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Economic Development, International Trade, and Income Distribution

Xiaokai Yang
Department of Economics, Monash University

Dingsheng Zhang
Department of Economics, Monash University and
Institute for Advanced Economic Studies, Wuhan University

This version: September 2001

JEL code: D30, F10, O10.
Key words: Income distribution, division of labor, dual structure, economic development

We are grateful to Guangzhen Sun, Lin Zhou, Meng-Chun Liu for helpful discussion and to the Australian Research Council for financial support (Large Grant A79602713) is gratefully acknowledged. We are solely responsible for the remaining errors.

Abstract: This paper applies the inframarginal analysis, which is a combination of marginal and total cost-benefit analysis, to investigate the relationship between division of labor, the extent of the market, productivity, and inequality of income distribution. The model with transaction costs and exogenous and endogenous comparative advantages shows that as trading efficiency is improved, the general equilibrium discontinuously jumps from autarky to partial division of labor with a dual structure, then to the complete division of labor where dual structure disappears. In this process different groups of individuals with different trading efficiency get involved in a certain level of division of labor at different stages of development. As the leading group gets involved in a higher level of division of level, leaving others behind dual structure emerges and inequality increases. As latecomers catch up dual structure disappears and inequality declines. When the leader goes to an even higher level of specialization, dual structure occurs and inequality increases again. Inequality decreases again as the latecomers catch up. Hence, the equilibrium degree of inequality fluctuates in this development process. The relationship between inequality and productivity is neither monotonically positive nor monotonically negative. It might not be of inverted U-curve. The key driving force of economic development and trade is improvement in trading efficiency.

1. Introduction
The purpose of this paper is twofold. First, we develop a general equilibrium model with endogenous specialization to show that the relationship between economic development and inequality of income distribution is neither monotonic nor an inverted U-curve. Second, we use the general equilibrium model to investigate interdependence between the extent of the market, the level of division of labor, productivity, and the degree of inequality of income distribution.

Let us motivate the two tasks one by one. Krugman (1995, 1996) and Krugman and Venables (1995) vividly document the fact that the relationship between economic development and income distribution comes to the focus of public concern in the 1970s and 1990s. But this is always a controversial issue in economic literature. Some models and theories are developed, with empirical evidence sometimes, to show that there is a positive correlation between economic development and inequality of income distribution (Banerjee and Newman, 1993, Lewis, 1955, Palma, 1978, Li and Zou, 1998, Chang and Ram, 2000, for instance). Other models are developed, with empirical evidence sometimes, to show that there is a negative correlation between inequality and international trade, which relates to economic development (Aghion, Caroli, and Garcia-Pena Losa, 1999, Alesina and Rodrik, 1994, Galor and Zeira, 1993, Thompson, 1995 and Fei, Ranis, and Kuo, 1979, Frank, 1977, Balassa, 1986, for instance).

Not only data from developing and newly industrialized countries are contradictory, but also data from developed countries generate more controversies. Kuznetz (1955) proposed the hypothesis of inverted U-curve of the relationship between inequality and per capita income and provided some support for it from US data. Krugman and Venables (1995) use a general equilibrium model with global economies of scale to predict such an inverted U-curve of inequality. Greenwood and Jovanovic (1990) use a dynamic equilibrium model to predict the inverted U-curve. Some theories and data show that there is a negative or insignificant correlation between trade or development and inequality in the developed country (see, for instance, Krugman and Lawrence, 1994 and Katz and Murphy, 1992). Others show a positive correlation between trade and inequality in the developed country (see, for instance, Grossman, 1998, Murphy and Welch, 1991, Borjas, Freeman, and Katz, 1992, Karoly and Klerman, 1994, Sachs and Shatz, 1995 ). But Ram (1997) provides new empirical evidence for an uninverted-U pattern in the developed countries, taking into account of data since World War II. Jones (1998, p. 65) also shows that the ratio of GDP per worker in the 5th-richest country to GDP per worker in the 5th-poorest country fluctuated from 1960 to 1990.

The controversy and new evidence call for new models and theories that can resolve it. In the current paper, we develop a general equilibrium model to show that the relationship between inequality and trade that relates to economic development is neither monotonic nor an inverted U-curve.

In our general equilibrium model of endogenous specialization, economic development is described as an evolutionary process of division of labor that is driven by improvements in trading efficiency. Because of differences in trading efficiencies between countries and between different groups of residents in the same country, those individuals with better trading efficiencies will be involved in the division of labor and related trade before others are. Inequality increases because of the dual structure. As latecomers catch up, the dual structure disappears, so that inequality declines. As the leading group goes to an even higher level of specialization, leaving others behind, dual structure emerges and inequality increases again. As latecomers catch up, the dual structure disappears and inequality decreases again. This ratcheting process of inequality and equality generates fluctuation of the degree of inequality of income distribution. This implies that the relationship between inequality and economic development is neither monotonically positive nor monotonically negative. It may not be a simple inverted U-curve.

The intuition behind the model is as follows. If the relationship between inequality and economic development is monotonic, then in the very developed country, income distribution must be either extremely equal or extremely unequal. This is true too for an inverted U-curve between inequality and per capital income. But we cannot see either of these two extreme cases. Hence, inequality of income distribution must fluctuate as the equilibrium level of division of labor evolves. This evolution gets a group of individuals involved in a higher level of division of labor earlier than others. Hence, a dual structure in which some individuals are more specialized (or more commercialized) than others keeps emerging and disappearing as the equilibrium level of division of labor increases. A new data set in Deininger and Squire (1996) supports our hypothesis. It indicates that there is no systematical link between growth and changes in aggregate inequality. Recent regressions of Barro (1999) and Banerjee and Duflo (1999) suggest also that no monotonic correlation between inequality and growth performance can be supported by data.

The second purpose of the current paper is to explore the intrinsic relationship between the development of division of labor and changes in inequality of income distribution. Kuznetz (1955) explained inequality of income distribution by per capita income. This is certainly not a general equilibrium view since per capita income is endogenous in a general equilibrium model, which itself should be explained by parameters. Murphy, Shleifer, and Vishny (1989) show that unequal income distribution restricts the extent of the market, so that economies of scale cannot be fully exploited and economic development is retarded. We put this idea together with Allyn Young's conjecture that "not only division of labor is dependent on the extent of the market, but also, the extent of the market is determined by the level of division of labor", to develop a general equilibrium mechanism that simultaneously determines the extent of the market, the level of division of labor, productivity, and degree of inequality of income distribution.
We will examine effects of the coexistence of exogenous and endogenous comparative advantages on inequality of income distribution. Yang (1994) and Yang and Borland (1991) have drawn the distinction between David Ricardo's exogenous comparative advantage (Ricardo, 1817) and Adam Smith's endogenous comparative advantage (Smith, 1776). There is an extensive literature on exogenous comparative advantage in trade theory (see, for instance, Dixit and Norman, 1980). Separately, there are many models of endogenous comparative advantage in the growing literature on endogenous specialization (see Yang and Ng, 1998 for a recent survey on this literature and references there). The current paper develops a general equilibrium model with the trade off between transaction costs and endogenous and exogenous comparative advantages. We shall show that as trading efficiencies are improved, the scope for efficiently balancing this trade off is enlarged. Hence, the equilibrium level of division of labor increases. The existence of exogenous comparative advantage implies that different types of individuals are sequentially involved in the division of labor. Part of the population are first involved in a low level of division of labor, the rest being left behind. The emergence of this dual structure increases inequality of income distribution. Then the rest of the population are involved in this low level of division of labor, catching up rich fellows. This catch up process reduces duality and related inequality. Then, part of the population go to an even higher level of division of labor, increasing duality and related inequality. Then the rest who are left behind catch up, reducing duality and inequality again. This ratcheting process goes on, generating fluctuation of the degree of duality of economic structure and of the degree of inequality of income distribution. In this development process, the most important determinant of equilibrium aggregate productivity and welfare is trading efficiency rather than inequality of income distribution. This is called irrelevance of inequality (or equality) of income distribution to economic development.

Early studies of structural changes and dual structure rely on the assumption of disequilibrium in some markets to predict dual structure and structural changes. For instance, Lewis (1955) tried to explain dual structure between commercialized and self-sufficient sectors by evolution of division of labor and related productivity progress (see also Ranis, 1988). Due to lack of appropriate analytical tools, he ended up with a model based on disequilibrium in labor market caused by institutional wage. Chenery (1979) used market disequilibrium to explain structural changes. Recently, general equilibrium models are used to study dual structure. In some of these models, such as in Khandker and Rashid's equilibrium model (1995), dual structure is exogenously assumed. They cannot predict the emergence and evolution of dual structure. In a recent literature of formal equilibrium models of high development economics, evolution of dual structure between the manufacturing sector with economies of scale in production and the agricultural sector with constant returns to scale can be predicted (see Krugman and Vanables, 1995, 1996, and Fujita and Krugman, 1995). The equilibrium models with endogenous geographical location of economic activities of Krugman and Venables (1995) and Baldwin and Venables (1995) attribute the emergence of dual structure to the geographical concentration of economic activities in economic development that marginalizes peripheral areas. Kelly (1997), based on Murphy, Shleifer, and Vishny (1989), develops a dynamic general equilibrium model that predicts spontaneous evolution of a dual structure between the modern sector with economies of scale and the traditional sector with constant returns technology. As trading efficiencies are sufficiently improved, the level of division of labor increases and dual structure disappears. Our model in this paper is complementary to these general equilibrium models that predict the emergence and evolution of dual structure. We pay more attention to the effects of evolution of individuals' levels of specialization and the coexistence of exogenous and endogenous comparative advantages on the emergence and evolution of dual structure.

The rest of this paper is organized as follows. Section 2 presents the 2x2 Ricardian model with transaction costs and endogenous and exogenous comparative advantages. Section 3 solves for general equilibrium and its inframarginal comparative statics. Section 4 extends the analysis to consider not only income distribution in the developing country but also that in the developed country. The concluding section summarizes the findings of the paper and suggests possible extensions.

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