This paper proposes a new mechanism linking trade and wage inequality in developing countries-the quality-upgrading mechanism-and investigates its empirical implications in panel data on Mexican manufacturing plants. In a model with heterogeneous plants and quality differentiatiation, more productive plants produce higher-quality goods than less productive plants, and they pay higher wages to maintain a higher-quality workforce. Only the most productive plants enter the export market, and Southern exporters produce higher-quality goods for export than for the domestic market, to appeal to richer Northern consumers. An exchange-rate devaluation leads more-productive Southern plants to increase exports, upgrade quality, and raise wages relative to less-productive plants within the same industry, increasing within-industry wage dispersion. Using the late-1994 peso crisis as a source of variation and a variety of proxies for plant productivity, I find that initially more productive plants increased theexport share of sales, white-collar wages, blue-collar wages, the relative wage of white-collar workers, and ISO 9000 certification more than initially less productive plants during the peso crisis period and that these differential changes were greaterthan in periods without devaluations before and after the crisis period. These findings support the hypothesis that quality upgrading induced by the exchange-rate shock increased within-industry wage inequality.
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