Varying markups and income inequality in an open economy

Empirically and theoretically trade openness has been found to increase especially within-country wage income inequality. Recently, empirical studies have emphasized also the role of capital income, capital gains and top incomes earners in the widening of total income distributions in various countries. We contribute to the literature by analysing how a change in markups in an open economy affects different income inequality measures and unemployment rate. While the assumption of fixed markups has still been common in theoretical models that analyse the topic, in empirical studies markups have been often found to decrease when an open economy faces tougher competition. We use the general equilibrium framework of Egger and Kreickemeier (2012) for the analysis, which includes firm heterogeneity in productivity, fair wage setting and an analysis on the effects for different income inequality measures. We find, contrary to earlier studies, that tougher competition increases the unemployment rate, income inequality between capital income and wage income and the Gini indexes of both wage and capital income. This is due to the increase in the productivity level required to operate, which subsequently decreases the number of firms. Labour supply increases, since the more productive firms that stay in operation need less employees than the less productive firms that drop out of business. In the end, a smaller share of firm owners and employees will be able to enjoy the export premium in profits and wages and income distributions widen.