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

Trade with UnemploymentPart 2: New Insights from Old Trade Theory Carl Davidson Michigan State University

“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

“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?

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

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)

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)

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

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

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?

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

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

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

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)

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)

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?

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

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

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

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

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

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

Trade and Wages • Subtract the two expressions yields where * measures the relative factor intensities of the two sectors (in value terms); * > 0 means that sector X is relatively more labor intensive than sector Y

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

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

Trade and Wages • Note also: The price increase is a convex comb. of factor changes Thus, labor gains in real terms

Stolper-Samuelson • Trade benefits a country’s 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

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); * > 0 means that sector X is relatively more labor intensive than sector Y (with perfect competition, ** > 0).

Px/Py RS PM clearing RD X/Y w/r FM clearing 45o line w/r

Adding Unemployment • Yesterday I noted that with unemployment the product market clearing conditions can be written as Px = αLxwXu + αKxrXv Py = αLywYu + αKyrYv • Differentiate to get

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…

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 unemployedfactors

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

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

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)

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

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

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

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

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

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

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)

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

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

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

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

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

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

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

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

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