Trade Liberalization and Inequality: Re-examining Theory and Empirical Evidence

This paper re-examines the theoretical and empirical evidence regarding the impact of trade liberalization on income inequality and attempts to identify areas for future research. Since the 1980s, there has been a rise in inequality in both the developed and developing world. This was also the time when many developing countries liberalised their trade regimes, which resulted in an increase in flow of goods and services, and capital and labour flows. Economists argue that trade based on factor proportions theory cannot account for the increasing wage inequality since the 1980s. Through this paper, the author has examined the theory as well as several recent studies that indicate a potential role of international trade in affecting wage inequality that operates through channels other than the Stolper-Samuelson type effects - New trade theory, residual wage inequality, industry wage premiums, skill biased technological change (SBTC), global product sharing and New new trade theories (heterogeneous firms). The main question is - how to isolate the effects of trade from other simultaneous changes in the economic environment that may have induced shifts in the relative demand and supply of skilled labour. Further research needs to be done on how important are these new channels relative to SBTC in explaining growing inequality in these countries. The study can be further extended to include not only the impact of international trade, but also the effect of financial globalization on inequality.