Sources of Heterogeneous Gains from Trade: Income Differences and Non‐Homothetic Preferences

Abstract

This paper considers the interrelationship between a hierarchy of consumption needs of agricultural goods, manufactures, and services as a central feature of the demand side of economies and the demand for skilled and unskilled workers, whose incomes differ. The relationship is established as skilled and unskilled labor are used in conjunction with capital goods in a nested constant‐elasticity‐of‐substitution (CES) production function, which features capital‐skill complementarity and a substitutive relationship between the bundle of capital and skills on the one hand and unskilled labor on the other hand. Incomes differ across countries both within and between types of workers. As trade costs change, relative and absolute incomes of worker types change and so does the worker‐type‐specific pattern of consumption. A calibration and simulation exercise documents that a consideration of the supply‐and‐demand‐side linkage in this hierarchy‐of‐needs model matters quantitatively for the role of trade liberalization in the world economy.