Ebook Globalization, product differentiation and wage inequality
In the late 1970s a group of theorists working independently (Norman, 1976; Krugman, 1979; Lancaster, 1980) revolutionized the way economists think about international trade with a powerful insight: trade liberalization induces similar nations to specialize in different varieties of the same product, giving rise to intra industry exchanges as consumers love variety. The empirical dominance of this form of trade, formerly posing a major challenge to trade theory, ceased therefore to be a puzzle. Furthermore, a new and potentially important source of gains from trade was uncovered: intra industry trade specialization allows economies of scale and expands the set of product varieties available to consumers, thereby increasing aggregate welfare.
The conceptual framework that made this breakthrough possible was the monopolistic competition model of Lancaster (1979), Spence (1976) and Dixit and Stiglitz (1977). By allowing to study imperfect competition in a tractable general equilibrium framework, this model has naturally become the workhorse theory of international trade, alongside the perfectly competitive paradigm. The elegance and simplicity of the monopolistic competition model comes at a cost, however. The set of differentiated varieties into which firms can specialize is exogenously given and there is no cost to product differentiation. Consequently, in equilibrium each variety is produced by a single firm, which acts as a monopolist in the market for it. While the different varieties of a given product are linked by the elasticity of substitution, producers do not engage in any form of strategic interaction.
In this paper we develop a model of oligopoly in general equilibrium to argue that the process by which firms differentiate their product from their rivals’ requires skilled labor and is affected by strategic interaction between producers. As a result, an intraindustry trade expansion following trade liberalization has potentially important implications for the relative rewards of skilled and unskilled workers and the intersectoral allocation of resources. In addition, since product differentiation is resource consuming, trade liberalization between similar nations entails a potential trade-off between production and variety.
To formalize these arguments we build on the model by Neary (2009) who offers a theoretically consistent but tractable model of oligopoly in general equilibrium (GOLE). There are two countries each in which there is a continuum of imperfectly competitive industries. Firms have market power, allowing for strategic interaction, within their own industries. However, since each industry is small relative to the economy as a whole, each firm treats factor prices, goods prices in the other sectors and national income parametrically. Like in the monopolistic competition model, consumers seek variety and firms produce horizontally differentiated products. As a distinctive feature of our setup, the degree of product differentiation is endogenously determined, as firms optimally decide how much to invest in product innovation, taking into account that this process requires skilled labor. We also deviate from the standard framework by assuming that some industries are open to trade while others are shielded from international competition. Aggregation across sectors allows for the endogenous determination of economy-wide variables, most importantly factor rewards and aggregate welfare.
The key partial equilibrium result of our model is that trade cost reductions in non shielded industries increase firms’ incentives to invest in product innovation in order to horizontally differentiate their products from those produced by their foreign rivals. This strategic effect is shown to be predominantly caused by increased import competition, leading ceteris paribus to an increase in the relative demand for skilled labor. However, since trade is intraindustry, trade liberalization also leads to higher export volumes. As suming that product innovation requires skilled labor while production requires unskilled labor, the effect of trade liberalization on the relative demand for skilled and unskilled labor is consequently ambiguous.
In general equilibrium we show that globalization — measured either as a marginal trade cost reduction in non-shielded industries or a marginal reduction in the number of shielded industries — generally leads to higher wages for both skilled and unskilled workers. The effect on the skill premium is generally ambiguous but more likely to be positive the larger the share of shielded industries in the economy and the more elastic unskilled labor supply is relative to skilled labor supply. If skill upgrading is possible, we also identify a potential welfare trade-off between output and variety. If innovation incentives outweigh production incentives, globalization might paradoxically lead to less total output but this will be compensated by greater product variety. Even without innovation, we show that the welfare effects of globalization are not clear-cut in our model. When parts of the economy are shielded from international competition, globalization leads to a reallocation of resources from shielded to non-shielded industries with ambiguous welfare consequences.
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