Unemployment with trade and firm heterogeneity

• Date: 01 March 2020
• DOI: http://doi.org/10.1111/ijet.12250
• Published date: 01 March 2020

Received: 23 February 2019

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Accepted: 19 November 2019

DOI: 10.1111/ijet.12250

ORIGINAL ARTICLE

Unemployment with trade and firm

heterogeneity

Li‐Wen Hung

1

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Shin‐Kun Peng

2

1

Institute of Economics, Academia

Sinica, Taipei, Taiwan

2

Department of Economics, National

Taiwan University, and Institute of

Economics, Academia Sinica, Taipei,

Taiwan

Correspondence

Shin‐Kun Peng, Department of

Economics, Institute of Economics,

National Taiwan University, Academia

Sinica, Taipei, Taiwan.

Email: speng@econ.sinica.edu.tw

Funding information

Academia Sinica, Grant/Award Number:

AS‐IA‐105‐H04

Abstract

By specifying the setting of the footloose capital model with

firm heterogeneity, this paper examines the effects of trade

liberalization on unemployment through two different

mechanisms: firstly, we embed search frictions into the

labor market; and secondly, we consider fair wages as the

source of unemployment. In the model with search

frictions, we find that both the expected wage and

employment rate could be higher for a small country with

better search technology. In the fair wage setting, the

results show that an increase in trade freeness increases the

unemployment rate of the large (small) country when the

trade freeness is sufficiently high (low). Finally, we try to

compare the welfare levels under different scenarios and

discover that unemployment may lead to a deterioration in

the welfare gains from trade.

KEYWORDS

fair wages, firm heterogeneity, search frictions, unemployment

JEL CLASSIFICATION

F1; J3; L1; R1

1

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INTRODUCTION AND RELATED LITERATURE

The fierce debate on the unemployment issue associated with trade liberalization has been going on

for a few decades. When we assess the benefits from trade liberalization, we cannot ignore the labor

markets. In this research, we study labor market imperfections generated by search frictions and fair

Int J Econ Theory. 2020;16:62–81.wileyonlinelibrary.com/journal/ijet62

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© 2019 IAET

wage preferences. Because of information asymmetry, firms cannot search for workers without

incurring costs. In fact, the World Bank has published the “rigidity of employment index”

1

to measure

hiring and firing difficulties across countries. However, a search friction model alone cannot explain

why wage inequality prevails in labor markets. Thus, we implement fair wage preferences to

emphasize the connection between wages and firm productivity. Nevertheless, it is hard to measure

the notion of “fairness”in reality. Past studies have conducted a huge number of empirical exercises

to test this hypothesis (Skott, 2005; Charles, 2011) and have found significant evidence to support it. It

is thus natural to investigate wages, unemployment rate, welfare levels based on these two scenarios.

Labor is usually assumed to be the only production input in past literature; nevertheless,

international capital flows also play a key role in production processes. For example, according

to Ratha et al. (2016), foreign direct investment has become a vital capital resource for many

developing and underdeveloped countries, and the trend is still increasing. Thus, we also

include capital flows in our analytical framework. Finally, evaluating the welfare gains from

trade is also an essential topic for policy‐makers. After considering the unemployment and

capital, we obtain a modified welfare indicator similar to that in Arkolakis et al. (2012), and try

to disentangle the channels that influence welfare levels after trade liberalization.

There are several strands of the literature related to our research. The first concerns the

general equilibrium model setting. Yang and Zeng (2015) extend the footloose capital model to

incorporate a heterogeneous firm setting, as in Melitz (2003). They discover that the wage

inequality between two countries increases when the relative exporting and domestic fixed costs

are high. If the relative cost is sufficiently small, the inequality increases at first and then

converges as the exposure to trade increases. However, these papers do not consider the

unemployment issue, which is an essential topic for trade.

The second strand investigates the impacts of trade on unemployment. Search frictions, efficiency

wages, fair wage preferences, and minimum wages are usually considered when unemployment is

presented. Helpman and Itskhoki (2010) combine the Melitz model with search frictions and find

that decreases in domestic search frictions harm the welfare of the other country. However, if the

search frictions proportionally decrease in differentiated sectors at the same time, they benefit both

countries. Furthermore, the country with lower search frictions may not have a lower

unemployment rate. Helpman et al. (2010) consider labor heterogeneity and discover that trade

enlarges wage inequality.

2

Felbermayr et al. (2013) find that higher search frictions increase not only

domestic unemployment but also the unemployment in the foreign counterpart.

Other kinds of mechanisms are also widely discussed. Egger and Kreickemeier (2009)

introduce fair wage preferences in a Melitz model and show that the average profit of active

firms, aggregate welfare, and the unemployment rate increase after trade liberalization. Egger

et al. (2012) introduce minimum wages to explain labor market imperfections and demonstrate

that a hike in the minimum wage harms domestic workers as well as foreign ones. All the

aforementioned papers use labor as the sole production factor.

The last stream of the literature is concerned with the evaluation of the impacts on welfare.

Yang and Zeng (2015) implement both labor and capital as production factors to relax the trade

balance conditions that Arkolakis et al. (2012) propose and demonstrate that the relative factor

1

The rigidity of employment index evaluates the regulation of employment, and it is composed of three sub‐indexes: a difficulty of hiring index, a rigidity of

hours index, and a difficulty of firing index. Higher values imply more rigid regulations; see https://datacatalog.worldbank.org/search/indicators?

search_api_views_fulltext_op=AND&query=Rigidity+of+employment+index&nid=&sort_by=field_wbddh_modified_date&f.

2

Itskhoki and Helpman (2015) extend the model further to explore the dynamic process of trade liberalization. They find that firms with the highest

productivity expand employment, some firms fire workers and stay in the market, others lay off workers and exit the market gradually, and still others leave the

market immediately.

HUNG AND PENG

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