Trade and Wage Inequality: A Specific Factor Model with Intermediate Goods

In this paper we have made an attempt to explain the observed rising inequality between unskilled and skilled wages, or, fall in relative wages of unskilled labour within a general equilibrium framework by introducing specific factors and non- traded intermediate goods. For this we set up two distinct models of trade. The first model shows that for a small economy with specific factors freer trade may cause (a) both skilled and unskilled wages to rise, and, (b) the two wage rates may move in opposite directions depending on the trade – induced patterns of specialization. The model also suggests that while trade may increase wage inequality, this does not imply that poverty increases as wages of unskilled workers increase. By extending the model to incorporate intermediate goods we have shown that wage inequality may unambiguously increase (decrease). However, it is seen that this is a consequence of the structure of trade and not trade per se.