The objective of this paper is to understand the connection between the wage level and an exporter's sensitivity to trade costs. This paper asks a simple question: Does economic theory tell us that domestic production is more affected by reductions in trade costs with a low-wage country compared with a high-wage country?
Background
Increased trade with China contributed to a large decline in U.S. manufacturing (Pierce and Schott 2013; Autor et al. 2013). Large effects have also been seen when trade costs have decreased with other low-wage countries (see, for example, Hine and Wright (1998)).
Methods
To explore the connection between wages and sensitivity to trade costs, we present a Melitz (2003)-style heterogeneous firm trade model. Our model is based on Rodriguez Lopez (2011). Our model features non-constant elasticity of substitution, which generates endogenous markups. Price adjustments in firm-level data are consistent with the consumer preferences used in our model and not with other models of endogenous markups (Cook 2014). We test this model by testing its implications for the variation in exchange rate pass-through by country.
Results
A firm in a low-wage country has an advantage in international markets because it is able to sell its goods at a lower price. An increase in tariffs results in an erosion of this advantage, but the firm's profits are less elastic with respect to trade costs than if the firm were exporting from a higher wage country. Our model shows that the variety of goods being imported from a lower wage country, such as China, would be more affected by an increase in trade costs. This model also predicts that the number of U.S. producers would decrease more following a decrease in trade costs with a low-wage country.
Policy Implications
As the US enters the Trans-Pacific Partnership (TPP) and the Transatlantic Trade and Investment Partnership (TTIP), trade costs will be reduced for many U.S. imports. This paper shows that the degree to which U.S. producers are affected by the decrease in trade costs depends on country-level exporter characteristics. Understanding how the employment effects of trade differ with exporter characteristics is a first step in being able to better evaluate the effects of trade policy.