A common feature in many trade-policy applications is the Armington (1969) assumption of national product differentiation. Brown (1987) critiques these applications, questioning the validity of simulated liberalizations that result in very large adverse terms-of-trade effects for relatively small countries. We expand this critique by noting that at the calibration stage of formulating most Armington models sub-national (firm-level) product differentiation is not considered. The resulting marginal-cost pricing at the sub-national level implicitly allocates market power over unique varieties away from optimizing firms and toward the whim of the policy authority. Although pervasive in applications, this allocation of market power to countries rather than firms is a troubling departure from traditional tenets.
This study contributes to the policy simulation literature in two important ways. First, we use a generalized model of nested differentiation to illustrate the mutual consistency between traditional models of national differentiation and the large-group monopolistic competition models popular in new trade theory. Second, we identify a tension in calibration assumptions between firm-level market power and national-level international-policy lever age. Market power is conceptually observable, and is show to be an important consideration in applied welfare analysis. Assuming optimal firm-level pricing over a country’s varieties can significantly reduce the implied optimal tariff.
The employment consequences of long-term investments have for a long time been a controversial issue in economics and this issue seems to underlie many disputes between firm owners and labor unions. In conventional models of imperfectly competitive labor markets, for example Layard, Nickell and Jackmann (1991), the investments have no effect on equilibrium unemployment. This is due to the specification of a Cobb-Douglas production function, which implies a constant wage elasticity of labor demand. For this class of production functions, investments or interest rates will have no effect on the wage determination, achieved through wage negotiations due to the constant wage elasticity, and therefore no effect on equilibrium unemployment.
Many reservations can be raised against the Cobb-Douglas specification, according to which the elasticity of substitution between labor and capital is equal to one. For the U.S. economy empirical studies have produced estimates according to which the elasticity of substitution empirical studies lies well below one (see e.g. Lucas (1969), Chirinko (2002), Chirinko et.al (2004) and Antras (2004)). Also empirical evidence concerning international data seems to consistently yield estimates, which do not lie in conformity with the Cobb-Douglas specification (see e.g. Rowthorn (1995), (1999), Duffy and Papageorgiou (2000) and Pessoa et. al (2004)). Berthold et. al (1999) have argued that the elasticity of substitution between capital and labor for Germany and France are higher than one. It has also been argued that when trying to explain variations in the labor share there is a need to depart from the usual assumption of a Cobb-Douglas production function (see Bentolila and Saint-Paul (2002)).
The implementation and the sustainability of intergenerational redistributive programs are crucial issues in the current political debate. On the one hand, demographic changes alter the economic nature underlying the enforcement of redistributive welfare programs; on the other hand public policies can be manipulated for political purposes, turning out to be more responsive to political pressures than to changes in economic environment. For this reasons, it becomes critical to explore the conditions under which intergenerational transfers, as outcome of a political voting game, can be implemented and why the welfare system developed so far has became a stable institution if modern society.
