Trade with Unemployment

1. Trade with Unemployment Carl Davidson Michigan State University

2. 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?

3. 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

4. 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)

5. 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)

6. 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

7. 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

8. 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.

9. 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

10. 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

11. 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

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

13. 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

14. 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

15. 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

16. 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?

17. 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)

18. 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)

19. 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

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

21. Why should we care? • Reason 3: What labor economics has taught us about the structure of labor markets and the personal costs from dislocation

22. 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)

23. 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, so…we 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

25. 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)

26. 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

27. 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 model’s fundamentals, can therefore be calibrated and used for policy analysis more easily than most models of unemployment

28. 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)

29. 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)

30. 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

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

32. 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

33. 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

34. 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

35. 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 • Θj = vj/uj = measures labor market tightness

36. Job Creation • m(u,v)/u = m(θ) = rate at which unemp. workers find new jobs m’(θ) > 0 • m(u,v)/v = m(θ)/θ = z(θ) = rate at which vacancies are filled z’(θ)< 0

37. 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 δ

38. Asset Value Equations Solve for VU, take Δt to zero, we get rVU = b + π[VE – VU] This is the general form for asset value equations

39. Asset Value Equations (Workers) • ρVju = b + mj(θj)[Vje – Vju] • ρVje = wj + δj[Vju – Vje] • In equilibrium, we must have VXu = VYu

40. Asset Value Equation (Firms) • ρVXv = - cx + zx(θx)[VXf – VXv] • ρVXf = px – wx - cx + δx[VXv – 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

41. 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 = β[px – cx] + (1 – β)rVXu • β denotes labor’s share of surplus • Only one value for β leads to efficiency (talk about externalities)

42. Factor Market Clearing • L0 = X + Y + ux + uy • K0 = X + Y + vx + vy • Steady-state conditions: δjX = mj(j)ux for j = X,Y

43. Factor Market Clearing • Using ss conditions we can rewrite as L0 = αLXX + αLYY K0 = αKXX + αKYY • The α terms are similar to the a terms from the standard model – they measure unit input requirements taking into account unemployed factors of production

44. Unit input req. with search αLX = 1 + (uX/X) αKX = 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

45. 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)

46. Product Market Clearing • SS equations along with asset value equations imply that Px = αLxρVXu + αKxρVXv Py = αLyρVYu + αKyρVYv • To make comparison easier, define wju = ρVju rjv = ρVjv

47. Equilibrium with Search L0 = αLXX + αLYY K0 = αKXX + αKYY Px = αLxwXu + αKxrXv Py = αLywYu + αKyrYv wXu = wYu rXv = rYv

48. 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