Trade with Unemployment
Carl Davidson
Michigan State University
An Outline of the Lectures
• Day 1
– Why should we care?
– What is the appropriate framework?
• Day 2
– Insights using “old trade theory?”
• Day 3
– How can we extend “new trade theory” to
account for unemployment and what are
the big questions to tackle next?
Why should we care?
• Reason 1: Public perceptions about the
important impact of international trade
The public and most politicians seems
absolutely convinced that trade is all
about the jobs that it creates and/or
destroys
Some Quotes
• Unfair trade agreements, passed by
both Republicans and Democrats, have
sent millions of jobs to other countries.
We need to stop this hemorrhaging and
find ways for American workers to
compete in the new market.
Russ Feingold
(US Senator -- Wisconsin)
Some Quotes
• Over the last five years, Wisconsinites
have lost nearly 80,000 manufacturing
jobs, largely because of unfair trade
agreements and questionable
administration policies.
Russ Feingold
(US Senator -- Wisconsin)
Some Quotes
• The Bush Administration and the
Congress have to stop ignoring this
crisis in international trade. The longer
we ignore it, the more American jobs
will move overseas. It's just that simple
Byron Dorgan
US Senator – North Dakota
More Quotes
• There is $1.4 billion a day in trade that
goes back and forth across the border.
That means millions of jobs and
livelihoods for families here in Canada
and for families in the United States.
Paul Cellucci
US Ambassador to Canada
More Quotes
• Since NAFTA was put in place, Mexico
has lost 1.9 million jobs and most
Mexicans' real wages have fallen.
Stephen Lynch
US Congressman – Mass.
More Quotes
• The global economy is a fact. The
expansion of world trade - with exports
up over 50 per cent since 1990 - has
created millions of new jobs and
offered many the chance to move from
poverty towards prosperity………
and, above all that more open markets
and more trade mean growth and new
jobs .
Tony Blair
Statement to the WTO 1998
More Quotes
• “[Free trade is] the key to jobs for our
people, prosperity and actually to
development in the poorest parts of the
world.”
Tony Blair
Statement to Canadian
Parliament, 2001
An Intriguing Quote
• Trade creates jobs and lifts people out
of poverty. And when that happens,
societies stabilize and grow. And there
is nothing like a stable society to fight
terrorism and strengthen democracy,
freedom and rule of law.
Dennis Hastert
Speaker of the House
Last Political Quote
• Sound science must be a basis to
governing our trade relations around
the globe.
Bill Frist
Senate Majority Leader
The Academic Response
• “It should be possible to emphasize to
students that the level of employment
is a macroeconomic issue…..
depending in the long run on the
natural rate of unemployment, with
microeconomic policies like tariffs
having little net effect.”
Paul Krugman
AER 1993
The Academic Response
• “Economists understand that the
effects of protectionist policies is not
on the overall employment of domestic
resources, but rather on the allocation
of resources across productive
activities.”
Michael Mussa
AER 1993
What is Wrong Here?
• We have no basis for these beliefs
• All our basic trade models assume full
employment
• These claims lack credibility, too easy
for non-academics to simply dismiss
• Most empirical work focuses on
industry studies, not aggregate impact
• Economies with unemployment may
behave very differently from economies
with full employment
Why should we care?
• Reason 2: What macroeconomics has
taught us about the importance of
imperfect labor markets
Do models that account for
unemployment behave in approximately
the same way as full employment
models? If not, how do they differ?
Original Presumption?
• The “natural rate of unemployment," in other
words, is the level that would be ground out
by the Walrasian system of general
equilibrium equations, provided there is
embedded in them the actual structural
characteristics of the labor and commodity
markets, including market imperfections,
stochastic variability in demands and
supplies, the cost of gathering information
about job vacancies and labor availabilities,
the costs of mobility, and so on.”
Milton Friedman (AEA Presidential Address)
Lessons from Macroeconomics
• Small market imperfections may lead to
big differences in equilibria (the
Diamond paradox)
• Market imperfections often generate
externalities and feedback effects;
expectations become very important
(Mortensen 1982; Diamond 1980s)
Also…..
• I will argue later that even when
equilibria are efficient, models that
allow for unemployment behave
differently than full employment models
• Example: The link between trade and
wages (Stolper-Samuelson Theorem)
will be fundamentally different in the
presence of unemployment
Implications
• Institutions (in particular, the structure
of the labor market) matter!
• Tell Krugman story from StolperSamuelson Theorem
Why should we care?
• Reason 3: What labor economics has
taught us about the structure of labor
markets and the personal costs from
dislocation
Differences in Institutions
• US labor market: very flexible (much
turnover), weak union presence, little or
no regulations concerning firing/hiring
• Europe: inflexible (less turnover, rigid
wages), strong unions in some
countries, many countries have firing
costs
• Australia, Japan have different
structures as well (Freeman 1994, 1998)
Implications elsewhere
• Labor and macroeconomists realize
these difference have important
implications (in terms of training,
macroeconomic performance, ….)
• Hard to believe that this does not
matter for the impact of trade (some
realization of this in labor market
distortions literature of 1970s –
Bhagwati, Magee and others)
Adjustment Costs
• Traditional view in trade literature:
Costs are probably small (Baldwin et al,
Magee and others), much smaller than
gains, so…we can compensate the
losers without exhausting the gains
• Estimates of costs ignore search and
training costs, treat unemployment in
an ad hoc manner
• We do not compensate the losers
Adjustment Costs
• Labor economists have found that the
personal costs of worker dislocation
may be quite high (Jacobsen et al 1993;
Kletzer 2001)
• Now indications that aggregate costs
may be higher than previously thought
(Trefler AER 2004, DM 2001)
What sort of framework should
we use?
•
•
•
•
•
Search theory?
Efficiency or fair wages?
Incomplete contracts?
Union power?
Minimum/rigid wages?
• It probably does not matter
Focus will be on search theory
• Advantages: Intuitive appeal, can be
added without altering basic structure
of most models, leads to a rich
framework (heterogeneity on both
sides of the labor market), considerable
empirical work pins down features of
the model’s fundamentals, can
therefore be calibrated and used for
policy analysis more easily than most
models of unemployment
Focus will be on search theory
• Disadvantages: Dynamics, which are
so important for analysis of
adjustment, can get quite messy very
quickly; restricting attention to one
framework leaves one with the
impression that results are not general
– this is usually not the case
(emphasized in DM 2004)
Old Theory: HOS Model
• Work with the classic 2x2x2 model
• 2 factors: K, L available in fixed
inelastic supplies in 2 countries (H
and F)
• 2 goods: X, Y produced according to
CRTS production functions
• All markets perfectly competitive (in
labor market, this implies wages
adjust to ensure full employment)
Key Equations
• Factor Markets must clear:
L0 = LX + LY = aLXX + aLYY
K0 = KX + KY = aKXX + aKYY
• Product Markets must clear:
PX = aLXwx + aKXrx
PY = aLYwy + aKYry
• Implicit
wX = wY
and
rX = r Y
Unit input requirements
Kj
akj
X(L,K)=1
Lj
aLj
Adding Search
• Key new assumption: It takes time and
effort for unemployed firms and firms
with vacancies to find each other
• Extension will be based on Mortensen
and Pissarides (1994); earlier work
(DMM 1988; Hosios 1989) was a special
case of this model
Basic Structure
• Fixed supply of L and K in two
countries (H and F)
• Two goods: X and Y
• L can search for a job in either sector
• L chooses a sector to search in order
to max exp lifetime income
Basic Structure
• Each entrepreneur owns one unit of K
and can create one vacancy in either
sector
• Vacancies are created to max exp
lifetime profit
• Each firm employs at most one worker
• For simplicity, assume that each filled
vacancy results in one unit of output
Job Creation
• mj(uj,vj) = new jobs created in sector
j depends on searching workers
and open vacancies
• Empirical work suggests matching
function characterized by CRTS
• Θj = vj/uj = measures labor market
tightness
Job Creation
• m(u,v)/u = m(θ) = rate at which unemp.
workers find new jobs
m’(θ) > 0
• m(u,v)/v = m(θ)/θ = z(θ) = rate at which
vacancies are filled
z’(θ) < 0
Job Destruction
• Employed workers in sector j quit if
they expect to earn more searching
in sector i
• Firms in sector j fire workers if they
expect to earn more creating a
vacancy in sector j
• There is also involuntary separation
that occurs at rate δ
Asset Value Equations
b(t )   (t )VE  [1   (t )]VU
VU 
1  r (t )
Solve for VU, take Δt to zero, we get
rVU = b + π[VE – VU]
This is the general form for asset value
equations
Asset Value Equations (Workers)
• ρVju = b + mj(θj)[Vje – Vju]
• ρVje = wj + δj[Vju – Vje]
• In equilibrium, we must have
VXu = VYu
Asset Value Equation (Firms)
• ρVXv = - cx + zx(θx)[VXf – VXv]
• ρVXf = px – wx - cx + δx[VXv – VXf]
• In equilibrium, we must have
VXv = VYv
• Some versions of the model have free
entry, in which case we also have
VXv = VYv = 0
Wage Determination
• Frictions create market power on both
sides of the labor market – wages must
be negotiated -- Use Generalized Nash
Cooperative Bargaining Solution
• Can show that we get
wx = β[px – cx] + (1 – β)rVXu
• β denotes labor’s share of surplus
• Only one value for β leads to efficiency
(talk about externalities)
Factor Market Clearing
• L0 = X + Y + ux + uy
• K0 = X + Y + vx + vy
• Steady-state conditions:
δjX = mj(j)ux
for j = X,Y
Factor Market Clearing
• Using ss conditions we can rewrite as
L0 = αLXX + αLYY
K0 = αKXX + αKYY
• The α terms are similar to the a terms
from the standard model – they
measure unit input requirements taking
into account unemployed factors of
production
Unit input req. with search
αLX = 1 + (uX/X)
αKX = 1 + (vX/X)
If equilibrium is technically efficient,
agents are allocated across sectors so
that each unit of X is production at
minimum cost (in terms of foregone
production of Y), taking into account
the matching process
Unit input req. with search
• Equilibrium values determined by labor
and capital sorting across sectors to
equalize the expected return from
search and vacancy creation
• Key question: Is this sorting optimal?
(usually no – externalities present)
Product Market Clearing
• SS equations along with asset value
equations imply that
Px = αLxρVXu + αKxρVXv
Py = αLyρVYu + αKyρVYv
• To make comparison easier, define
wju = ρVju
rjv = ρVjv
Equilibrium with Search
L0 = αLXX + αLYY
K0 = αKXX + αKYY
Px = αLxwXu + αKxrXv
Py = αLywYu + αKyrYv
wXu = wYu
rXv = rYv
Comparison
• Remarkably similar structure
• Two key differences:
• Unit input requirements take into
account unemployed factors (are they
optimal?)
• In pricing equation, it is the return to
unemployed factors that show up
• In Part 2, we explore the implications