Trade with Unemployment Part 2: New Insights from Old Trade Theory

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Trade with UnemploymentPart 2 New Insights
from Old Trade Theory

• Carl Davidson
• Michigan State University

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Old Trade Theory

• For simplicity, I will focus on the 2 sector HOS
  and Ricardian GE models
• Here the industry is the appropriate unit of
  measure (firms within an industry are all the
  same)
• All markets are perfectly competitive, there is
  full employment

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Old Trade Theory

• Focus on the two biggest questions
• What causes trade?
• Who gains and who loses from trade? That is, what
  is the link between trade and factor rewards?
• How does adding unemployment change the answers?

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What Causes Trade (Ricardo)?

• Interaction of cross-sector differences and
  cross-country differences
• In Ricardian model, labor productivity varies
  across countries and, for at least one country,
  across sectors

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What Causes Trade (HOS)?

• Sectors differ in their use of factors (factor
  intensities, measured by aij)
• Countries differ in endowments of resources
• Differences in factor use across sectors coupled
  with differences in endowments across countries
  leads to trade between countries (HO Theorem)

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HO Theorem

• If a country has a relatively large endowment of
  labor, labor will be relatively cheap in that
  country
• In that country, it will therefore be relatively
  cheap to produce good that are labor intensive in
  production (i.e., the autarkic price of that good
  will be low relative to ROW)

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HO Theorem

• Countries will have a comparative advantage in
  the good that makes relatively intensive use of
  its relatively abundant factor

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Adding Unemployment

• Basic point The structure of the labor market
  can influence trade patterns
• In our search framework, workers cycle between
  periods of employment and unemployment the
  employment process is risky
• Workers take this risk into account when choosing
  an occupation

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Adding Unemployment

• Suppose that two countries are identical in all
  aspects except for the structure of their labor
  markets
• In the labor markets, matching technologies and
  job security may differ for a variety of reasons
  (info flows, policies related to hiring and
  firing,)
• What are the implications?

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Adding Unemployment

• Suppose that in one country the matching
  technology is relatively less efficient in a
  sector than it is in the same sector in other
  countries
• Then, workers face more risk looking for a job in
  that sector than they do in other countries
  they must be paid a compensating differential to
  seek such a job
• The compensating differential pushes up autarkic
  prices and makes it less likely the country can
  export that good

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Adding Unemployment

• Suppose that in one country jobs are less secure
  in a sector than they are in the same sector in
  other countries
• Then, workers face more risk looking for a job in
  that sector than they do in other countries
  they must be paid a compensating differential to
  seek such a job
• The compensating differential pushes up autarkic
  prices and makes it less likely the country can
  export that good

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Bottom Line

• Employment risk affects wages
• Wages affect autarkic prices and trade patterns
• A country is more likely to have a comparative
  advantage in a good that is produced in a sector
  with a relatively low duration of unemployment
  and a relatively high job duration

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Empirical Evidence?

• Substantial evidence that job creation/job
  destruction rates vary across sectors and
  countries (DHS 1996 and the work that followed)
• Evidence that employment risk affects
  compensating differentials (Abowd and Ashenfelter
  1981)

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Empirical Evidence?

• Using two sources of data on turnover (DHS for
  job turnover, BLS for worker turnover) we found
  strong evidence that industry trade position is
  strongly and negatively tied to job destruction
  rate that is, the higher the job destruction
  rate, the more you import (Davidson Matusz RIE
  2004)

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Empirical Evidence?

• Alternative story a surge of imports destroys
  jobs, increases job destruction rate (workers in
  more open sectors face less job security)
• What is the direction of causality?

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Causality?

• One story (ours) is about LR behavior look at
  relationship between trade position and average
  turnover rate
• Second is a SR story look at trade position and
  deviation of turnover rate from the mean
• In all regressions, relationship much stronger
  for mean turnover rate

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Additional Evidence

• Janiak (Working Paper 2006) Looks at how changes
  in trade patterns (caused by liberalization)
  affects turnover rates findings similar to
  ours, but story of causation reversed
• Cunat and Melitz (Working Paper 2006) Argue that
  labor market flexibility shapes comparative
  advantage find that countries with flexible
  labor markets specialize in high volatility
  industries

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Trade and Factor Rewards (R)

• In Ricardian model, some factors are sector
  specific, some are mobile
• Free trade benefits factors specific to the
  export sector and harms those specific to the
  import sector
• Impact on mobile factors is ambiguous
• For specific factors, industry affiliation is all
  that matters

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Trade and Wages (HOS)

• Many results in HOS model based on manipulation
  of market clearing conditions
• L0 LX LY aLXX aLYY
• K0 KX KY aKXX aKYY
• PX aLXwx aKXrx
• PY aLYwy aKYry

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

• Totally diff. one product market clearing
  expression to get

But, since unit input requirements are optimal,
the last two terms sum to zero
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Trade and Wages

• Subtract the two expressions yields

where ? measures the relative factor
intensities of the two sectors (in value terms)
? gt 0 means that sector X is relatively more
labor intensive than sector Y
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Trade and Wages

• Suppose that the world price of a labor-intensive
  good rises (PX increases)
• Prod. of X rises. Factors released from sector Y
  are less labor intensive than those absorbed in
  sector X.
• Demand for L rises, demand for K falls.
• w rises (L gains), r falls (K loses), regardless
  of where it is employed

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Trade and Wages

• Is there another effect? After all, all firms
  become more K intensive (the aij terms change)
• But, changing the aij terms has no impact on
  prices since the aij terms were optimal (Envelope
  theorem)!
• This will be useful shortly

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Trade and Wages

• Note also The price increase is a convex comb.
  of factor changes

Thus, labor gains in real terms
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Stolper-Samuelson

• Trade benefits a countrys abundant factor and
  harms its scarce factor (industry affiliation
  does not matter)
• Protection of an industry benefits the factor
  used relatively intensively in that sector

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More Details on HOS

• Totally diff. the factor market clearing
  expressions yields

where ? measures the relative factor
intensities of the two sectors (in physical
terms) ? gt 0 means that sector X is relatively
more labor intensive than sector Y (with perfect
competition, ?? gt 0).
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Px/Py
RS
PM clearing
RD
X/Y
w/r
FM clearing
45o line
w/r
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Adding Unemployment

• Yesterday I noted that with unemployment the
  product market clearing conditions can be written
  as
• Px aLxwXu aKxrXv
• Py aLywYu aKyrYv
• Differentiate to get

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Adding Unemployment

• Key question Are the unit input requirements
  optimal? If so, last two terms sum to zero
  again.
• If so we get an extension of Stolper-Samuelson

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Adding Unemployment

• It is now the unemployed factors that move to
  clear factor markets
• An increase in a price attracts more unemployed
  factors to that sector
• This changes the mix of unemp. factors
• Usual SS result, but the implication is now for
  the return to unemployed factors

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Extended Stolper-Samuelson

• If a country protects a good produced in a labor
  intensive sector, all unemployed labor benefits
  and all idle capital is harmed

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An Important Exception

• But, this version only holds if unit input
  requirements (which include unemployed factors)
  are optimal
• Why?
• When you differentiate factor market clearing
  conditions the envelope theorem no longer applies
  can get feedback effects on prices this is
  due to externalities in the search process

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Implications?

• The free trade equilibrium may not be optimal
  equilibrium unemployment may be too high or too
  low
• The relative supply curve need not be upward
  sloping it can bend back, leading to multiple
  free trade equilibria
• Expectations about economic activity become quite
  important
• See DMM (1987, 1988, 1991)

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Why not emphasize these results?

• Based on controversial, hard to measure search
  externalities it is unclear if such
  externalities are important, hard to predict
  which way they go more research needed
• Other interesting insights are present even when
  unit input requirements are optimal

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Back to Stolper-Samuelson

• Hard to test extended SS cannot observe return
  to unemployed or idle factors
• What about the return to employed factors?
• We get a convex combination of SS and Specific
  Factors (SF, or Ricardian) effects

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Trade and Wages with Unemployment

• When factors are employed, frictions create an
  attachment to that sector this makes them
  quasi-fixed factors this generates SF effects
• All employed workers realize that they will spend
  a fraction of life unemployed this generates SS
  effects

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Predictions

• Trade and factor rewards will be linked by a
  convex comb. of SF and SS effects
• SS effects will be strong in high turnover
  industries
• SF effects will be strong in low turnover sectors

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Empirical Evidence

• How to test this?
• Some have tried to test SS by looking at
  political contributions
• SS predicts that factor abundance determines
  views on trade policy
• SF predicts that industry affiliation determines
  view on trade policy

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Empirical Evidence

• In the past it has been difficult to find much
  support for SS empirically
• Magee (1980) looked at lobbying behavior, found
  support only for SF
• Dismissed as a misunderstanding of SS, which is
  really about long run behavior

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Empirical Evidence

• More recent evidence suggests that industry
  affiliation and factor abundance play a role
  (Beaulieu and Magee 2004)
• Also some evidence that voting behavior in US and
  Canada consistent with SS (Beaulieu 1998, 2000
  Balistreri 1997 Slaughter 1998)

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Prediction of our Model

• Relatively abundant factors employed in import
  sectors should favor protection if turnover is
  low, free trade if turnover is high
• Relatively scarce factors employed in export
  sectors should favor free trade if turnover is
  low, protection if turnover is high

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Data

• Look at PAC contributions in US aimed at
  influencing NAFTA and GATT
• These lobbies typically give to both parties (for
  access), will give more to one to influence
  outcome and policy
• Theory says Base decision on factor abundance
  (SS effect), industry affiliation (SF effect) and
  turnover rates

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Data

• DHS Turnover data (robust to other measures)
  use average turnover rate for 1988-1992
• Get PAC contributions from Federal Election
  Committee look at share going to supporters of
  NAFTA, approval of GATT (Uruguay Round), and both

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Data

• PACs can be linked to an industry based on data
  from the Center for Responsible Politics and from
  info on the web
• PACs classified as representing import-competing
  or exporting industry based on net trade position
  from NBER trade data

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Predictions

• High Turnover Industries
• Capital and labor should differ in preferences
  toward trade policy
• Low Turnover Industries
• Capital and labor should have the same
  preferences toward trade policy

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Fraction of 1991-92 PAC contributions given to
free trade proponents
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Fraction of 1991-92 PAC contributions given to
free trade proponents
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Extensions

• Can add controls, look at differences in
  differences, add fixed effects, results do not go
  away, often get stronger
• Bottom Line There is (strong?) support for the
  theory that the structure of the labor market
  effects the link between trade and wages

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Important Extensions

• With the model established, it can be used to
  look at a whole host of important issues that
  could not be addressed in full employment models
• For example
• Costs of adjustment (taking spells of
  unemployment and retraining into account)
• What is the best way to compensate those harmed
  by trade liberalization