Why Has Inequality Increased in China? toward a Theory of International Matching∗

It seems entirely fitting to discuss the Chinese economy on this occasion of the opening of the Renmin-Monash Advanced Centre of Economic Studies (ACES). One of the most striking features of that economy is the remarkable pace at which it has grown in the past one or two decades. A real challenge for economists is to account for this extraordinary success story. I think that a potentially significant part of the answer is provided in work by Xiaokai Yang and his coauthors. Yang shows clearly how a finer division of labour, i.e., a higher degree of specialization, can be a powerful engine for economic expansion. Progressive refinement of the division of labour, made possible by reductions in transaction costs (especially, in the Chinese case, reductions in the cost of conducting international trade), creates significant increasing returns, which in turn foster growth. But the conjunction of economic expansion and international trade seems to result in unfortunate side effects, such as rising inequality of income. Indeed, China has experienced a sharp increase in inequality during its recent boom. Yet, it is not at all clear theoretically why inequality should go together with growth in GNP and trade. Given his breadth of interests, it is not surprising that Xiaokai Yang should have studied this problem too, as in his work with Dingsheng Zhang. Yang and Zhang (2003) view an increase in income inequality as the consequence of uneven progression in the division of labour. Although expansion of trade provides the opportunity to specialize, not everyone