TRADE, TECHNOLOGICAL CHANGE, AND WAGE INEQUALITY: THE CASE OF MEXICO

• Date: 01 February 2021
• Author: Andrea Waddle
• DOI: http://doi.org/10.1111/iere.12485
• Published date: 01 February 2021

INTERNATIONALECONOMIC REVIEW

Vol. 62, No. 1, February 2021 DOI: 10.1111/iere.12485

TRADE, TECHNOLOGICAL CHANGE, AND WAGE INEQUALITY: THE CASE OF

MEXICO∗

By Andrea Waddle1

University of Richmond, Richmond, VA, U.S.A.

Following the U.S.–Mexico trade integration, the skill premium rose dramatically in Mexico. Standard trade

theory predicts the skill premium in a skill-scarce country should fall—not rise—following such an integration.

This article reconciles theory and data by building a model in which intermediate producers in Mexico begin

to produce for the U.S. supply chain following liberalization. To do so, they must rent ideas from the United

States, which are more skill-intensive, thus increasing the skill premium. This mechanism is supported by the

data: Mexican plants and industries that trade more with the United States rent more U.S. technology and

have higher skill premia.

1. introduction

Standard trade theory has stark predictions for how factor prices should respond to trade

integration between a skill-scarce and a skill-abundant country. In particular, models that are

based on the Heckscher–Ohlin (henceforth H–O) theory predict that the ratio of wages paid

to skilled versus unskilled workers (the skill premium) should rise in the skill-abundant coun-

try and fall in the skill-scarce country when the two countries open to trade with one an-

other. A puzzle that has arisen in the context of this prediction is that when integrating with

the world economy, many skill-scarce countries instead experience rising skill premia.2Mex-

ico is the canonical example of a country whose skill premium not only rose, but rose by much

more than that of its more-developed counterpart, the United States, during the period after

Mexico opened to trade. These observations have led researchers to propose several mech-

anisms by which trade liberalizations induce an increase in the relative demand for skill. In

this article, I add to this literature by arguing that trade liberalization, by stimulating invest-

ment in skill-biased technologies and facilitating cross-border diffusion of these technologies,

plays a signif‌icant role in explaining the aforementioned facts. I use the case of the Mexican

trade liberalization and integration into the supply chain of American companies to explore

the impact that technological transfer, which takes place as a part of this integration, has on

the wages of workers in Mexico. I show that, although a reduction in tariffs may cause an en-

dogenous increase in domestic technologies, a key component to the increase in Mexico’s skill

premium is the diffusion of technology from the United States to Mexico.

I begin by providing empirical evidence of the importance of two policy levers in determin-

ing the change in the skill premium in Mexico: tariffs and intellectual property rights (IPR)

∗Manuscript received May 2018; revised August 2020.

1I am indebted to Tim Kehoe and Ellen McGrattan for valuable advice and guidance. I would also like to thank

Cristina Arellano, Ariel Burstein, Harold Cole, Alessandro Dovis, Larry Jones, Yoshinori Kurokawa, Fabrizio Perri,

Collin Rabe, Joe Steinberg, David Wiczer, the participants of the Trade workshop at the University of Minnesota,

and anonymous referees for their useful comments. Tyler Pike provided excellent research assistance, and the Univer-

sity of Minnesota Doctoral Dissertation Fellowship provided f‌inancial support. All errors are my own. Please address

correspondence to: Andrea Waddle, University of Richmond, 28 Westhampton Way, Richmond, VA 23173, U.S.A.

Phone: +804-662-3165, Fax: +804-289-8878. E-mail: awaddle@richmond.edu.

2See Goldberg and Pavcnik (2007) for a nice summary of this literature.

243

© (2020) by the Economics Department of the University of Pennsylvania and the Osaka University Institute of So-

cial and Economic Research Association

244 waddle

protections. I use complete U.S. ownership as a proxy for IPR protections and show that Mex-

ican plants and industries that experience lower tariffs and stronger IPR protections tend to

receive more transferred technology, as measured by royalty payments. I f‌ind that, although

both policy levers are important, IPR protections are far more important in determining the

extent of technological diffusion. I then show that these royalty payments for technology

transfers correlate to higher average skill premia both at the plant and industry levels. I inter-

pret these results as supporting the idea that supply chains are a channel through which tech-

nology is transferred and that this technology transfer is an important determinant of the skill

premium. The plant-level surveys have been used in the past in order to analyze the impact of

trade on the skill premium; however, I am the f‌irst, to my knowledge, to use the information

on royalty payments to provide evidence that rental of technology has an impact on the skill

premium. I use these results to guide my modeling choices and f‌ind that the model produces

consistent results in which both policy levers impact the skill premium, with the IP wedge hav-

ing a greater impact.

I then adapt a standard trade model in a way that consistent with these observations in that

it allows for trade liberalization to increase both trade in goods and diffusion of technology.

I model technology as technology capital, similar to the model in McGrattan and Prescott

(2009), but I allow for the technology capital to be rented from f‌inal goods producers, who

own and invest in it, to intermediate goods producers, who use it. The model, thus, allows

for technology capital to be endogenously accumulated and diffused across borders through

trade.3Importantly, technology capital is nonrival, which means that using it in multiple lo-

cations increases its marginal productivity. This will impact both the extent of technological

diffusion and its accumulation. I model trade liberalization as a reduction both in tariffs on

goods and in distortions to the use of foreign technology capital and use this model in order

to quantitatively assess the importance of technological diffusion for driving increases in the

skill premium.

I discipline my exercise using manufacturing data from Mexico and the United States. Be-

cause my interest lies primarily in how the skill premium changed in Mexico, I target the level

of the skill premium in the initial period. I use aggregated industry data from Mexico on roy-

alty payments to identify the parameter that governs the importance of technology capital in

production. In particular, I match royalty payments as a percentage of payroll payments in the

period before trade liberalization. I use 1984–86 as the “pre-reform” period; as documented

below, the majority of Mexican trade reforms began in 1986. I also set the relative productiv-

ity of the manufacturing sectors in the two countries, the relative supply of skilled workers in

each country, and the skill intensity of each industry to match the data in the prereform pe-

riod. In order to analyze the impact of trade reform on the skill premium, I then conduct an

experiment where tariffs on goods and frictions on the use of foreign technology capital are

lowered. Although direct observation of the reduction in tariffs that occurred in the data is

possible, I am not able to directly observe a measure of the distortions on foreign technology

capital. I instead set initial distortions to match the industry-by-industry fraction of interme-

diate goods that are traded between the two countries, as well as industry-by-industry royalty

payments, in the prereform period.

My baseline experiment includes both a change in tariff rates between the United States

and Mexico and a reduction in the distortions to the use of foreign technology capital (IP

wedge), which matches the change in trade f‌lows and royalty payments observed during the

liberalization between the two countries in the late 1980s. I f‌ind that this reduction in both

barriers to trade in goods and in technology results in an increase in the Mexican skill pre-

mium of 15% in the model economy. I furthermore f‌ind that if there were complete erosion

3In the online appendix, I have included a case study of this type of technological transfer, which occurs partially

through ownership channels and partially through trade. It describes transfer of technology capital in the form of

“know-how” and blueprints.

trade, technology, & inequality 245

of barriers to using foreign technology, the skill premium would have risen by 30% in Mexico,

as compared to the 53% increase observed in the data.

Technological diffusion is key to these results. In order to show this, I contrast the baseline

in which both distortions are reduced with the case in which tariffs and nontariff barriers fall,

but distortions to the use of foreign capital remain high, thus impeding the diffusion of tech-

nology from the United States to Mexico. I f‌ind that this is only able to account for a 2% in-

crease in the skill premium in Mexico, which is consistent with what is found in Burstein and

Vogel (2017). In the model, the large increase in the skill premium is generated by a shift in

production toward more skill-intensive sectors as the IP wedge in those sectors falls. The re-

duction in the distortions to the use of foreign technology capital increases the incentive of

Mexican producers to adopt this technology, but also may induce an increase in the domes-

tic stock of technology capital as the returns to investing in technology capital increase, simi-

lar to results in related works such as Burstein and Vogel (2017) and Bustos (2011). However,

the domestic technological deepening is small and thus adoption of foreign technology capital

generates much larger increases in the skill premium as f‌irms move toward producing for the

U.S. supply chain and thus adopt U.S. technologies.

This has implications for how we think about the impact of trade liberalization on the skill

premium. My f‌indings suggest that, even when tariffs are reduced by the same margins in two

developing countries, the impact of these liberalizations could be very different. In particu-

lar, a country that integrates more fully into the supply chain of a more advanced country is

the benef‌iciary of the diffusion of technology capital. This diffusion is the primary force that

drives changes in the skill premium. Countries that simply lower tariffs but do not integrate

more fully into the supply chain of f‌irms headquartered in their more advanced counterparts

will be less likely to gain access to more advanced technologies. This in turn will imply that the

skill premium will not increase by as much following this type of liberalization. This result is

signif‌icant, as part of the puzzle facing this literature has been the fact that developing coun-

tries experience very different impacts of trade liberalization on the skill premium. Moreover,

this result suggests that there is a missing component in the literature that studies the interac-

tion between trade and technology. Existing works are frequently silent on the source of the

technologies that are adopted following a trade liberalization, assuming that these more ad-

vanced technologies exist within the liberalizing country and are simply not being operated

preliberalization. In contrast, when the model forces countries to develop their own technolo-

gies through investment, there is little change in the domestic stock of this technology capital

following the liberalization and, hence, little change in the skill premium. This suggests that,

especially in the case of developing countries integrating with advanced ones, the extent of

technological diffusion will be a key driver of changes in the skill premium and thus previous

studies may be overstating the increases in the skill premium that should be expected follow-

ing a trade liberalization.

I conduct an additional experiment in which I consider a liberalization between two devel-

oped countries, the United States and Canada. I use the calibrated parameters of the base-

line model, but set skill abundance, productivity, and tariffs to the observed levels in these

two countries in 1980. I then exploit the change in trade that occurred after the signing of the

Canada–U.S. Trade Agreement to test the implications of the model for this kind of liberal-

ization. I f‌ind that, in part because the H–O forces are no longer playing a large role, this has

a larger impact on the U.S. skill premium than the integration with Mexico did, primarily be-

cause of the increased return to investment in technology capital for both countries due to its

nonrival nature. U.S. f‌irms face fewer distortions to using their technology capital in Canada

than to its use in Mexico. We can think of this as being due to stronger intellectual property

protection laws in Canada, which look more similar to those in the United States than their

Mexican counterparts. Therefore, both U.S. and Canadian f‌irms exploit the increased oppor-

tunity to use their nonrival technology capital in the foreign country, thus increasing the re-

turn to investing in it. This causes the stock of technology capital to rise in both countries, in-

ducing an increase in the skill premia. Because this exercise is not fully calibrated, I do not