Fragmentation in Production, Vertical Integration and Wage Inequality: A Theoretical Note

Developing a three-sector and four-factor general equilibrium model, this paper offers an explanation of wage inequality in a vertically fragmented production structure typical of off-shore outsourcing to developing countries like China or India. The model characterizes a typical developing economy where intermediate good is produced using capital and local low-skilled worker, traditional sector uses unskilled worker to produce agricultural products and skilled worker works in tandem with intermediates to produce final goods for export. The model furnishes that wage dispersion could be explained theoretically in this specific-factor general equilibrium structure where factor returns are endogenously determined within a production structure with middle products. In particular, scenario analysis shows that increase in relative price of final good aggravates wage inequality, whereas opposite happens when price of intermediates and import-competing sector inflates. Skilling the unskilled and protecting the sector intensive in low-skilled could attenuate the adverse impact.