Income distribution and vertical comparative advantage. Theory and evidence

In this paper, we provide a general model discussing the impact of non-homothetic preferences on the vertical comparative advantage of countries, i.e. the existence of demand-based determinants of the quality content of production and exports. We show that while average income positively impacts the quality mix of a country's exports, the impact of inequality depends on the shape of the income expansion path of consumption of high quality varieties. Along levels of income where the Engel curve for high-quality varieties is increasing and convex, inequality increases aggregate demand for high quality varieties, more and more rapidly along income. Our empirical results on the quality content of bilateral export flows within the enlarged EU confirm our theoretical predictions. We show that a country's income distribution has a significant impact on the quality of its exports. Moreover, the impact of inequality on the quality of exports is all the more positive that the exporter is rich. Our estimations are robust to instrumentation and inclusion of controls for supply-side determinants. In a quantification exercise, we show that the positive effect of inequality can be substantial and is magnified when coupled with an increase in average income. This suggests that a growing middle class is decisive for internal demand to drive quality upgrading of production and exports of a country.