International trade has been rightfully touted as an engine of economic growth, but its impact on the labor market might differ among different economies. Over the last few decades, China’s unsurpassable growth numbers have caught the world’s attention. The labor-intensive economy of China has been the focus of numerous international trade studies, with the impact of import competition from China on the labor markets in developed and developing economies receiving considerable attention. A quantitative study by ACI analyses how intense competition from China affects wage inequality within Mexican plants. It finds that plants downgrade product quality owing to competition from China and thereby induce a decline in the skill premium of Mexican firms.

Using detailed plant-level panel data for Mexican plants and product-level bilateral trade flows from 1994 to 2007, the study investigates how competition from China affects Mexican plants operating in domestic (Mexico) and foreign (US) markets and how the effect varies across exporting and non-exporting Mexican firms. Chinese competition is measured as the weighted sum of the shares of China’s exports to Mexico and the US. As Figure 1 shows, China’s share in manufacturing imports has grown exponentially in both US and Mexico. The authors relate changes in exposure to China’s imports to changes in the skill premium – white-collar wage to blue-collar wage ratio. There are two main findings of this paper. First, the reduction in the skill premium of Mexican firms due to competition from Chinese firms is made through adjustments in product quality. Second, alluding to the difference between exporting and non-exporting firms, the negative impact of this competition is weaker for firms exporting to the high-income foreign market (i.e., the US).

In other words, when faced with increasing competition from China, Mexican plants respond by “downgrading their product quality due to a reduction in the innovation rent.” As a result, more white-collar workers of lower skill levels are hired, which decreases the wage difference between skilled and unskilled workers. This quality downgrading is, however, less intense for products sold in the high-income foreign market. Particularly, a one-percentage-point increase in China’s import share causes Mexican plants to depreciate quality by about 5.1%. This decrease virtually disappears for products exported to high-income countries, i.e., the US.

Counterintuitively, Mexican firms resort to downgrading product quality instead of upgrading it in the face of competition. Why? The authors conjecture that the marginal cost difference between new entrant firms and those that exit reduces as the market gets inundated with new entrants. As a result, the marginal cost of quality upgrading remains intact, but its marginal benefit declines. Therefore, firms choose to downgrade product quality instead of investing in upgrading it.

Researchers have argued that international trade primarily benefits the countries involved; however, it may also negatively affect local labor markets in the long term. While the reduction in skill premium (representing wage inequality) seems like a favorable outcome, the upstream adjustments leading up to this outcome do not paint an encouraging picture. Mexican producers downgrade their product quality to compete with China’s relatively inexpensive products. This is achieved by hiring less-skilled workers, which leads to a superficial reduction in the skill premium. These results have far-reaching implications and essential lessons for policymakers looking after the labor market in Mexico. The educational attainments of potential workers could decline in response to an increased demand for relatively less-skilled workers.  Although the study identifies the channel through which trade affects wages in Mexico, these findings also warrant similar inquiries in other mid-income open economies.

By Shubhangi GUPTA

Researchers: Thi Hang BANH, Mauro CASELLI