Evaluating the Factor-Content Approach to Measuring the Effect of Trade on Wage Inequality

This paper addresses two questions: (i) can factor content of trade be used to measure the effect of trade on wage inequality in a given year, with tastes and technology constant; and (ii) can it be used to measure the contribution of trade to the change in wage inequality between two years, with tastes and technology allowed to change? Deardorff and Staiger (1988) had shown that the answer to the first question can be given in the affirmative provided all production functions and the utility function are Cobb-Douglas. I demonstrate, as does Deardorff (2000) independently, that the affirmative answer can be extended to the case when all production functions and the utility function take the CES form with identical elasticity of substitution. I further demonstrate that we can answer the second question in the affirmative under the same conditions as the first. I then examine critically the assumptions underlying these conclusions. They include identical elasticities of substitution across all production functions and the utility function, absence of increasing returns and non-competing imports, homotheticity of demand, and no endogenous response of factor supplies to trade. I conclude that, taken as a whole, these assumptions are sufficiently strong to leave many analysts, including myself, skeptical of the estimates based the factor-content approach. Center for International Economics, Department of Economics, University of Maryland, College Park MD 20742-7211, Email: [email protected]; phone: 301 405 3546; fax: 301 405 7835. In writing this paper, I have benefited greatly from numerous conversations with and comments from Jagdish Bhagwati. I also thank Don Davis, Praveen Kumar, Peter Neary, Robert Staiger, Adrian Wood and participants of International Economics workshops at Columbia University, University of Maryland, West Virginia University and the 1998 Summer Workshop at the University of Warwick. Special thanks go to Robert Feenstra for several suggestions, leading to many improvements in the paper.