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This paper studies the relationship between income distribution and international integration in a canonical trade setting with one change. In the standard model prices are solely a function of (constant) marginal costs and (constant) elasticities, implying that information on individual incomes are of no value to a firm. To allow a more realistic role for consumer level information, a firm’s strategy space is expanded to include non-linear prices. Now profit maximizing firms use information on income distribution to design a product for each income class and set prices to induce each group to optimally select the appropriate option. Equilibrium involves designs below the first best for low income groups and above the first best for high income groups – welfare differences are more exaggerated than income differences. When countries with differing income distributions integrate this has implications for the size of these distortions, influencing the gains from trade both within and across countries. These implications are quantified and shown to be potentially significant factors affecting welfare outcomes from integration – with the consequences more pronounced at lower trade costs. The structure of trade and expenditure patterns that emerge also match a range of empirical findings. These results are driven by firm strategy based on income difference alone as preferences are assumed to be identical and homothetic across countries, placing the distribution of income at the center of the analysis.
This paper considers the implications of allowing firms to be sophisticated enough to design product lines. Such a level of sophistication makes them interested in consumer level information, and the distribution of income in particular. Enriching firm behavior in this way results in a tractable model and provides a link between the distribution of income and the gains from trade.
This link arises as firms implicitly discriminate between the various income classes, which in equilibrium results in a product line that differs from what a utilitarian social planner would choose. Since the distortions are largest at the lower end of the income distribution, this is where the consequences of international integration are also most pronounced. Trade can reduce these distortions in countries whose income distributions dominate the global distribution, while amplifying them in countries that are dominated.
This structure implies that the impact of integration is even more pronounced under a process of gradual liberalization since the variety and design dimensions of welfare respond differentially to the level of trade barriers. In particular, design changes occur disproportionately at lower trade barriers, with the potential to derail the process of trade liberalization. Quantifying the relative importance of this mechanism suggests that it is a legitimate issue that could significantly complicate future integration efforts.