Anything But Conventional: Wage Inequality and International Trade

Stop thinking about U.S. trade and wages using conventional trade theory, or at least stop doing it so readily. This is the advice of a June 2010 working paper co-written by economists Lawrence Edwards and Robert Z. Lawrence for the Peterson Institute for International Economics.

Conventional trade theory considers growing U.S. wage inequality to be a result of declining relative prices for unskilled labor-intensive goods– in other words, imports from China. Picture a world divided into developing and developed

countries, the former with relatively more unskilled labor and the latter with relatively less. Say the world makes only two goods, one of which requires relatively more unskilled labor. When the world trades, the relative price of the unskilled labor-intensive goods in developed countries drops, along with relative wages for unskilled workers in these countries. That’s conventional trade theory (the Heckscher-Ohlin theory and the Stolpher-Samuelson theorem) in a nutshell.

Edwards and Lawrence don’t see these patterns borne out in the data. By the authors’ analysis of numbers aggregated by the Bureau of Labor Statistics and the International Trade Commission, relative domestic prices of U.S. manufacturing goods competing directly with developing-country imports did decline substantially from 1987 to 2006. But after weighting these data by the proportion of production workers engaged in manufacturing the underlying goods, something strange occurs: prices actually rise.

“[F]ears of rising US wage inequality from developing-country imports in recent years are unwarranted,” Edwards and Lawrence argue, seeming to take aim at the consensus view that has followed the lead of economist and New York Times columnist Paul Krugman’s famous 2008 reversal. Krugman, who pioneered new trade theory, had previously held that trade liberalization bore little responsibility for growing wage inequality in the U.S.

In short, the authors find that imports from developing countries do not, on average, provide evidence of greater use of unskilled labor than imports from developed countries, even after accounting for productivity changes and dropping the problematic category of computers and electronics. A series of regression procedures demonstrates that, in the aggregate, imports from developing countries have not caused increased wage inequality in the U.S.

So what’s going on? By Edwards and Lawrence’s account, the rub lies in nonspecialization, a necessary assumption in the Heckscher-Ohlin theory that requires import-competing U.S. products to be essentially the same as their substitutes imported from developing countries. If that’s not actually the case – if we attribute something substantive to country of origin or if economists mistakenly assume that these goods function as substitutes – the story blows up.