Factor Price Overshooting with Trade Liberalization: Theory and Evidence

This paper develops an intra-industry trade model with skilled and unskilled labor as factors of production, endogenous accumulation of skilled labor and firm heterogeneity in factor intensities to examine the effect of trade reforms on factor prices. Since exporters are more skill intensive than non-exporters, a decrease in trade barriers initially increases wage inequality between skilled and unskilled worker, as a result of an increase in the relative demand for skilled labor. Over time, however, as agents respond to the change in relative wages by investing in skilled labor, the relative wage of skilled labor decreases. Evidence from Chilean plant-level data supports the idea of factor price overshooting with trade liberalization.