Does globalization lead to unemployment? While of enormous interest to policy makers, the academic economist’s answer to this question is bound to be ambiguous. The theory of the second best teaches that dismantling barriers to trade in an environment featuring additional pre-existing distortions in the labor market that give rise to unemployment can either exacerbate or attenuate the welfare damage of those distortions (Lipsey and Lancaster, 1956). Hence, the answer to the above question will almost necessarily depend on modeling details. It therefore comes with some relief that merging the leading macroeconomic explanation of unemployment the Pissarides (2000) search and matching model–with the most recent version of the Krugman (1980) trade model–the Melitz (2003) model with heterogeneous firms–yields an unambiguous conclusion: globalization modeled as various types of trade liberalization lowers the equilibrium long-run rate of unemployment.
The Melitz (2003) trade model is a natural starting point to study unemployment in an open economy. It combines increasing returns to scale in production and product differentiation with heterogeneous firms. It has been successfully applied to a number of questions and has done very well in empirical studies (see the survey of Helpman, 2006). In that model, trade liberalization puts inefficient firms out of business while offering new opportunities to efficient ones. That selection effect leads to an aggregate productivity gain. There is ample evidence for this effect, both from microeconometric and from aggregate data (Bernard et al., 2003).
Similarly, the search and matching model of Mortensen and Pissarides (1994) has been successfully applied to a large number of environments, both in theoretical and empirical studies. Its main advantage over other models of unemployment is that it is based on a robust, empirically verifiable presumption, namely the existence of labor market turnover. Any conceivable labor market is likely to feature turnover, regardless of a country’s institutional details or workers’ and trade unions preferences. If job creation is not instantaneous due to search frictions, turnover yields equilibrium unemployment. Davidson and Matusz (2004) argue that the minimalist perspective on labor markets embodied in search-matching models is particularly useful in general equilibrium trade models.
Bringing the two models together is complicated by the fact that the basic search-matching model relies on perfect competition and constant returns to scale. This assumption is not satisfied in Krugman (1980) type trade models. Bertola (1994) and Stole and Zwiebel (1996a,b) show that individual wage bargaining in multiple worker firms with market power leads to an over-hiring effect as employers exploit local monopoly power. We follow Felbermayr and Prat (2007) and Ebell and Haefke (2006) to solve this issue. Importantly, firms with different productivities turn out to pay the same wage rate. This is an important feature, since it implies that the general equilibrium of the merged Melitz-Pissarides model is recursive. Product market equilibrium (average productivity) is essentially independent from labor market outcomes (labor market tightness), but the inverse is not true. Trade liberalization leads to a long-run improvement in average productivity, which in turn reduces the average firm’s real cost of posting vacancies relative to its marginal revenue. The new steady state reached after trade liberalization displays a lower equilibrium rate of unemployment. Hence, trade liberalization offers an additional channel for welfare gains by reducing the severity of search frictions.
This result stands in contrast to Egger and Kreickemeier (2006), who integrate the fair wage hypothesis into the Melitz model and find that globalization increases unemployment. This result, however, hinges on an ad-hoc wage formulation of a reference wage. Davidson et al. (1988) is the first paper to integrate search unemployment into a trade model. In a stream of subsequent papers (e.g., Davidson et al., 1999), the authors have explored different product market configurations.5 However, they generally keep the twin assumptions of perfect competition and constant returns to scale and their focus is on the effect of search frictions on patterns of comparative advantage. The paper that is closest to our work is Davidson et al. (2007), which analyzes search unemployment in the heterogeneous firms environment proposed by Albrecht and Vroman (2002). That paper studies how the existence of search frictions affects the endogenous determination of firm productivities. In our paper, the direction of causality is exactly the opposite, as we stick with the Melitz (2003) assumption of an exogenous sampling distribution (though, of course, the ex post distribution of productivities is endogenous).
The empirical relation between unemployment and trade liberalization is unclear. Blanchard (2005) writes that there is much intuitive appeal to the idea that globalization causes turmoil on labor markets, “...but the data just do not show it...” (p. 27). Our model is consistent with this finding. The rate of labor market turnover (the equilibrium flow into unemployment) does increase, but so does labor market tightness. As a result, the rate of unemployment actually falls. Davis et al. (1996) show for the U.S., that sectors in which productivity increases, feature higher turnover rates and net job creation, a result that is in tune with our theoretical results.
The remainder of this paper is organized as follows. In chapter 2, we present the closed economy version of our model and show that the equilibrium of the Melitz-cum-Pissarides model displays a surprisingly strong degree of recursivity and–hence–tractability. In chapter 3 we derive our key results on the effects of trade liberalization on equilibrium unemployment. We distinguish two globalization scenarios: (i) a decrease in variable trade costs, and (ii) an increase in the number of trading partners (e.g., due to entry of emerging economies. Chapter 4 shows that our model can be readily calibrated and presents simulation results for the U.S. economy. Finally, chapter 5 provides the conclusions and an outlook on further research.
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