Trade liberalisation and cross‐firm wage heterogeneity: Theory and evidence from China

In this paper, we first build a simple model with firm heterogeneity that features input and output tariffs in firms’ production decisions. We show that tariff reduction, due to trade liberalisation, has different effects on firms’ profit. Input tariff reduction generates a cost‐saving effect which benefits firms whilst output tariff reduction results in a competition effect which may hurt domestic firms. Given the fair wage argument, trade liberalisation may affect wages across firms due to the joint effects on firm profit. Using detailed Chinese manufacturing firm data from 1998 to 2007, we conduct empirical tests to investigate how trade liberalisation affects Chinese firm wages. In particular, we measure the joint effects of input and output tariff reduction by the applying the new measurement on the effective rate of protection. Furthermore, we also control for the effect of the iterated use of inputs with an index of a firm’s position on value chain. We found that from 1998 to 2007, Chinese manufacturing firms paid higher wages due to higher tariff protection when firms’ status on value chain was controlled. The result remains robust when more control variables are included and the endogeneity problem is considered.