Discussion Paper Details

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Title: Skill Premium and Trade Puzzles: A Solution Linking Production and Preferences

Author(s): Justin Caron, Thibault Fally and James R. Markusen

Publication Date: June 2012

Keyword(s): gravity, income, missing trade, non-homothetic preferences and skill premium

Programme Area(s): International Trade and Regional Economics

Abstract: International trade theory is a general-equilibrium discipline, yet most of the standard portfolio of research focuses on the production side of general equilibrium. In addition, we do not have a good understanding of the relationship between characteristics of goods in production and characteristics of preferences. This paper conducts an empirical investigation into the relationship between a good's factor intensity in production and its income elasticity of demand in consumption. In particular, we find a strong and significant positive relationship between skilled-labor intensity in production and income elasticity of demand for several types of preferences, with and without accounting for trade costs and differences in prices. Counter-factual simulations yield a number of results. We can explain about half of ?missing trade?, and show an important role for per-capita income in understanding trade/GDP ratios, the choice of trading partners, and the composition of trade. Furthermore, an equal rise in productivity in all sectors in all countries leads to a rising skill premium in all countries, with particularly large increases in developing countries.

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Bibliographic Reference

Caron, J, Fally, T and Markusen, J. 2012. 'Skill Premium and Trade Puzzles: A Solution Linking Production and Preferences'. London, Centre for Economic Policy Research.