DP12077 Per-Capita Income and the Demand for Skills
Almost all of the literature about the growth of income inequality and the relationship between
skilled and unskilled wages approaches the issue from the production side of general equilibrium
(skill-biased technical change, international trade). Here, we add a role for income-dependent
demand interacted with factor intensities in production. We explore how income growth and
trade liberalization influence the demand for skilled labor when preferences are non-homothetic
and income-elastic goods are more intensive in skilled labor, an empirical regularity documented in
Caron, Fally and Markusen (2014). In one experiment, counterfactual simulations show that sector neutral
productivity growth, which generates shifts in consumption towards skill-intensive goods,
leads to significant increases in the skill premium: in developing countries, a one percent increase
in productivity leads to a 0.1 to 0.25 percent increase in the skill premium. In several countries,
including China and India, simulations suggest that the historical growth experienced in the last 25
years may have led to an increase in the skill premium of more than 10%. In a second experiment,
we show that trade cost reductions generate quantitatively very different outcomes once we account
for non-homothetic preferences. These imply substantially less predicted net factor content of trade
and allow for a shift in consumption patterns caused by trade-induced income growth. Overall,
the negative effect of trade cost reductions on the skill premium predicted for developing countries
under homothetic preferences (Stolper-Samuelson) is strongly mitigated, and sometimes reversed.
