International Trade and Income Differences

Standards of living between the richest and poorest countries differ by more than a factor of 30. Is there a role for international trade in accounting for this fact? To answer this question, I construct a multi-country general equilibrium model. Within this framework, I derive an accounting procedure analytically decomposing income per worker into three components: differences in capital-output ratios, productivity, and a contribution from trade. Since the contribution from trade is measurable, I am able to quantify the variation in income per worker attributable to trade. In a sample of 77 countries, I show that the contribution from trade is negligible, less than 1 percent. That is, trade's contribution is so small that relative incomes are almost the same in a model with no trade. To further understand this result and how cross-country income differences respond to changes in barriers to trade, I calibrate the model by picking country specific productivity parameters and trade costs so the pattern of bilateral trade implied by the model matches the data. I find the calibrated trade costs are systematically asymmetric with poor countries facing higher costs to export their goods relative to rich countries. Furthermore, my calibrated model generates both prices and cross-country income differences consistent with the data. Through counterfactual exercises, I find that by removing the asymmetry in trade costs (i.e. provide poor countries with equivalent market access to rich countries markets) cross-country income differences decline by up to 34 percent. Eliminating all barriers to trade reduces cross-country income differences by up to 56 percent. By facilitating a more efficient allocation of production across countries, reductions in barriers to trade are quantitatively important for economic development.

For more information, contact Wilfred Either.