Impact of Trade Liberalisation on Wage Inequality and Skill Formation: A Theoretical Analysis
| Published date | 01 November 2024 |
| DOI | http://doi.org/10.1177/00157325231166243 |
| Author | Priya Brata Dutta,Niladri Saha |
| Date | 01 November 2024 |
Impact of Trade
Liberalisation on
Wage Inequality
and Skill Formation:
A Theoretical Analysis
Priya Brata Dutta1 and Niladri Saha1
Abstract
We consider a small open economy with three sector and four factors. Agricultural
sector produces output with unskilled labour and land. Manufacturing sector and
skill formation sector produce output with skilled labour and capital. Skill forma-
tion sector transforms the unskilled labour into skilled labour. We also consider
an extended version of this model where agricultural sector also uses capital. So
capital is mobile between all three sectors. Both change in the price of manu-
facturing sector and capital stock alter skill formation in a similar direction. But
change in the price of manufacturing sector leads to change in skilled–unskilled
wage inequality in the same direction whereas due to change in capital stock it
changes in opposite direction. In our extended study, where capital is mobile
between all three sectors, the results of the basic model are unaltered.
JEL Codes: F13, J31
Keywords
Wage inequality, skilled labour, unskilled labour, skill formation, general equilib-
rium, trade liberalisation
Original Article
1 Economics and Politics Department, Visva-Bharati University, Shantiniketan, Bhirbhum West
Bengal, India
Corresponding author:
Priya Brata Dutta, Economics and Politics Department, Visva-Bharati University, Shantiniketan,
Bhirbhum, West Bengal 731235, India.
E-mail: priyabratadutta@gmail.com
Foreign Trade Review
59(4) 501–533, 2024
© 2023 Indian Institute of
Foreign Trade
Article reuse guidelines:
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DOI: 10.1177/00157325231166243
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502 Foreign Trade Review 59(4)
Introduction
Dierence in skill among workers (skilled–unskilled labour), the existence of
wage inequality, skill formation, unemployment due to dierence in skill, these
are the important issues in the literature of trade and labour economics. Due to
mismatch of skills among the workers there exists dierence in wages as well.
Thus, there exists wage inequality in the economy. This income inequality
increased in US between 1960s and 1970s1 and in European countries between
1978 and 1988 (see, e.g., Katz et al., 1992; Lawrence, 1994). We nd similar
picture in many developing countries (DCs) because wage inequality problem
has worsened in many Latin American and South Asian countries in the mid-
1980s (see, e.g., Banga, 2005; Beyer et al., 1999; Borjas & Ramey, 1993; Dev,
2000; Wood, 1997). The only exception here is East Asian countries between
1960s and 1970s where skilled–unskilled wage actually improved (see, e.g.,
Acharyya & Marjit, 2000; Wood, 1997). Dierent studies point out dierent rea-
sons for this increase in income inequality. Trade liberalisation and technologi-
cal progress are the main two controversial reasons of this phenomenon.2 Many
empirical studies point out other causes of this growing inequality such as inter-
national outsourcing (refer to Feenstra & Hanson, 1997), increase in the price
of skill intensive good (refer to Beyer et al., 1999; Hanson & Harrison, 1999;
Harrison & Hanson, 1999), entry of overpopulated low-income countries such as
Bangladesh, China, India, Indonesia and Pakistan in the global market (Wood, 1997).
There exists a lot of theoretical works dealing with the issue of this growing
wage inequality. They adopt the framework of static competitive general equilib-
rium models3 of small open economies in which there exist two different types of
labour—skilled and unskilled. The ratio of wage rate of the skilled worker to that
of the unskilled worker is taken as a measure of wage inequality in these models.
We can divide the existing theoretical literature into two groups. One group of
models assumes exogenous supply of skilled labour and this group includes works
of Gupta and Dutta (2012, 2010a, 2010b), Chaudhuri (2008, 2004), Yabuuchi and
Chaudhuri (2007), Chaudhuri and Yabuuchi (2008, 2007), Beladi et al. (2008),
Marjit and Acharyya (2006, 2003), Marjit and Kar (2005), Marjit et al. (2004),
Dutta and Ghosh (2021) and Mahata et al. (2020). Hence, these models cannot
analyse the role played by endogenous skill formation on the skilled–unskilled
wage inequality. Another small group of models considers endogenous forma-
tion of skilled labour with static competitive general equilibrium models; and this
group includes works of Beladi et al. (2011), Gupta and Dutta (2010a), Yabuuchi
and Chaudhuri (2009), Kar and Beladi (2004) and Marjit and Acharyya (2003).
But most of them assume unskilled labour and capital use as the factor of produc-
tion in the skill formation sector except Gupta and Dutta (2010a), where skill
formation sector uses skilled labour and capital as inputs. However, Gupta and
Dutta (2010a) consider a four-sector general equilibrium model where effect of
change in different parameters on skilled–unskilled wage inequality depends on
intensity ranking between different sectors; whereas in our model it is independ-
ent of intensity ranking.
Dutta and Saha 503
In our study, we analyse the effect of change in different globalisation-related
parameters on DCs’ skilled–unskilled wage inequality and skill formation,
in presence of various types of capital mobility (domestic and foreign capital)
among different sectors. We consider a small open economy with three sectors
and four factors. Agricultural sector produces output with unskilled labour and
land. Manufacturing sector and skill formation sector produce output with skilled
labour and capital. Like Gupta and Dutta (2010a), we consider skill formation
sector transforms the unskilled labour into skilled labour; and, in this static model,
this transformation takes place instantaneously.4 Here, skill formation sector is
considered as an education sector, where production of new skilled labour means
the transformation of a part of unskilled labour into new skilled labour. These
new skilled workers are added to the existing stock of skilled workers at the next
point of time. So, in this static model, the production of new skilled workers
does not affect the stock of existing skilled workers. This educational service is
internationally non-traded. We consider that total number of labours present in
the economy is exogenously given. We also consider an extended version of this
model where agricultural sector also uses capital. So capital is mobile between all
three sectors in the extended model.
We now turn to explain the motivation behind addressing this research gap.
In reality, skilled workers are employed in various manufacturing units produc-
ing technologically sophisticated traded products; and also, a substantial part of
skilled labour is employed in non-traded educational sector. It is well known that
the education sector that transforms the unskilled labour into skilled labour can-
not run without skilled labour. Teachers in educational institute are always skilled
workers. This motivates us to introduce endogenous skill formation with the help
of skilled labour in this model.
We derive interesting results related to globalisation, such as change in tariff rate
and capital inflow, from our model. Both trade liberalisation and investment liber-
alisation improve the skilled unskilled wage gap but trade liberalisation lowers the
skill formation and investment liberalisation raises it. In our extended study where
capital is mobile between all three sectors, rise in the price of manufacturing sector
raises both the skilled–unskilled wage inequality and skill formation if the manufac-
turing sector is capital intensive compare to agricultural sector.
This article is organised as follows. The second section describes the basic
model with mobility of capital among manufacturing sector and skill forma-
tion sector only. The third section analyses extended version with mobile capital
among all three sectors; and concluding remarks are made in the last section.
The Basic Model
Most of the less developed countries (LDCs) or DCs have a traditional agricul-
tural sector which uses unskilled labour and land as inputs. Another feature of the
LDCs or DCs is a manufacturing sector which uses skilled labour and capital as
inputs. This model has these certain features. This model follows all the assump-
tions of small open economy. There are three sectors and four primary factors in
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