International trade and income inequality

Abstract

We propose a theory that explains why international trade can widen a wage gap between top income earners and others and cause job polarization. In the basic model, we consider two symmetric countries in which individuals with different abilities work either as knowledge workers, who develop products produced in a differentiated-good sector, or as production workers, who engage in actual production processes. In equilibrium, ex ante symmetric firms post different wages for knowledge workers and hence attract workers with different abilities, creating the firm heterogeneity in product quality. International trade will benefit firms that produce high-quality products and harm firms that produce low-quality products. The relative wage gap between individuals with high ability and those with low ability expands as a result. Indeed, we show that international trade increases the real wages for those with lowest and highest abilities but decreases the real wages for those with intermediate abilities. We also extend the basic model to the one with asymmetric countries and show that income inequality worsens in the smaller or talent-scarce country while it lessens in the talent-abundant country as a result of international trade.