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This paper shows how the degree of credit-market imperfections affects the steady-state distributions of income and wealth, human capital investment, and the pattern of comparative advantage. The impact of trade liberalization on the accumulation of human capital depends on how it affects (1) the incentives to accumulate human capital, (2) the borrowing constraints facing human capital accumulation, and (3) the distribution of income and wealth. If the degree of credit market imperfections is low in the skill-abundant countries and high in the skill-scarce countries, then trade liberalization can increase investments in human capital in both types of countries.

It is widely recognized that differences in human capital or skill across countries play an important role in determining differences in growth rates and per capita income levels across countries. As well, skill differentials form the basis of much of the trade between the skill-abundant developed countries in the North and the skill-scarce developing countries in the South.1 While trade based on skill differential always provides static gains from specialization, the dynamic gains depend on how the investment in human capital is affected. This makes the question of how trade affects skill accumulation an important one. In a pioneering paper, Findlay and Kierzkowski (1983) extended the static Heckscher–Ohlin model of trade by endogenizing human capital accumulation to show that trade amplifies initial differences in factor endowments. The channel of influence is the Stolper–Samuelson effect of trade on factor prices which raises the reward of the abundant factor in each country. This provides further incentives to accumulate human capital in skill-abundant countries and does the opposite in skill-scarce countries. Similar results were also obtained by Grossman and Helpman (1991). Two recent papers — Cartiglia (1997) and Eicher (1999) — show that trade leads to convergence in human capital endowments. A key element of both these papers is that skill is used in the formation of skill (education sector uses skilled labor), and therefore, any rise in the price of skill has an adverse effect on skill accumulation. In Cartiglia (1997) the credit market is missing, therefore, investment in human capital has to be self-financed from the initial endowment. A trade-induced rise in the skilled wage in a skill-abundant country increases the cost of education and hence exacerbates the borrowing constraint facing investment in human capital. In Eicher (1999) there is a domestic credit market where the savings of the unskilled workers are used to finance the investment in human capital. Now, a trade-induced decrease in the unskilled wage in a skill-abundant country reduces the resources available for financing investment in human capital, while a rise in the cost of education increases the need for resources to finance investment in human capital.2 Therefore, in both these papers trade liberalization reduces the investment in human capital in a skill-abundant country. The opposite happens in a skill-scarce country giving rise to the convergence in human capital endowments after opening up to trade. This literature, however, has ignored the impact of trade on investments in human capital coming through changes in the distribution of income and wealth. This is a serious omission because the distribution of wealth becomes an important determinant of investments in human capital in the presence of borrowing constraints. The main contribution of our paper lies in bringing the distributions of income and wealth to the centre of the discussion of the impact of trade on factor endowments. It endogenizes the wealth distribution in the presence of credit market imperfections and shows that changes in the distribution of wealth brought about by trade have additional and, in some cases, offsetting effects on the accumulation of human capital. It is first shown that there exists a unique invariant steady-state distribution of wealth for a given degree of credit-market imperfection. A decrease in the degree of credit-market imperfection implies an improvement in the steady state distribution of wealth in the first order stochastic dominance sense. The degree of credit-market imperfections affects investments in human capital both directly and indirectly by improving the steady-state distribution of wealth, and hence, it becomes a determinant of the pattern of comparative advantage. This new result shows how an institutional variable like the degree of credit-market imperfections can become a determinant of the pattern of comparative advantage. Next it is discussed how trade liberalization affects investments in human capital by, among other things, altering the distribution of wealth. Trade liberalization increases the incentive to invest in human capital in a skill-abundant country. However, an increase in the skilled wage raises the cost of education, which worsens the borrowing constraint in a world with credit-market imperfections. In addition, the support of the steady-state distribution of wealth is widened. The widening of support at the bottom end has a negative impact on the investment in human capital. Intuitively, trade liberalization reduces the unskilled wage, which reduces the bequest of the unskilled, making their descendants more prone to borrowing constraint. The net effect on investments in human capital depends on the relative strengths of these three effects. The opposite happens in a skill-scarce country. There the negative incentive effect has to be balanced against the positive effect arising from the distributional changes and the relaxation of borrowing constraint due to reduced cost of education. The support of the steady state distribution of wealth shrinks to a smaller interval. The increase in the wealth of individuals at the bottom end caused by a rise in the unskilled wage has a positive impact on the investment in human capital of their descendants. The unskilled are able to leave a larger bequest, which relaxes the borrowing constraint for their descendants.

This paper constructs a dynamic general equilibrium model where the pattern of comparative advantage depends on the degree of credit market imperfections affecting human capital investments. Endogenizing wealth distribution by allowing for intergenerational transfers, the paper identifies a novel channel of influence of trade liberalization on investment in human capital. Changes in the distribution of wealth brought about by trade liberalization have additional and, in some cases offsetting effects on the accumulation of human capital. This makes it possible for trade liberalization to increase investments in human capital in both skill-abundant and skill-scarce countries. Therefore, trade liberalization could potentially yield dynamic gains to all trading partners. Before ending the paper we discuss the reasons for introducing several special elements in the model and their implications. The reason for introducing heterogeneous ability is to allow for two-way (both upward and downward) intergenerational mobility, which results in a unique invariant steady state distribution of income. In the absence of heterogeneous ability, there will be no intergenerational mobility, and the steady state distribution of income will be determined by the initial distribution of income as in Galor and Zeira (1993). However, heterogeneous ability alone is not sufficient to generate a unique steady state distribution. It is the partially open credit market along with heterogeneous ability that provides two-way intergenerational mobility. Partially open credit market allows high ability individuals to invest in human capital even if they are born poor. If the credit market is completely missing, then heterogeneous ability will result only in downward mobility and no upward mobility. In this case in steady state everyone will become unskilled. Therefore, both heterogeneous ability and partially open credit market are essential features of the model. Also, the assumption that the ability of each individual is publicly known is a simplifying one, given our story of imperfection in the credit market. Without this assumption the contract in the credit market is much more complicated. However, modelling credit market imperfections in an alternative way a la Galor and Zeira (1993) will obviate the need for this assumption without changing any of the qualitative results in the paper. The reason for choosing our story of credit market imperfections is analytical tractability of the distributional dynamics. In our story, the bequest left by a skilled person does not depend directly on the degree of credit market imperfections, π, but using Galor and Zeira’s (1993) story will mean that for borrowers (a<qws) the bequest depends on the borrowing rate of interest i. For lenders the relevant rate of interest will continue to be r. Therefore, even among the educated, bequest functions differ depending on whether they are borrowers or lenders making the distributional dynamics more complicated. The assumption that skill is used in the formation of skill is also not crucial for getting the new insights about trade affecting investment in human capital through changes in the distribution of wealth. Even if the direct cost of education is just a fixed amount of numeraire good, the changes in the steady state distribution of wealth will produce similar effects. Also, we can completely get rid of the direct cost of education, and have just the opportunity cost which is foregone wages. If we allow consumption in the first period, similar results will appear. Now borrowing constraint will affect consumption possibilities of those born poor who would like to invest in education. If they cannot borrow for consumption in the first period, high marginal utility of first period consumption may not justify investments in human capital. This formulation of the model will make it applicable to the cases where there are no direct costs of education, such as primary education in most countries or public education more generally. One shortcoming of the paper is that the model developed here is one of a small open economy rather than a two country case. The main reason for doing this is analytical tractability. The small open economy assumption allows us to solve the model for an exogenous product price ratio and rate of interest. This makes the distributional dynamics a simple linear Markov process. If the rate of interest and product prices are endogenous, the wealth dynamics will become non-linear making it extremely difficult to study the steady-state wealth distribution. Future research will try to address this issue.