July 5 2005 16 5 WSPC SPI j085 200 DLTC 00005 Division of Labour Transaction Costs Vol 1 No 1 2005 67 71 World Scientific Publishing Company WHY HAS INEQUALITY INCREASED IN CHINA TOWARD A THEORY OF INTERNATIONAL MATCHING E MASKIN Institute for Advanced Study Einstein Drive Princeton NJ 08549 USA maskin ias edu Received 26 February 2005 Revised 15 April 2005 A theory is outlined for why an expansion of international trade may aggravate inequality in developing countries such as China Keywords Inequality China matching It seems entirely fitting to discuss the Chinese economy on this occasion of the opening of the Renmin Monash Advanced Centre of Economic Studies ACES One of the most striking features of that economy is the remarkable pace at which it has grown in the past one or two decades A real challenge for economists is to account for this extraordinary success story I think that a potentially significant part of the answer is provided in work by Xiaokai Yang and his coauthors Yang shows clearly how a finer division of labour i e a higher degree of specialization can be a powerful engine for economic expansion Progressive refinement of the division of labour made possible by reductions in transaction costs especially in the Chinese case reductions in the cost of conducting international trade creates significant increasing returns which in turn foster growth But the conjunction of economic expansion and international trade seems to result in unfortunate side effects such as rising inequality of income Indeed China has experienced a sharp increase in inequality during its recent boom Yet it is not at all clear theoretically why inequality should go together with growth in GNP and trade Given his breadth of interests it is not surprising that Xiaokai Yang should have studied this problem too as in his work with Dingsheng Zhang Yang and Zhang 2003 view an increase in income inequality as the consequence of uneven progression in the division of labour Although expansion of trade provides the opportunity to specialize not everyone This paper is based on a talk delivered at the opening ceremony of the Renmin Monash Advanced Centre of Economic Studies ACES on 24 February 2005 at Renmin University Beijing I thank the NSF for research support 67 July 5 2005 16 5 WSPC SPI j085 200 DLTC 00005 68 E Maskin can exploit that opportunity immediately Those who specialize get rich those who cannot or will not do so remain poor Hence income inequality rises Today I would like to explore a complementary explanation for China s increase in inequality 1 Inequality and the Theory of Comparative Advantage For my purposes inequality is just the gap in income between rich and poor As I mentioned there is little doubt that China s growth in GNP and trade has been accompanied by an increase of inequality in this sense and the same has been true in many other countries as well At first blush this connection between trade and inequality in China may seem surprising This is because despite remarkable strides China is still a developing economy and the theory of comparative advantage the most widely accepted explanation for international trade patterns implies that expansion of international trade which I will call globalization should reduce inequality in developing countries Indeed this implication has been widely touted by proponents of and globalization Let me begin by reviewing the elements of the argument Any theory of trade must address the question of why countries trade with one another The answer according to the theory of comparative advantage is that countries trade because of their differences within the confines of the theory if all countries were identical in preferences and productive capabilities there would be no reason for them to trade But the theory goes a step further and posits that the important difference across countries is not in what people want their preferences nor in how they produce goods their techniques of production Rather the critical difference lies in their relative endowments of factors of production the inputs into the production process including labour which may be further divided into high skill and low skill workers capital including machinery equipment and technology and land Today I will concentrate on labour With its vast population China most likely has both more high skill and more low skill workers than the United States But what matters for the theory of comparative advantage is the ratio of the numbers of high skill to low skill workers And in spite of its economic expansion that ratio in China is still appreciably lower than in the US So China has a comparative advantage relative to the US in goods that are efficient to produce with a relatively low ratio e g clothing Similarly the US has a comparative advantage in goods for which the ratio is high e g computer software Given these differences it is instructive to compare the production patterns predicted by the theory both before and after globalization i e the great expansion of trade between the US and China Imagine first a state of affairs in which there is little trade between the two countries In this state Chinese companies must produce both software and clothing if consumers in China are to consume both goods as presumably they want to do I am ignoring the possibility that China might trade with some third country But the production of software is relatively inefficient in China because with proportionately so many low skill workers the labour force is better suited to making clothing July 5 2005 16 5 WSPC SPI j085 200 DLTC 00005 Why has Inequality Increased in China 69 Indeed a consequence of software being produced in China is that low skill Chinese workers suffer Low skill services are in only limited demand for such a high tech product Thus to the extent that software is produced instead of clothing the demand for low skill workers is depressed leading to a reduction in low skill wages By contrast high skill workers in China benefit from software production the high demand for their services drives up their incomes Now suppose that trade between China and the US is opened up perhaps because transportation costs decline It is no longer necessary for China to produce so much software which it can now obtain from the US With the decrease in software production China will now produce more clothing than previously exporting some of this to the US But because clothing uses low skill workers more
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