countries.
The empirical evidence on wage inequality in developing countries seems to contradict this
optimistic prediction.17 As shown, inter alia, by Robbins (1996) and Harrison and Hanson (1999),
many developing countries experiencing drastic trade liberalizations in the recent past, such as
Chile, Mexico, Costa Rica and Uruguay, have seen a concomitant increase in wage inequality and
a generalized increase in the relative demand for skilled labor (i.e., skill upgrading).
This puzzling evidence has stimulated an impressive body of research by way of new explana-
tions of the link between trade and labor markets. Here we briefly review the main explanations,
focusing on their implications for labor market outcomes in developing countries.
Outsourcing
Feenstra and Hanson (1996) formulate a model with capital mobility and a continuum of pro-
duction activities with different skill-intensities. They show that trade and investment liberal-
ization bring about North-South outsourcing of production activities which are at the same time
unskill-intensive relative to other activities performed in the North, and skill-intensive relative to
activities performed in the South. The main implication is that, contrary to the standard two-
sector Heckscher-Ohlin model, trade and investment liberalization increase the relative demand for
skilled labor in both regions, and can thus potentially explain the worldwide increase in the skill
premia.
The argument put forth by Feenstra and Hanson is consistent with the main stylized facts
concerning the labor market dynamics in both the developed and the developing world. Its empir-
ical relevance deserves further scrutiny, however. As argued, for instance, by Robbins (1996), this
model can be relevant for countries, such as Mexico, that experienced large FDI inflows in the last
17The prediction is based on the simple Stolper-Samuelson theorem. However, as noted by Turrini (2002), in a
more realistic higher dimensional setting, i.e., in the presence of many countries, sectors and production factors,
it is hard to discern empirically in which factor a country is relatively abundant and in which trade context that
factor is going to gain from trade liberalization. For instance, Turrini performs computable general equilibrium
simulations to show that the effects of trade liberalization on the relative wage of the unskilled in Latin America
critically depends on whether or not agriculture is also liberalized. A similar point is made by Harrison and Hanson
(1999). They argue that the dramatic increase in wage inequality after the 1985 trade reform in Mexico does not
necessarily contradict the Stolper-Samuelson theorem. The reason is that, prior to reform, protection in Mexico was
skewed toward low-skilled intensive sectors, and it fell most in these sectors after trade reform.
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