Integrated and unequal? The effects of trade on inequality in developing countries


Published 30.04.18

Does trade increase inequality? The answer is nuanced and context-specific, but the solution for policymakers is not protectionism.

Proponents of free trade advocate trade liberalisation or trade agreements by highlighting the aggregate gains that countries receive from trade. However, most theoretical models that predict aggregate gains from trade liberalisation also predict that trade generates winners and losers within a country, thereby potentially increasing inequality. If a policy has adverse distributional effects, the losers will likely try to block or reverse it. The current backlash against international trade in the US is a case in point. Competition from low-wage developing countries has contributed to the decline of manufacturing employment, labour market polarisation, and an increase in inequality in the US (Autor et. al 2013, Pierce and Schott 2016). Although it is still heavily debated whether import competition was the primary cause or merely a contributing factor to these phenomena, concerns about rising inequality within the US have led to calls for protectionism. 

The focus in developing countries 

While developed countries are mainly concerned with inequality and trade, the conversation in developing countries is more focused on trade’s contribution to economic growth and poverty reduction. Indeed, trade liberalisations have generated many aggregate gains for these societies (Goldberg and Pavcnik 2016). However, even if one believes that the distributional consequences of free trade are second-order relative to the first-order issues of growth and poverty reduction in developing countries, an understanding of these unequal distributional consequences is still critical to the survival of free trade. The current situation in the US shows that despite its aggregate benefits, free trade cannot be taken for granted. 

Many developing countries have experienced large-scale trade policy changes, ranging from import liberalisation to increased access to export markets. This has given researchers opportunities to study the effects of trade – through exporting and importing – on earnings and employment opportunities. The result is a large and growing body of research that examines the effects of international trade on income inequality in developing countries (Goldberg and Pavcnik 2007, 2016, Pavcnik 2017). 

What have we learned? 

Traditional gains from international trade are rooted in the concept of comparative advantage and achieved through the reallocation of labour and resources from import-competing to exporting industries. Worker mobility, however, is often constrained by rigid labour markets or the need for industry-specific skills. A large body of literature suggests that many developing countries face limited labour mobility, resulting in a lack of labour reallocation across industries in the short-run aftermath of large-scale trade reforms (Goldberg and Pavcnik 2007). Consequently, a first finding is that in developing countries, industry affiliation is important for the impact of trade policy changes on worker earnings in the short-run aftermath of trade reforms, with workers in industries exposed to intensified competition experiencing reductions in pay. 

Geographical concentration

A second robust finding is that the effects of international trade on earnings and employment are geographically concentrated and unequal within a country. Ultimately, the effects of international trade depend on a region’s level of exposure to import and export shocks. Individuals living in regions with a high concentration of industries benefiting from exporting fare better than individuals in less exposed regions (McCaig 2011, Erten and Leight 2017). Conversely, individuals in regions with a high concentration of industries subject to import competition fare worse than individuals in less exposed regions (Topalova 2010, Kovak 2013, Dix-Carneiro and Kovak 2017). 

One would expect individuals to relocate from adversely affected areas toward economic opportunities over time, causing the earnings differences to dissipate. In reality, however, there is imperfect inter-regional worker mobility. Thus, the unequal effects persist partly because of a lack of outmigration even five to nine years after large adverse trade shocks. 

Persistent adverse effects 

A third, and perhaps even more surprising finding from this literature is that the adverse effects of import competition on earnings and employment are persistent and can amplify with time. Lack of outmigration can last up to 20 years after a trade reform is implemented (Dix-Carneiro and Kovak 2017). Two forces contribute to an amplified response and slow decline in labour demand over time. First, agglomeration economies (i.e. economies where people and firms assemble near each other in industrial clusters and cities) amplify the initial negative effects of import liberalisation on the local labour demand. Second, capital adjusts slowly and gradually moves away from adversely affected regions and sectors, causing the relative demand for workers to further decline over time. 

Education and child labour decisions 

Fourth, the geographically concentrated effects of import competition can have longer-lasting effects by influencing education and child labour decisions of the next generation (Edmonds et al. 2009, 2010). More generally, the effects of trade on schooling and child labour depend on how trade affects parental income, employment opportunities, and returns to education. Even new exporting opportunities might have potentially adverse (and unexpected) effects on education across geography. For example, new jobs associated with exporting might require low levels of education and pay a premium over existing jobs (Atkin 2016). This increases the opportunity cost of schooling, inducing youths to drop out of school. 

Do consumers benefit from lower prices?

Lastly, an important benefit of international trade is that it gives consumers access to cheaper and previously unavailable consumption goods. The overall benefits to consumers depend in part on how the price savings at the border are passed through (by importing firms or distributors) to final prices of goods paid by the consumer. For example, a liberalised trade policy offers firms access to cheaper and previously unavailable production inputs, resulting in lower marginal costs of production. However, evidence suggests that lower marginal costs are only partially shared with consumers in the form of lower prices as firms often increase mark-ups (De Loecker et al. 2016). The study highlights the importance of market power considerations for how gains from input tariff liberalisation are ultimately shared between consumers and producers.

Concluding remarks 

Several qualifications are in order: 

  1. The effects discussed above are identified relative to other industries or regions. While this may be appropriate when the focus in on inequality, which is by definition a relative concept, one should be reminded that the above studies tell us little about aggregate welfare. 
  2. Past policy discussions on the implications of the global integration of developing countries had emphasised that trade was expected to reduce inequality in developing countries, by increasing the demand and earnings for less educated workers, and decreasing the demand and earnings for more educated workers. Yet, recent evidence suggests that the answer to the question “Does trade increase inequality?” depends on more than just the education levels of individuals. The answer is nuanced and context-specific. Trade’s effects on inequality also depend on the nature of the trade policy changes affecting trade patterns in a particular country; the economic mechanisms at work; capital and worker mobility across firms, industries, and geographic locations; and the income distribution positions of the individuals affected by trade liberalisation. 
  3. The literature so far suggests that trade is not the primary contributor to rising inequality in developing countries. However, trade’s adverse effects are heavily concentrated in certain regions or industries in developing and developed countries alike. Importantly, because these effects are so geographically concentrated, they have potentially significant spillovers to other outcomes, including schooling, crime, health, and the provision of public goods in the community. 
    Ultimately, these combined effects can lead not only to income inequality, but also to inequality of opportunity for the individuals living in affected communities. 

Despite these concerns, the solution is not a return to protectionism. Consumers in developing countries have benefited from international trade through access to cheaper and greater variety of products. International trade has also improved industry and firm performance in these countries, through reallocation of economic activity from less to more productive firms, the adoption of new technologies, access to cheaper and greater variety of inputs, innovation, and the elimination of distortions and inefficiencies (Goldberg and Pavcnik 2016). As increasing concerns about inequality have come to threaten what past trade liberalisations and agreements have achieved, academics and policymakers need to confront the challenges posed by the unequal distribution of globalisation’s gains head-on. 


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