Trade, Quality Upgrading and Wage Inequality in the Mexican Manufacturing Sector : Theory and Evidence from an Exchange Rate Shock

This paper proposes a new model of the link between expanding trade and rising wage inequality in developing countries, and investigates its causal implications in a newly constructed panel of Mexican manufacturing establishments. In a theoretical setting with heterogeneous firms and quality differentiation, only the most productive firms in a developing country like Mexico enter the export market, and they produce a better-quality good for export than for the domestic market in order to appeal to richer developed-country consumers. Producing high-quality goods requires paying high wages both to white-collar and to blue-collar - but especially to white-collar - employees. An increase in the incentive for developing-country producers to export generates differential quality upgrading within industries, as more-productive firms increase exports and produce a greater share of high-quality goods, while less-productive firms remain focused on the domestic market. This process raises wage inequality both between firms and within the firms that upgrade. The empirical part of the paper uses a major exchange rate shock - the Mexican peso crisis of late 1994 - to test this causal mechanism. I find robust evidence that during the years of the crisis initially more-productive plants increased both white-collar and blue-collar wages and increased the relative wage of white-collar workers as compared to initially less-productive plants. This pattern is absent in the periods before or after the crisis years. The results thus provide strong support for the hypothesis that differential quality upgrading induced by the exchange rate shock contributed to wage inequality in Mexico in the mid-1990s