Evaluating the Factor-Content Approach to Measuring the Effect of Trade on Wage Inequality
(Published: JIE 50, 2000, 91-116) This paper addresses two questions: (i) can factor content of trade be used to measure the effect of trade on wage inequality in a given year, with tastes and technology constant; and (ii) can it be used to measure the contribution of trade to the change in wage inequality between two years, with tastes and technology allowed to change? Deardorff and Staiger (1988) had shown that the answer to the first question can be given in the affirmative provided all production functions and the utility function are Cobb-Douglas. I demonstrate, as does Deardorff (2000) independently, that the affirmative answer can be extended to the case when all production functions and the utility function take the CES form with identical elasticity of substitution. I further demonstrate that we can answer the second question in the affirmative under the same conditions as the first. I then examine critically the assumptions underlying these conclusions. They include identical elasticities of substitution across all production functions and the utility function, absence of increasing returns and non-competing imports, homotheticity of demand, and no endogenous response of factor supplies to trade. I conclude that, taken as a whole, these assumptions are sufficiently strong to leave many analysts, including myself, skeptical of the estimates based the factor-content approach.