DP8286 Trade and the Skill Premium Puzzle with Capital Market Imperfections
An interesting puzzle is that trade liberalization in the 1980s and 1990s has been associated with a sharp increase in the skill premium in both developed and developing countries. This is in contrast with neoclassical theory, according to which trade should increase the relative return of the relatively abundant factor. We develop a simple model of trade with capital market imperfections, and show that trade can increase the skill premium in both the North and the South, and both in the short run as well as in the long run. We show that trade with a skill-intensive economy has two effects: it reduces the skilled wage, and thus discourages non talented agents out of the skilled labor force; and it reduces the cost of subsistence, thus allowing the talented offspring of unskilled workers to go to school. This compositional effect has a positive effect on the observed skill premium, possibly strong enough to counterweight the decrease in the skilled wage.