Income Inequality, Welfare, and the Patterns of Trade

In this paper, we study the effects of income inequality, both within and between countries, on welfare and trade volume in open economies when firms have price-setting power. We develop a two-country model of international trade featuring non-homothetic preferences and income inequality. Firms operate in the basic Krugman (1980) framework, with identical marginal costs and fixed costs of production. Consumer demand involves an extensive-margin consumption choice, such that firms face a trade-off between price and market size. A firm’s choice of a marginal consumer results in a market size determined by all consumers at least as wealthy as the marginal consumer. The price is then determined by the marginal consumer’s willingness to pay. This setup results in a price schedule where cheap mass market goods, accessible to all, coexist with expensive luxury goods, consumed only by the wealthy. Hence, rich and poor consumers have different consumption bundles and face different price levels citep{fajgelbaum_measuring_2016, faber2022firm, neiman2023rise}.
Rising income inequality, measured by a mean-preserving spread in income, leads to rising prices for mass market goods and falling prices for luxury goods, producing heterogeneous welfare effects: poorer individuals experience losses, while the rich benefit. On average, the price level falls and total product variety increases.
If one country is richer on average, it bears most of the fixed costs. This creates a divergence in price schedules, with the richer country’s schedule shifting upwards and the poorer country’s schedule shifting downwards. We refer to this phenomenon as the textit{Manhattan effect}: poor consumers fare worse when they are a small minority in a predominantly rich country. This is consistent with empirical evidence of citet{handbury_2021}, who shows that poor households in rich US cities face higher food prices than poorer ones. However, the richer country also has a larger population of wealthy consumers, which expands the market size at higher income levels. This eventually offsets the effect of higher fixed costs as they can be spread over more consumers. The import values of both countries increase when one becomes richer. In the rich country, the import volume increases more than the value, while import volumes in the poor country rise less than the import values due to the price divergence.