Trade policies, price shocks, and changes in exchange rates have a distributional impact whenever they affect the relative price of goods that are consumed at different intensities by high and low-income households. Low-income households consume relatively more tradeables (such as food), while high-income households consume relatively more non-tradeables (such as personal services).  If trade policy, for example, causes an increase on the price of food, a low-income household is likely to suffer a greater negative impact than a high-income household.

To understand the impact on welfare of changes in relative prices through the expenditure channel a common modelling approach is based on non-homothetic preferences. These provide the theoretical background for the construction of models that can be used in structural estimation of the cost of living. For the estimation part, a growing body of work in international trade adopts the Almost-Ideal Demand System (AIDS), although other forms of demand estimation are also being used.  The increasing availability of detailed microdata facilitates the evaluation of changes in welfare of households at different income levels, in particular the welfare effects associated with prices changes of different types of product as well as different qualities within a product category.

The general conclusion of this research is that the nature of the shock determines the variation in the welfare effects across groups at different income levels.  Trade liberalization or the entry of large retailers in the domestic market have in some cases been beneficial to low-income households. On the other hand a large exchange rate devaluation has been found not to be beneficial.  The formation of MERCOSUR, a customs union in Latin America was found to be beneficial to the poor in Argentina but the formation of the North American Free Trade Agreement was found to hurt the poor in Mexico.

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Deaton, A. and J. Muellbauer (1980) “An almost ideal demand system“, American Economic Review, 70 (3): 312–326.

Deaton, Angus. and John Muellbauer (1980) Economics and consumer behavior. Cambridge, UK: Cambridge University Press

Faber, Benjamin (2014) “Trade Liberalization, the Price of Quality, and Inequality: Evidence from Mexican Store Prices“, Working Paper.

Fajgelbaum, Pablo, Gene M. Grossman, and Elhanan Helpman (2011) “Income Distribution, Product Quality, and International Trade.” Journal of Political Economy, 119(4): 721-65.

Fajgelbaum, Pablo D, and Amit K Khandelwal (2016) “Measuring the unequal gains from trade.” Quarterly Journal of Economics, 131 (3):1113-80. [Working paper version]

Porto, Guido G. (2006) “Using survey data to assess the distributional effects of trade policy,” Journal of International Economics, 70 (1): 140–60. [Working paper version]