts of the globe during the last two decades of
the 20th century. Theoretically as well as empirically Heckscher-Ohlin-Samuelson model of
trade, with the Stolper-Samuelson result at its core, fails to explain such widening of wage
gap between skilled and unskilled labour particularly in the south. This paper discusses
alternative variants of the specific factor model accounting for the diverse trade pattern,
informal factor markets and existence of non-traded goods, that can help our
understanding of the wage gap phenomenon.
RAJAT ACHARYYA, SUGATA MARJIT

T
o have the world at your doorstep
is quite exciting. The most visible
part of such a contact is the over-
whelming proliferation of cable channels
in our TV sets. Our access to world news,
information regarding the consumption
standards worldwide, our exposure to
technological changes, encounter with the
websites, etc, get increasingly interwoven
with our lifestyle. Virtual distance between
us and any point in the globe has been
drastically reduced with far-reaching im-
plications for international trade, invest-
ment, income, employment and growth.
These in turn have effects on more desir-
able yardstick of development, poverty
and inequality. We think that the term
globalisation, as is popularly used, defines
a process of integration with the rest of
the world. Such integration is routed
through increasing volume of foreign trade
and investment. The major task of an
economist is to work out the welfare
implications of such a transformation both
from aggregate and distributive perspec-
tives. In regard to the distributive effect,
in particular, economists in the
industrialised world are worried over a
noticeable empirical phenomenon that
suggests a considerable decline in the
income of unskilled labour and/or a de-
cline in their employment relative to the
more skilled segment of the workforce.
This has happened in the US and in Europe
over the last 20 years and has roughly
coincided with the buoyant phase of inter-
national trade and investment. Substantial
research work has been devoted to this
aspect [Bhagwati 1995; Davis 1998;
Feenstra and Hanson 1995; Jones and
Engerman 1996; Leamer 1995; Wood 1997].
Inequality is a complex phenomenon
and trade and labour economists have
reduced it to the minimum dimension of
abstraction by focusing on the ratio of
unskilled to skilled wage rate and/or
employment. Also the issue of poverty and
inequality is far more important for the
developing countries both because of the
alarming and overwhelming proportion of
the population living below the poverty
line (however measured) in these nations
and also because inequality by halting
growth usually leads to the self-perpetu-
ation of a low-level equilibrium [Banerji
and Newman 1993; Gal-Or and Zeira
1993]. The agony of being stuck at a low
level equilibrium is what distinguishes the
south from the north. Having only an old
car in a world where everyone else owns
a top-of-the-line Mercedes may be psycho-
logically as painful as starving to death
while everyone else enjoys a lavish dinner.
However, in the latter example someone
dies whereas in the former the choice to
survive physically is always there. It is also
possible that a marginal increase in real
income from the subsistence level does a
lot of good even when a richer person
increases her income far more substan-
tially. An alternative scenario, with lower
income for the rich and no change in income
for the poor, may improve the Gini coef-
ficient but does not do anything for the
poor. There are plenty of such examples
that prove that the issue of inequality is
far more complex than the standardisation
of the problem in terms of the relative wage
of the unskilled. However, it is also im-
portant to recognise that the absolute real
income of the unskilled should be a crucial
category along with their relative position
in the economy. Substantial improvement
in the real income of poor workers can
definitely compensate for the rise in in-
equality. One purpose of this paper is to
deal with these two categories in terms of
analytical structures that substantially alter
the standard trade theoretic results.
As it always happens, inequality had to
grow in the developed world to make trade
and inequality a hot topic of research.
Historically the argument favouring free
trade has always been packaged with the
idea of compensation and redistribution to
make everyone better off through trade.
Theoretically, exposure to international
trade benefits factors used intensively in
the export sector. If these factors are at the
lower end of inequality, degree of inequal-
ity must get reduced through trade. This
is the cornerstone of the neoclassical trade
theory, technically known as the Stolper-
Samuelson (SS) result. If the US or Europe
have abundance of physical capital and/
or skilled workers and their trade pattern
with the rest of the world follows
Heckscher-Ohlin, we can expect concen-
tration of unskilled workers in their im-
port-competing sectors and consequently
freer trade must make these workers worse

Economic and Political Weekly September 23, 2000 3503

off both in absolute and relative terms.
This is precisely the argument of the trade
theorists linking Mexico-US trade and the
formation of NAFTA with the observed
widening wage gap. If the poor gets poorer
through trade, inequality is likely to grow.
In fact, one complaint has been that the
blue collared workers in the rich countries
have been increasingly exposed to fierce
competition from the Asian and Latin
American exports and therefore it is
natural that poverty and inequality will
grow as an inevitable fallout of the process
of globalisation.
The competing view of wage inequality,
however, tends to contain the backlash on
freer trade and argues that technological
change that depends increasingly on skilled
workforce must reduce the relative de-
mand for the unskilled. Hence, technology
and not trade is the real culprit. These
issues are summarised in Wood (1995).
Developing Country Scenario
Generally speaking not much attention
has been devoted to the analysis of
globalisation and inequality in the devel-
oping countries. Of course, we do not
undermine the recent works of Robbins
(1994, 1995, 1996a, 1996b) and Wood
(1997) and their empirical findings that
point towards growing wage inequality in
the southern hemisphere. What bothers us
is the thin list of theoretical possibilities
that are grounded in an antiquated dem-
onstration of the Stolper-Samuelson re-
sult. Moreover, an apathy towards having
a closer look at the labour markets of the
developing countries and a casual treatment
of the trade theory, ignoring the possibili-
ties that lie underneath the surface, means
committing the theory to conclusions which
are only artefacts of weak theorisation.
This is what this paper tries to avoid and
for this purpose we suggest models that
can be used in the applied work instead
of the straitjacket application of the Stolper-
Samuelson (SS) result.
Empirical methodology which illumi-
nates our view regarding trade and wage
inequality is extremely difficult to imple-
ment in an aggregative study because one
has to control for many variables that
determine the degree of inequality. Con-
trolling for other explanatory factors also
means that one is more or less certain about
the mechanism, which determines the
nature of such partial dependence of in-
equality on trade and investment. Explor-
ing such a mechanism rigorously is what
3504
we set out to do. It has to do with what
is the most likely outcome of liberalising
trade if one is concerned with the real
income of the poor workers, particularly
in an economy which exhibits large agri-
cultural sector, pockets of economic sophi-
stication, possibly dualism, large informal
labour markets, non-traded activities, capi-
tal constraint, etc. Such proliferation of
concerns sounds far too complex for an
experiment with the SS type result in a
general equilibrium framework. But as we
argue, between the vintage two-sector
Heckscher-Ohlin structure and a multi-
sector analytically unsolvable general
equilibrium model lies the possibility of
constructing something meaningful, of
course more transparent to people who
appreciate theory, but not less interesting
to a wide range of economists. In some of
our recent work we have tried to make
serious efforts in this respect and we will
present a bird’s-eye view of these models
[Acharyya and Marjit 1999; Marjit 1997;
Marjit et al 1997, Marjit and Acharyya
2000].
Before going to the next section, it should
be mentioned that the regional dimension
of trade and inequality has been a major
research topic for economists working on
various aspects of the European Union. A
different type of research is needed to
assess the impact of globalisation on inter-
regional disparity in a big country like
India. Should we expect that trading ac-
cording to comparative advantage would
lead to the convergence of economic well-
being of the Indian states? Such a dimen-
sion of inequality is noticeably absent in
countries such as Singapore, Hong Kong
and Taiwan. In India regional disparity,
imbalances and promotion of backward
states and regions have been highlighted
in the context of the devolution of fiscal
power between the centre and the states.
A small but growing literature has been
dealing with these issues for a while mainly
handling the divergence of per capita net
state domestic product (PCNSDP) in the
post-independence period [Ghosh et al
1998; Nagaraj et al 1997]. Little analysis
is available on how different regions have
performed in the post-reform period. One
intriguing statistical evidence is that the
coefficient of variation in PCNSDP does
have positive correlation with the open-
ness index for the entire post-indepen-
dence period. Such a correlation increased
substantially during the post-reform pe-
riod. Except some recent works by Krugman
(1997) and Deardorff and Courant (1992),
Economic and Political Weekly
trade and regional concentration or diver-
sifications have not received much atten-
tion from trade theorists. However, no
such attempt will be made in this paper
though this is certainly on our future re-
search agenda.
This paper has four sections. Section I
summarises the country experiences with
trade, wage distribution, poverty and
inequality. This part of the analysis is
basically informative and is not at all
exhaustive partly because no such analysis
is available and partly because the focus
of this paper is theoretical. Section II is
devoted to an overview of the neoclassical
trade theoretic results at the frontier of
research, which may help our understand-
ing of the issue of trade and wage gap. In
Section III we elaborate a theoretical re-
search agenda that explicitly focus on the
pattern of trade, labour markets and im-
perfections in a typical developing
economy.
I
Wage Inequality: Empirical
Evidences
Despite asymmetries in the extent of
changes in relative wages of skilled and
unskilled workers, the experiences of the
high and low/middle income countries are
more or less similar. Except for the east
Asian countries, the general trend that has
been observed is an increase in the ratio
of skilled to unskilled wages, i e, a wid-
ening wage gap between skilled and un-
skilled workers, in most part of the globe
since 1970s. In Europe, where national
institutions have a particularly strong in-
fluence on wage settings, the deterioration
of the relative position of the relatively
unskilled workers is reflected in rising
unemployment.
Over the 1970s although the US economy
became considerably open, the premium
earned by educated workers actually de-
clined. The situation has changed drasti-
cally from the 1980s onwards as the real
wages have stagnated and relative wages
have become more dispersed. These have
been accompanied by dramatic increase in
inequality of earnings based on education,
experience and occupation. For example,
as observed by Bound and Johnson (1992),
the ratio of the average wage of a college
graduate to the average wage of a high
school graduate rose by 15 per cent. Reich
(1991) put it more strongly: global com-
petition has bifurcated American workers
into two groups, the high-earning ‘sym-
September 23, 2000
bolic analysts’ whose talents are rewarded
by globalisation and the mass of ordinary
production workers whose earnings are
dispersed by it.
Another influential work in this regard
much cited by economists as well as by
the media is that of Borjas, Freeman and
Katz (1992). But their conclusion was not
very encouraging for the supporters of the
trade-wage gap nexus. The trade flows are
observed to explain at most 15 per cent
of the 12.4 per cent increase in the earnings
differential between college educated
workers and their high school educated
counterparts between 1980 and 1988.
Bhagwati and Dahejia (1998), however,
challenges this work on a more theoreti-
cally legitimate ground. Borjas et al, miss
the central point in their analysis that
international trade must affect commodity
prices in the desired direction before
anything can be inferred about the trade-
wage gap nexus. But as observed by
Bhagwati (1995) and by Lawrence and
Slaughter (1993), commodity prices have
changed in the opposite direction to that
required for the SS explanation. Leamer
(1995), on the other hand, has stressed that
some relative prices of US import com-
peting goods have indeed fallen during
this period, especially those for textiles
and apparel.
The case of Europe is altogether differ-
ent. With national institutions having a
strong influence on wage setting there, the
important issue is the degree to which such
institutional and regulatory forces repressed
wage adjustments and instead raised un-
employment. The strongest bastion of the
European Monetary Union (EMU), Ger-
many, has exhibited significant unemploy-
ment rates and the root cause has often
been cited to be rigid labour laws and
social safety net contributions of the
employer. Whereas the workers out of job
for more than a year accounted for just 6.3
per cent of total unemployment in the US,
the share was typically about 40 per cent
in Germany, France, the UK and Italy.
However, Lawrence (1994) has reported
that between 1978 and 1988, the ratio of
manual to non-manual wages fell by 8.1
per cent in Germany and by 3 per cent in
Italy whereas they actually increased in
Belgium and Denmark. According to the
OECD Employment Outlook (1993), on
the other hand, there was a substantial
increase in the ratio of earnings of the
highest to lowest percentiles in the UK.
Similar was the finding of Katz, Loveman
and Blanchflower (1992).
Economic and Political Weekly September 23, 2000
The studies by Robbins covering Argen-
tina, Chile, Colombia, Costa Rica, Mexico
and Uruguay, reveal widening of the skill
differentials in wages (by the level of edu-
cation) in almost all these countries con-
trary to conventional wisdom. The indices
for wages, the weighted averages across
sex and experience, and the ratio of wage
of workers with secondary level education
to that of workers with primary level of
education as reported by Robbins are clear
indication of the widening wage gap
phenomenon. Pederson (1998) corrobo-
rates the findings of Robbins for Chile by
reporting a study that shows that during
the 1980s the ratio of the wage of the
university graduates to high school gradu-
ates went up by 56 per cent. On the con-
trary, however, Meller (1998) finds the
white-blue wage differentials going down
between 1984 and 1992.
There are also some empirically observed
strong associations between trade
liberalisation and widening wage gap as
shown in Table 1. Except in cases of second
phase liberalisation programmes in Ar-
gentina and in Chile, the wage gap has
widened with reduction of trade barriers.
In Chile average tariff rates were reduced
from over 100 per cent prior to 1975 to
11 per cent by 1979.
Openness rose from about 20 to 55 per
cent during 1970-90. Though during
1976-89, the period of study of Robbins
(1995), Colombia did not liberalise its
trade regime significantly, its currency
was devalued over 60 per cent between
1985 and 1989. The openness index there
hovered around 25 per cent. In almost all
these cases the relative demand for skilled
workers has been found to be rising im-
plying a possible trade-wage gap nexus.
Mexico is another example where skilled-
unskilled wage gap increased in parallel
with radical trade liberalisation. The tariffs
were reduced there by 45 per cent and
import licences by more than 75 per cent
Table 1: Effects of Increased Openness in Latin American Countries
Country and Years Changes in Trade
Reform
Argentina
1967-82 Barrier reduction with appreciation
1989-93 Barrier reduction with appreciation
Chile
1974-79 Barrier reduction with devaluation
1984-92 Devaluation
Colombia (1985-94) Devaluation till 1989, barrier reduction
during 1990-92
Costa Rica (1985-93) Barrier reduction and devaluation
Uruguay 1990-95 Barrier reduction
Source: As reported in Wood (1997).
between 1985 and 1987. The wage gap
between non-production and production
workers in manufacturing, on the other
hand, widened during 1984-90 [Feenstra
and Hanson 1995].
For east Asia the empirical findings
available so far point towards declining
inequality. Except in case of Hong Kong,
the wage gap declined in Korea and Taiwan
during the 1960s and in Singapore during
1970s. In all these three cases, according
to Wood (1997), changes in trade regime
were partly responsible. On the other hand,
he attributes the widening wage gap in
Hong Kong to the large increase in the
relative supply of unskilled labour instead
of trade policy change. However, the major
problem with the empirical exercise, as
pointed out by Wood himself, is that the
data on relative wages suffers from gaps
and deficiencies. Moreover, while finding
the relationship between trade and wage
gap, only few analyses have attempted to
control for the internal influences on the
movement of relative wages.
Similar to the experience of the three
tigers, Robbins (1994) finds persistent
compression of wage differentials by the
level of education in Malaysia from 1973-
89 particularly between university gradu-
ates and educated workers. This went on
in the early 1990s with the skilled and
semi-skilled blue collar workers in manu-
facturing sector gaining relative to others.
However, despite the increasing openness
from a high initial level of 70 per cent in
1970 to nearly 100 per cent in 1983 and
then to 150 per cent by 1992, and shift in
demand in favour of less skilled workers
within industries because of trade related
changes in product mix, Robbins (1994)
denies the role of trade openness in such
a decline in the wage gap. The relative
growth in the number of highly educated
workers is what he ascribed as the pri-
mary factor behind the compression of the
wage gap.
Skill Differentials Relative Demand
in Wages for Skill
Widened Rising
Narrowed Falling
Widened Rising
Fluctuated Rising
Widened Rising
Widened except
during 1988-90 Rising
Widened Rising
3505
 The case of Philippines is less transparent the impact of a more open trade environ- factor supply or endowment base of the
during its modest liberalisation episode ment since there may be several factors country can be accommodated through
(1978-88). Skill differentials in wages affecting demand and supply of labour. changes only in the composition of out-
widened during severe recession in 1982- But it is a convenient starting point. puts. Thus no changes in factor prices and
86, but then narrowed again [Robbins consequently in factor intensities are needed
1994]. II to clear the domestic factor markets. This
The evidence in south Asia is not very Standard Trade Theory often misunderstood one-to-one correspon-
systematic. Though any comprehensive dence between commodity prices and factor
empirical study is yet to come by, some The wage determination process in a prices, given the state of the technology,
casual empiricism points out widening trading economy is important in under- holds the centre-stage of the HOS model
wage gap in south Asia including India. standing the relationship between trade and the wage gap debate.2 In particular,
The impact of the so-called globalisation liberalisation and the wage gap. As neatly when Pi is the weighted average of all
in this region is studied from a broader summarised in Jones and Engerman (1996), commodity price changes, in absence of
perspective of employment, growth and in any general equilibrium (GE) model any no money illusion, equation 1 boils
poverty by Dev (2000), Khan (1998) and factor prices are influenced by commodity down to
Tendulkar et al (1996). The employment prices, factor endowments and technol-
scenario, according to Dev (2000), is ogy. If Pi, Ei and Ti denote effects of w^ i = Σj βj ^pj ...(2)
encouraging enough at the aggregate level changes in commodity prices, in endow- Therefore, for a trading economy, the wages
though not so much at a more disaggregate ment or factor supply base and in technol- are uniquely determined from outside, no
level in the post-liberalisation era. On the ogy respectively, then the relative change matter how small or large the volume of
other hand, Khan (1998) finds that the in price of factor i is given as, trade is, given the technology. Recently,
process of expansion in foreign trade and ^ =P + E + T Leamer (1995) has put it in a different way:
wi i i i ...(1)
investment in south Asian countries is even though trade dependence, volume of
consistent with rising incidence of poverty where wi denotes proportional change in trade as a proportion of GDP, is low in
in these nations. Typically, if poverty is money wage. the US, the existence of the apparel indus-
really on the rise then it must worsen the The important point to understand in this try means that wage of the unskilled worker
inequality situation. context is that any other factors, such as in the US is determined in Shanghai.
Although no systematic study on wage trade deficit or surplus, volumes of trade Another important characteristic of the
dispersion caused by trade liberalisation and the like, cannot affect factor prices wage-price relationship in equation 2 is the
in India is available, there is one interest- independent of Pi, Ei and Ti.1 magnification effect as we will demon-
ing piece of evidence that points to grow- The effects of these three terms in equa- strate later in the context of a 2x2 HOS
ing wage inequality in the post-reform tion 1 on wages, however, depend on the model with no joint production. This is the
period. In Table 2 we look at the range of number of goods versus the number of essence of the much celebrated Stolper-
wages for the lowest daily paid unskilled factors. An economy consuming m goods Samuelson (SS) theorem and is reflected
workers in the organised sectors for the and having n factors of production, will in the fact that at least one βj is greater
periods 1985-86 and 1993-94. Since the produce only n goods, when m > n, at a than unity and another is negative [Jones
process of economic reforms started in given set of world commodity prices. The and Engerman 1996:36]. Thus the factor
1991-92, we use these two periods as pre- (m – n) remaining goods will be imported price changes are more than proportionate
reform and post-reform data points respec- entirely. The even case, number of goods to commodity price changes.
tively. Note that for all states there is equal to number of factors, describe the Does the unique relationship in equa-
substantial difference between the maxi- HOS scenario whereas m < n describes the tion 2 mean that any increase in the ratio
mum and minimum value for both periods. specific factor model a la Jones (1971). In of skilled and unskilled workers in the
If we assume perfect labour mobility within both the even and the m > n cases, the economy over time, for example, through
the states, this looks a bit awkward. The unique result is that Ei = 0. That is, at given education and training, has no impact on
only meaningful explanation is that the commodity prices, factor prices are the wage gap? The answer depends on the
data is available at some level of aggre- uniquely determined and any change in importance of the economy in the world
gation and part of the differential possibly
Table 2: Range of Minimum Wages for Lowest Daily Paid Unskilled Workers in
captures productivity or skill gap even Organised Sectors
among the unskilled. Of course, there may (in Rupees)
be cost of living differences as well. 1985-86 1993-94
Whatever be the case, what is striking is Central/ Minimum Maximum Range/ Minimum Maximum Range/
the difference in the extent of the gap State Government Min Wage Min Wage
between the maximum and minimum wage Central 8.50 12.75 0.50 19.82 37.37 0.88
over the two periods. This difference or Andhra Pradesh 7.00 18.00 1.57 11.00 40.00 2.60
range as a proportion of minimum wage Bihar 8.50 8.50 0.00 16.00 26.24 0.64
has increased by more than seven times for Kerala 12.00 15.00 0.25 19.50 75.40 2.86
Maharashtra 6.00 10.00 0.66 11.00 64.00 4.80
Maharashtra, 15 times for Tamil Nadu and Punjab 14.00 16.44 0.17 41.50 41.50 0.00
uniformly for other states except Punjab. Tamil Nadu 8.00 11.00 0.38 8.00 49.20 5.15
The average was about 0.48 in 1985-86 Uttar Pradesh 8.00 9.50 0.18 18.00 42.00 1.33
West Bengal 7.29 10.15 0.39 7.76 45.00 4.79
and more than 2 in 1993-94. Such wid-
ening of the gap does not necessarily reflect Source: Annual Report 1993-94, Ministry of Labour, Government of India.

3506 Economic and Political Weekly September 23, 2000

market. With full sectoral factor mobility,
such changes in factor endowment must
affect the world commodity prices first in
order to influence the wages. If the country
is small enough to affect the commodity
prices, there would certainly be no changes
in wages. Otherwise, with the output
composition changing, the world relative
price of skill-intensive commodity will fall
through consequent excess supply. Ac-
cordingly, given equation 2, the relative
wages change.
But changes in factor supplies will have
a direct influence on factor returns when
the number of factors is greater than the
number of goods (m < n). Thus, in a
specific factor model, Ei ≠ 0.
Having such understanding of wage
determination process in the standard trade
theoretic general equilibrium models, let
us now turn to the explanation of the wage
gap phenomenon. The cornerstone of the
trade theorists’ argument on the link be-
tween trade liberalisation and widening
wage gap is the HOS model and the Stolper-
Samuelson theorem. But the problem with
such an argument is that simultaneous
widening of wage gap in the trading na-
tions cannot be justified theoretically
though observed empirically. To fix idea,
suppose in a two country, two commodity
framework the home country exports good
X, i e, it has a comparative advantage in
good X, indicated by the lower relative
price of good X:
pa < pa* ...(3)
Whatever may be the source of such
comparative advantage or price differences,
through arbitrage (buying cheap and sell-
ing dear) and consequent physical move-
ments of goods across national borders,
the domestic prices will eventually be
equalised thereby stopping any further
movements of goods. Thus, the relative
price of good X rises in the home country
and falls in the foreign country.
How are the factor prices expected to
change consequent upon such commodity
price movements? Suppose the home
exportables are relatively unskilled labour-
intensive. As the relative price of ex-
portables increases, the production of the
import-competing good Y contracts and
that of the exportable good X increases.
The consequent resource reallocation leads
to an excess demand for unskilled labour
and an excess supply of skilled labour
because the expanding X sector requires
more unskilled labour and can absorb fewer
skilled labourers than are released by the
Economic and Political Weekly September 23, 2000
contracting Y sector. Hence, the unskilled
money wage increases whereas the skilled
money wage declines.
However, we can expect something more
than just these changes in the absolute
prices. An appeal to the SS theorem in-
dicates that freer trade causes the real
wage to increase and the real return to
capital fall [Caves et al 1996]:
^ ^ ^ ^
w > PX > 0 > PY > wS ...(4)
This is essentially a restatement of the
price magnification effect implied by
equation 2. It is to be noted that unskilled
workers gain through trade.
Conversely, in the foreign country a
similar argument leads to,
^ ^ ^ ^
wS* > PY* > 0 > PX* > w* ...(5)
That is, free trade makes foreign skilled
workers better off and unskilled workers
worse off.
What the above price magnification
effects or the (generalised) SS theorem
indicate is that trade liberalisation causes
the wage gap to change asymmetrically in
the two countries. Therefore, the HOS
model with the SS theorem at its core does
not take us very far in explaining the more
or less similar income distributional ef-
fects of free trade observed in the north
and in the south.
There is one exception, however, of the
above asymmetric effect when production
technology exhibits factor intensity rever-
sal (FIR). But this is an exception rather
than a rule. Another plausible case is where
countries produce similar as well as dif-
ferent goods such that the relatively skill-
intensive good in one country is not so
skill-intensive in the other. In a three
commodity setting, for example, if coun-
tries completely specialise in the most and
least skill-intensive commodities with the
moderately skill-intensive commodity
produced in common, symmetric changes
in wage gap can be obtained.3
III
Alternative Theoretical
Framework
From the empirical evidence cited in
Section I it is immediate that for the trade
theorists the task at hand is twofold. The
first is to generate more or less symmetric
changes in the wage gap in the trading
nations. The second is to explain widening
wage gap through increased trade in the
south or the developing countries having
an abundance of unskilled workers. On
both the counts we have seen that the
standard HOS model or its variants fail to
corroborate the empirical findings. One
important property of the HOS model as
explained above is the independence of
wages from endowments of skilled and
unskilled workers. Any changes in such
factor supplies can affect wages only
through changes in world commodity prices
and that too when the country is an im-
portant trader in the world market. In terms
of our discussion in Section II above this
means for a small open economy (or as a
matter fact, for given world prices), Ei = 0.
But the findings of Robbins (1996a) of
strong domestic supply impact on relative
wages in Colombia suggest forces incon-
sistent with this property of the HOS model.
As pointed out earlier, in the specific
factor model of trade where the number
of factors of production is greater than the
number of traded goods, the endowment
base of the economy has direct influence
on wages. It may appear obvious then to
presuppose better applicability of such a
model on the basis of the findings of
Robbins (1996a). But the specific factor
model too, unless modified, cannot explain
the symmetric changes, in the wage gap
in the trading nations. The main problem
with these standard theories is their failure
to capture the diverse trade pattern that the
developing nations are showing up in their
export baskets of late, and the institutional
characteristics specific to them. Our on-
going theoretical research indicates that
inclusion of trade in intermediate goods
in a variant of the specific factor model
may generate symmetric changes in factor
prices. On the other hand, pecularities such
as exporting both skill-intensive manufac-
turing and unskilled labour intensive ag-
ricultural products, coexistence of
organised and informal labour markets and
the production of goods that are not (or
cannot be) traded, are capable of explain-
ing the relationship between openness and
wage-gap in the south. In the rest of the
paper we sketch a theoretical structure
incorporating these features to highlight
the trade and widening wage gap nexus.
Trade Pattern
Of late, the trade pattern of the devel-
oping countries as reflected in their export
baskets has become more diversified than
it was a decade ago. Such diverse trade
patterns cannot effectively be captured
through an aggregative index of skill-in-
tensity of exports. India’s export pattern
is one such example revealing the draw-
3507
back of the aggregative measure. From
exporters of primary products at large,
India has emerged as a large exporter of
softwares which is highly skill-intensive.
Gems and jewelleries, another major ex-
port item during 1990s, also involve a
good deal of skilled labour. Thus despite
several agricultural goods being exported,
it would not only be unfair but also per-
verse to assume India’s exports as rela-
tively unskilled labour-intensive while
analysing the effect of terms of trade
changes on the wage gap. Examples of
other southern countries are not hard to
find. Consequently, it is quite obvious that
labelling the south as exporters of un-
skilled labour-intensive goods with too
much analytical dependence on the SS
theorem produce theoretical results largely
at variance with observed wage move-
ments in the south.
As pointed out by Jones et al (1999),
production and trade pattern of a country
must match the specific composition of
resources. Every country should produce
and export goods consistent with its factor
endowments no doubt, but this does not
and should not mean that an unskilled
labour abundant country will export only
unskilled labour intensive goods. In case
of India, exports of rice and softwares are
indeed consistent with the available prod-
uct-specific factors. In the following we
consider a variant of the specific-factor
model incorporating such diverse trade
pattern as discussed in Marjit and Acharyya
(2000).
Consider a small open economy produc-
ing three goods: an agricultural good (X)
that uses unskilled labour (L) and land (T);
and two manufacturing goods – Y, using
unskilled labour and capital (K), and Z that
combines capital with skilled labour (S).
Goods Z and X are exported whereas Y
is imported by this country. The markets
are perfectly competitive and production
technology exhibits constant returns to
scale.
Given the world prices of the final goods,
the zero profit conditions are described as:
PX = aLXW + aTXR ...(6)
PY = aLYW + aKYr ...(7)
PZ = aSZWS + aKZr ...(8)
Factor price flexibility, on the other hand
ensures full employment of all factors:
S = aSZZ ...(9)
K = aKYY + aKZZ ...(10)
L = aLYY + aLXX ...(11)
T = aTXX ...(12)
3508
Of course, we have the input choice con-
ditions described by the input coefficients,
aij. Note that these seven equations are
sufficient to determine the seven variables
– four factor prices and three output levels.
However, being a variant of the specific
factor model, factor endowments do have
perceptible influence on factor prices unlike
in an HOS model.
Now suppose booming global trade
prospects increases the world price of Z.
For a given value of agricultural output (X)
and hence demand for unskilled labour,
the Y-Z subsystem defined by eqs 7-11
gives us the standard 2 x 3 specific factor
set up with skilled and unskilled labour as
the two specific factors and capital as the
mobile factor. Thus, as demonstrated in
Jones (1971), increase in PZ raises WS and
reduces W. However, as W goes down,
unskilled labour moves to agriculture
reducing the output of Y and expanding
that of X. This arrests the fall in W to some
extent but not fully because in the final
equilibrium production of Y must contract
since capital leaves this sector for the
expanding Z sector. Therefore, wage gap
widens indicating the importance of pat-
tern of exports.
What happens when world price of
agricultural exports goes up? With un-
skilled labour drawn into agriculture con-
sequent upon this, the unskilled wage
increases and this pushes down the return
to capital to maintain the zero profit con-
dition in the Y sector as its price has not
changed. By the same token WS must rise.
The change in wage gap is, therefore,
ambiguous. Formally,
^ ^ ^ labour abundant LDCs through trade
WS – W = –r (θKZ – θKY)/θSZθLY ...(13)
where θijs are the factor income shares.
Therefore, an improvement in the terms of
trade through an increase in the price of
agricultural exports will widen the wage gap
if θKZ > θKY. With the decline in the return
to capital, the cost saving is more in the
Z sector than in the Y sector if capital cost
share is higher in this sector. This, in turn,
necessitates greater increase in the skilled
wage than the unskilled money wage to
maintain zero profit conditions in these
sectors at given world prices, PZ and PY.
Hence the wage gap widens notwithstand-
ing the fact that it is agriculture, which does
not use skilled labour, that has expanded.
The latent complementarity between ag-
riculture and skilled manufacturing leads
to increasing inequality in this case.
Moreover, as agricultural output expands
consequent upon the increase in its price,
Economic and Political Weekly
land being fixed in supply and specific to
this sector, return to land must increase.
This implies that the increase in the un-
skilled money wage must be less than pro-
portionate to the increase in PX. Hence, the
real wage for the unskilled workers mea-
sured in terms of agricultural output falls.
Non-traded Production
As well documented by Agenor (1996),
Cole and Sanders (1985), Fields (1990),
Mazumdar (1983, 1993), informal sectors
provide most of the employment in most
of the developing countries. The 1991
census report in India also tells the same
story: share of informal sectors in total
employment is almost 90 per cent and this
has been the scenario during the 1980s and
1990s. In fact, as documented in Dev
(2000), during 1973-93, in almost all sectors
the share of informal segments has either
remained the same or increased. This has
been the highest in agriculture around 99
per cent, followed by around 90 and 81
per cents respectively in construction and
manufacturing. Accordingly, these char-
acteristics of the labour markets in the
LDCs must be accounted for in the expla-
nation of the wage gap phenomenon. Of
late, we have made an attempt in this
regard in Marjit and Acharyya (2000).
It is also well known by now that the
existence of the non-traded goods, the
market for which must clear domestically,
significantly alter many standard results of
the trade models. Since most of the non-
traded production in the LDCs uses un-
skilled labour intensively, any discussion
of widening wage gap in the unskilled
liberalisation cannot be complete without
such non-traded goods being taken into
account.
As argued in Acharyya and Marjit (1999),
however, the more important issue is the
nature of such non-traded sectors. In
particular, whether non-traded production
is organised in the informal or in the formal
sector may appear to be crucial. Essentially
the way formal and informal sectors are
modelled in the literature, the issue at hand
can be rephrased as examining the role of
non-traded production under alternative
wage formation assumption: (higher)
contractual unskilled wage or fully flex-
ible market-determined unskilled wage.
Since the traded sectors compete with the
non-traded sectors for the scarce resources
they use in commonly and the non-traded
production by definition must match its
domestic demand, trade liberalisation in-
September 23, 2000
duced expansion of activities in the traded
sectors will be possible only through a fall
in the demand for non-tradeables. This
necessitates an increase in the price of non-
traded goods and consequent changes in
domestic income distribution. Herein
comes the role of the nature of the non-
trade sector. If it is a formal sector with
a contractual wage, the non-traded price
may be determined solely by the cost of
production independent of the demand for
non-traded good. In such a case demand
variation consequent upon trade
liberalisation induced real income changes
alters only non-traded production. Accord-
ingly any change in the wage gap is trig-
gered by the consequent resource reallo-
cation across the non-traded and traded
sectors. But if the non-traded sector is an
informal sector, variations in the demand
for non-traded good is followed by changes
in both production and price of the
non-traded good. Accordingly, trade
liberalisation will have quite different
implications on the wage gap between
skilled and unskilled workers.
To fix ideas, we extend the earlier equa-
tion system by incorporating a non-traded
sector. First consider the case where rural
labour market is informal whereas the urban
labour market is organised. It is important
to note that unskilled workers who cannot
find any job in the urban organised sector(s)
at high institutionally given money wage
move to the rural sectors to work at even
lower market-determined money wage. In
this regard we deviate from the standard
Harris-Todaro type assumption and instead
follow the available empirical evidences
cited in Agenor (1996), Agenor and Montiel
(1996) and Mazumdar (1993) that low-
skilled workers cannot afford to remain
unemployed. Therefore, in a way unskilled
labour is fully employed in our extended
model as well although there are two distinct
wage rates.
Now from our assumption regarding the
nature of rural and urban labour markets,
it follows that the manufacturing Y sector
hires unskilled labour at a given money
wage, W, whereas the agricultural workers
offer their work at the market-determined
lower money wage, W. To begin with,
suppose the non-traded good (N) is pro-
duced in the urban formal sector. If only
labour is used to produce this good, which
is of course just a simplifying assumption,
the non-traded price is cost-determined:
PN = aLNW ...(14)
Output is, on the other hand, demand-
determined given the simplifying assump-
Economic and Political Weekly September 23, 2000
tion that α proportion of total urban in-
come is spent on the non-traded good and
that the rural population does not have
access to this output:
PNN = a[(aLYY + aLNN)W
+ WSS + rK] ...(15)
These two equations are added to the basic
structure described earlier and the full
employment condition for unskilled labour,
eq 11, now contains an additional term,
aLNN.
The important point to note is that the
formal sectors form an independent sub-
system of the economy. The output and
prices of the factors used in production of
Z, Y and N are all determined independent
of the informal agricultural sector.4 But
the wage rate, the return to land and the
agricultural output level crucially depend
on the equilibrium values in the formal
sectors of the economy. This is exactly
what we can expect. Since only those
unskilled workers who are not employed
in the formal import competing and non-
traded sectors at the higher contracted wage
moves to informal agriculture, it is obvi-
ous that its production activities will be
constrained by the outputs and hence by
the demand for unskilled labour in the
formal sectors. Herein comes the role of
the non-traded good. Had all goods been
traded, production of agricultural exports
would not necessarily be constrained by
the demand for non-traded good and the
consequent demand for unskilled labour.
Any excess demand would have been met
through imports.
In such a set-up let us examine how an
increase in the price of manufacturing
exports affects the wage gap. The imme-
diate impact will be an increase in the
skilled wage and with the rate of return
to capital held fixed by the given world
price of importable and the ad valorem
tariff rate, such increase will be more than
proportionate. Consequently input substi-
tution effect will raise production of manu-
facturing exports. This causes output of
the import competing good to fall since
some capital is withdrawn to support the
additional production of the Z good.
But the change in urban income, at the
initial non-traded output, is ambiguous as
evident from equation 15: whereas the
income of the capitalists remain unchanged,
that of the skilled workers increase and the
wage income of the workers in the Y sector
decrease. Consequently, the demand for
non-traded good and hence its output level
may go either way.
If non-traded production falls, some
unskilled labour will be released from this
sector as well along with that from the
import competing sector and accordingly
the unskilled wage must fall to absorb
them in informal agriculture. But if non-
traded production increases, not signifi-
cantly though, some of the released un-
skilled labour will be absorbed in the non-
traded sector thereby necessitating much
smaller wage fall in the informal agricul-
tural sector. In either case, the wage gap
widens. It is only when non-traded pro-
duction increases significantly, requiring
more unskilled labour than is released by
the contracting import competing sector,
the unskilled wage will go up and the wage
gap may decline consequent upon such
(net) excess demand for unskilled labour
in the formal sector as a whole.
Import liberalisation through tariff re-
duction, however, can be shown to widen
the wage gap unambiguously. On the other
hand, when the non-traded good is
produced in the informal sector, PN is
no longer independent of domestic de-
mand. In such a case, as shown in Acharyya
and Marjit (1999), the wage gap is more
pronounced under import liberalisation
compared to the above case of formal
sector production of non-traded good.
That is, the informal non-traded sector
by itself appears to be source of the
deteriorating position of the unskilled
workers.
With the possible exception of the east
Asian countries, increased foreign trade
and investment have increased wage in-
equality in almost all parts of the globe
during the last two decades of the 20th
century. Theoretically as well as empiri-
cally HOS model of trade with the Stolper-
Samuelson result at its core fails to explain
such widening of wage gap between skilled
and unskilled labour particularly in the
south. The main problem with these stan-
dard theories is their failure to capture the
diverse trade pattern that the developing
nations are showing in their export baskets
of late, and the institutional characteristics
specific to them. Instead of straightjacket
application of the HOS model and too
much emphasis on the Stolper-Samuelson
theorem, one needs to focus on these
aspects. In this paper we have discussed
alternative variants of the specific factor
model accounting for the diverse trade
pattern, informal factor markets and ex-
istence of non-traded goods, that can
explain to a large extent the wage gap
phenomenon. EPW
3509
 Notes
[This paper has grown out of our ongoing work
on Trade and Inequality. We would like to thank
Amiya K Bagchi, Satya P Das, Ananya Ghosh
Dastidar, Ronald Jones, Utsa Patnaik, Dipak
Nayyar, and seminar and conference participants
at the CSSS, Calcutta, Copenhagen Business
School, IGIDR, Mumbai, JNU, Delhi and the
University of Mumbai for stimulating discussions.]
1 Another factor that has no direct influence, of
course, in absence of any non-traded good, is
the devaluation or revaluation of the nominal
exchange rates. Exchange rate changes
proportionately raises all commodity prices and
money wages leaving relative wages unchanged.
Thus, as correctly pointed out by Robbins
(1995a), the work on trade and wages by Murphy
and Welch (1991) that emphasised on
revaluation of US dollar was based on a false
premise.
2 Such one-to-one correspondence fails to hold
when domestic factors of production are not
sectorally mobile or the production technologies
exhibit factor intensity reversals.
3 We are indebted to Ron Jones for pointing this
out.
4 If we assume that a fraction of the rural income
is spent on the non-traded good, the formal non-
traded sector is no longer a part of the
independent subsystem.
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