Trade with Unemployment

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Trade with Unemployment

• Carl Davidson
• Michigan State University

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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?

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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

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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)

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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)

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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

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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

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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.

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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

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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

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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

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Last Political Quote

• Sound science must be a basis to governing our
  trade relations around the globe. Bill Frist
• Senate Majority Leader

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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

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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

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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

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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?

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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)

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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)

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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

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Implications

• Institutions (in particular, the structure of the
  labor market) matter!
• Tell Krugman story from Stolper-Samuelson Theorem

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Why should we care?

• Reason 3 What labor economics has taught us
  about the structure of labor markets and the
  personal costs from dislocation

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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)

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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)

24
Adjustment Costs

• Traditional view in trade literature Costs are
  probably small (Baldwin et al, Magee and others),
  much smaller than gains, sowe 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

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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)

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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

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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 models
  fundamentals, can therefore be calibrated and
  used for policy analysis more easily than most
  models of unemployment

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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)

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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)

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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 rY

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Unit input requirements
Kj
akj
X(L,K)1
Lj
aLj
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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

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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

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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

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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
• Tj vj/uj measures labor market tightness

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Job Creation

• m(u,v)/u m(?) rate at which unemp. workers
  find new jobs
• m(?) gt 0
• m(u,v)/v m(?)/? z(?) rate at which
  vacancies are filled
• z(?) lt 0

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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 d

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Asset Value Equations
Solve for VU, take ?t to zero, we get rVU b
pVE VU This is the general form for asset
value equations
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Asset Value Equations (Workers)

• ?Vju b mj(?j)Vje Vju
• ?Vje wj djVju Vje
• In equilibrium, we must have
• VXu VYu

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Asset Value Equation (Firms)

• ?VXv - cx zx(?x)VXf VXv
• ?VXf px wx - cx dxVXv 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

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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 ßpx cx (1 ß)rVXu
• ß denotes labors share of surplus
• Only one value for ß leads to efficiency (talk
  about externalities)

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Factor Market Clearing

• L0 X Y ux uy
• K0 X Y vx vy
• Steady-state conditions
• djX mj(?j)ux for j X,Y

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Factor Market Clearing

• Using ss conditions we can rewrite as L0 aLXX
  aLYY
• K0 aKXX aKYY
• The a terms are similar to the a terms from the
  standard model they measure unit input
  requirements taking into account unemployed
  factors of production

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Unit input req. with search
aLX 1 (uX/X) aKX 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
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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)

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Product Market Clearing

• SS equations along with asset value equations
  imply that
• Px aLx?VXu aKx?VXv
• Py aLy?VYu aKy?VYv
• To make comparison easier, define
• wju ?Vju rjv ?Vjv

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Equilibrium with Search

• L0 aLXX aLYY
• K0 aKXX aKYY
• Px aLxwXu aKxrXv
• Py aLywYu aKyrYv
• wXu wYu rXv rYv

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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