Trade, overeducation, and wage inequality

Contrary to the predictions of the 2x2x2 Heckscher-Ohlin model, empirical evidence shows that trade openness causes the skill premium to increase in some developing countries and to decrease in others. This paper introduces a North-South setup, where the labor force is divided into skilled and unskilled workers. There are two types of firms: producers of final goods and producers of intermediate goods. There are two types of final goods: a complex good and a simple good. The former is produced utilizing skilled workers who completed their training, and a range of complex complementary intermediates. The latter is produced utilizing skilled workers who did not complete their training, unskilled workers, and a range of simple complementary intermediates. Complex and simple intermediates are produced by technology monopolists in the North, and used by producers of final goods both in the North and in the South. The results suggest that the skill premium increases in the North after trade liberalization if and only if the employment in the complex sector relative to the simple sector in the North is higher than that in the South. On the other hand, the effect of trade liberalization on the skill premium in the South depends on the level of overeducation. The skill premium is the ratio of the weighted average wage of all skilled workers to that of the unskilled workers. The wage of skilled workers is a weighted average of the wage of the skilled workers in the complex sector and in the simple sector. In the South, trade openness causes a decrease in the wage of the former and an increase in the wage of the latter. If the portion of the latter is higher than that of the former, the weighted average wage of skilled workers and the skill premium increase after trade liberalization. Otherwise, the skill premium declines. Therefore, the effect of trade liberalization on the skill premium in the South depends on the level of skill mismatch, or the portion of skilled workers in the simple sector. The empirical estimation using a threshold estimation technique provides evidence to support the theoretical findings.