Why does international vertical specialisation affect within‐firm skill premium in China? Investigation and interpretation

With highly disaggregated data during 2000–2006 in China, we construct the firm‐level international vertical specialisation index and find that China's ascension to WTO decreased the index in manufacturing firms. We investigate its relationship with measured skill premium in manufacturing firms and find that a one percentage point decrease in international vertical specialisation could lead to as much as a two‐tenth percentage point deduction in the skill premium. The effect is more pronounced when the specialisation is with OECD developed economies, while it is reversed with non‐OECD economies. Furthermore, the relationship is only significant in ordinary firms though processing firms also experienced changes in international vertical specialisation during the same period. Our results are robust to various empirical alternatives. We then propose a model that features a two‐stage production in Melitz's (2003, Econometrica, 71, 1695) heterogeneous firm model. The model can explain the puzzle why China's trade volume surged after entering WTO, while the degree of international vertical specialisation decreased. Furthermore, it also explains why vertical specialisation might affect within‐firm skill premium under trade liberalisation.