Trade Liberalization, Wage Inequality, and Endogenously Determined Nontraded Goods

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Wage inequality fell in the 1960s and 1970s in Korea, Taiwan and Singapore but rose in the 1980s and 1990s in many developing countries that liberalized trade. This paper provides an explanation based on a model in which trade barriers give rise to nontraded goods. The model generates a U-shaped relationship between trade liberalization and wage inequality. When trade barriers are relatively high (low), trade liberalization causes wage inequality to fall (rise). The key is that trade liberalization, while increasing the demand for traded goods, reduces the demand for nontraded goods; the net effect determines relative wages.