Competitive selection, trade, and employment: The strategic use of subsidies

• Published date: 01 November 2018
• Author: Catia Montagna,Hassan Molana
• DOI: http://doi.org/10.1111/roie.12354
• Date: 01 November 2018

ORIGINAL ARTICLE

Competitive selection, trade, and employment:

The strategic use of subsidies

Hassan Molana

1

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Catia Montagna

2

1

University of Dundee, Scotland, United

Kingdom

2

University of Aberdeen, Scotland,

United Kingdom

Correspondence

Catia Montagna, University of Aberdeen,

King’s College, Aberdeen AB24 3FX,

Scotland, United Kingdom.

Email: c.montagna@abdn.ac.uk

Funding Information

European Union’s Seventh Framework

Programme for research, technological

development, and demonstration under

Grant Agreement No. 290647

Abstract

Within a heterogeneous-firms model with endogenous labor

supply, intra-industry competitive selection is shown to affect

the impact of wage (and entry) subsidies. Optimal uniform

wage subsidies are always positive even though, by reducing

industry selectivity, they lower average productivity. Because

of international selection and fiscal externalities, noncoopera-

tive policies entail under-subsidization of wages. Targeted

(domestic-only or export) wage subsidies are dominated from

a welfare point of view by a uniform subsidy. While always

having an opposite effect on average productivity, an optimal

entry subsidy is shown to be less effective than an optimal uni-

form wage subsidy in raising employment and welfare.

1

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INTRODUCTION

Since the 1990s, welfare state reforms in Europe have tended to be characterized by a shift in emphasis

from the use of passive to that of active labor market policies. The combination of relatively low

employment protection and interventions targeted towards an increase in workers’employability often

includes direct job creation measures such as wage and employment subsidies.

1

This type of subsidy

accounted for about 25 percent of total active labor market policies on average in the OECD in 2003

and their use was intensified since the start of the ‘Great Recession’in 2007. In addition, while they

have often been introduced to support specific types of workers (such as the young or the long-term

unemployed), they have increasingly been perceived as a means to sustain job creation more generally

2

and demands for targeting them towards specific types of firms (as opposed to specific types of work-

ers) and/or sectors have abounded.

3

The literature on the assessment of employment creation policies has often adopted partial equilib-

rium approaches in which the focus is placed on microeconomic incentives for individual workers and/

or firms. These policies, however, have implications that go beyond individual agents’behavior and

affect aggregate performance via aggregation effects that start from the industry level.

In this paper we show that competitive selection forces within an industry shape the general

equilibrium effects of these policies and, in the presence of cross-country externalities, they influence

the strategic behavior of governments. Specifically, within a two-country model characterized by firm

Received: 30 October 2016

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Revised: 18 April 2018

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Accepted: 22 April 2018

DOI: 10.1111/roie.12354

1154

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wileyonlinelibrary.com/journal/roie Rev Int Econ. 2018;26:1154–1177.

© 2018 John Wiley & Sons Ltd

heterogeneity and endogenous labor supply, we investigate how the interaction between economic

openness and competitive selection determines the effects of wage subsidies on aggregate productivity

and employment, and how international policy spillovers affect governments’incentives in adopting

them.

From a theoretical perspective, a wage or employment subsidy can be justified if it corrects distor-

tions that render the market equilibrium suboptimal.

4

Dixit and Stiglitz (1977) show that when the con-

sumption bundle consists of a constant elasticity of substitution (CES) basket of varieties of a

differentiated good produced under monopolistic competition and a homogenous good produced com-

petitively, differences in price mark-ups between sectors result in an inefficient market allocation corre-

sponding to an under-consumption of the differentiated good. Subsidizing its production is shown to

reduce the impact of this distortion by reallocating resources across sectors. If, instead of another con-

sumption good, the outside good is leisure, with consumers determining their labor supply endoge-

nously, the monopolistic distortion highlighted by Dixit and Stiglitz goes through implying that labor is

under-utilized. It is then straightforward to devise a wage subsidy scheme that, at least partially, corrects

this distortion, yields higher employment and output, and raises consumers’utility. As we show in this

paper, with firm heterogeneity, which implies the endogeneity of marginal and average industry produc-

tivities, intra-industry competitive selection is an additional channel that shapes policy effectiveness and

the strategic interaction between governments. Specifically, we show that wage subsidies do not only

affect aggregate employment directly, but also via changes in aggregate productivity that result from

reallocation effects across countries, away from leisure, and across firms. Ultimately, via a wage sub-

sidy, governments control the selectivity of competition and thus contribute to correcting the market dis-

tortion that results in an under-consumption of the differentiated good and an under-utilization of labor.

Crucially, while a uniform subsidy reduces the selectivity of competition, making it easier to survive in

the industry and thus reducing average industry productivity, it increases aggregate employment, prod-

uct variety, and welfare. In this context, international policy spillovers, consisting of selection and fiscal

externalities, lead to noncooperative and cooperative policy equilibria that are characterized by positive

subsidies. The Nash equilibrium, however, entails levels of subsidization that fall short of those charac-

terizing the cooperative outcome. Targeted subsidization, to either the domestic-only or the export oper-

ations of firms, is shown to be dominated from a welfare point of view by a uniform subsidy.

Reforms of product markets—particularly aimed at facilitating entry—are considered as an effec-

tive means to increase aggregate productivity and employment.

5

Our analysis of an entry subsidy

reveals that while it always increases the strength of selection forces and hence average productivity in

the industry, it is less effective in raising employment and welfare than a wage subsidy. This is due to

the fact that the latter enables the government to tackle the monopolistic distortion more directly.

Our work is also related to a strand of the literature that highlights the impact of intra-industry real-

locations on aggregate performance. Di Giovanni and Levchenko (2012) find that the size composition

of industries interacts with trade openness in determining aggregate output volatility. Several studies

document how misallocations across heterogenous production units can affect aggregate productivity

and the transmission of shocks (e.g., Baily, Hulten, & Campbell, 1992; Restuccia & Rogerson, 2010,

G€

org et al., 2017). Of particular interest is the fact that different firms exhibit different cyclical patterns

of net job creation (Moscarini & Postel-Vinay, 2012; Elsby & Michaels, 2013). These papers, how-

ever, do not consider the interaction between competitive selection on the one hand, and labor market

policies aimed at increasing employment and trade openness on the other.

Another (still fairly small) strand of the literature to which our work is related concerns the impact of

policy on competitive selection. Demidova and Rodríguez-Clare (2009) focus on the effects of trade policy

in a small open economy, while Felbermayr, Jung, and Larch (2013) consider noncooperative tariff poli-

cies within a two-country setting. Contrary to our model, both of these papers assume an exogenous labor

MOLANA AND MONTAGNA

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