Trade, Unemployment and Inequality

Index
Ricardo
HOS
HOV
Technology & Human Capital
Melitz meets Pissarides
Inequality & Unemployment
University of Washington
Trade, Unemployment and Inequality

A quick review
Jorge Rojas-Vallejos
2015
Jorge Rojas-Vallejos (UW)
Trade, Unemployment & Inequality
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Content
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Content
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Technology
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Content
Ricardo
Technology
HOS
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Human Capital
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Content
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Technology
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Human Capital
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Content
Ricardo
Technology
HOS
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Human Capital
Inequality & Unemp.
Index
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Content
Detour
Ricardo
Technology
HOS
HOV
Human Capital
Inequality & Unemp.

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Trade
International Trade
1
Allocation of resources across economic activities,
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Trade
International Trade
1
Allocation of resources across economic activities,
Distribution of incomes across factors of production.
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Ricardian Model
The Ricardian Assumptions:
1
Two countries, two goods, one factor (labor),
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Ricardian Model
1
Labor is immobile across countries and mobile across sectors,
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Ricardian Model
1
Constant returns to scale (CRS) production,
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Ricardian Model
1
Identical and homothetic preferences,
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Ricardian Model
1
Perfect Competition (all agents are price takers).
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Ricardian Model
1
Perfect Competition (all agents are price takers).
Remark
The basic idea applied is opportunity cost. In a two-goods economy
a country will produce the one that requires less unit labour.
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Qwine
LChile
aChile
w
LChile
aChile
m
What do we know its true in Autarky? PPF = BC
Qmeat
Index
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HOV
Qwine
LChile
aChile
w
LChile
aChile
m
Qmeat
Index
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HOS
HOV
Qwine
LChile
aChile
w
LChile
aChile
m
Qmeat
Index
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HOS
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Qwine
LChile
aChile
w
LChile
aChile
m
Qmeat
Index
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Qwine
LChile
aChile
w
CChile
= QChile
m
m
LChile
aChile
m
Qmeat
Index
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HOS
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Qwine
LChile
aChile
w
CChile
= QChile
w
w
CChile
= QChile
m
m
LChile
aChile
m
Qmeat
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Qwine
LChile
aChile
w
CChile
= QChile
w
w
CChile
= QChile
m
m
LChile
aChile
m
Qmeat
What do we know its true in Autarky?

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Qwine
LChile
aChile
w
CChile
= QChile
w
w
CChile
= QChile
m
m
LChile
aChile
m
Qmeat

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In a trading equilibrium, assume

aCh
Pmeat
meat
Pwine
aCh
wine
>
Qwine
LCh
aCh
w
uaut
LCh
aCh
m
Qmeat
Index
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HOS
HOV

aCh
Pmeat
meat
Pwine
aCh
wine
>
Qwine
P
slope= Pmeat
wine
LCh
aCh
w
uaut
LCh
aCh
m
Qmeat
Index
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HOS
HOV

aCh
Pmeat
meat
Pwine
aCh
wine
>
Qwine
P
slope= Pmeat
wine
LCh
aCh
w
utrade
uaut
LCh
aCh
m
Qmeat
Index
Ricardo
HOS
HOV

aCh
Pmeat
meat
Pwine
aCh
wine
>
Qwine
P
slope= Pmeat
wine
LCh
aCh
w
utrade
uaut
CCh
m
LCh
aCh
m
Qmeat
Index
Ricardo
HOS
HOV

aCh
Pmeat
meat
Pwine
aCh
wine
>
Qwine
P
slope= Pmeat
wine
LCh
aCh
w
CCh
w
utrade
uaut
CCh
m
LCh
aCh
m
Qmeat
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Ricardian Model
Question
Some argue that high relative wages in the North relative to the
South are evidence of Northern exploitation of Southern workers.
What can we say about it in this framework?
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Ricardian Model
Question
Some argue that high relative wages in the North relative to the
South are evidence of Northern exploitation of Southern workers.
What can we say about it in this framework?
Yes, in this model wages are larger in the trading equilibrium than
in the autarky one.
multi-goods extension continuum of goods
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A Continuum of Goods
The Dornbusch, Fischer, and Samuelson model (1977).
1
A continuous of goods index by j [0, 1],
ac (j) is the amount of labour required in country c to produce

one unit of good j,
B
(j)
A(j) = aaA (j)
is a downward slope monotonic function representing the ratio of these ac (j) in the two countries of the model.
This model facilitates the analysis of the range of goods that a country will export and import.
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DFS model
Remark
An expansion of the labour endowment of one country relative to
other will cause it to expand its exports, NOT JUST by exporting
more of what it already exported, BUT ALSO by exporting goods
that it previously imported.
wA
wB
< aB (j)wB good j is produce in A and exported to B
=
aA (j)wA
So, we have:
A(j) > good j is produce in A and exported to B

A(j) < good j is produce in B and imported by A
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DFS model
Putting everything together gives:
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DFS model
With this framework many comparative statics can be done. DFS

also include transport costs explaining non-traded goods. Thus,
Remark
Each country has a fraction of goods that it will be able to produce
as long as they cost less than imported goods including the transport
cost.
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Many countries and Ricardo
Please see:
Eaton and Kortum (2002) Technology, Geography, and Trade,
Econometrica, pp: 1741-1779.
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Heckscher-Ohlin-Samuelson Model
We just saw in the Ricardian model that:
1
everyone wins from trade,
there is only one factor of production (labour),
outcome is complete specialization,
differences in technology are the underlying mechanism.
Too simple right?!
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We just saw in the Ricardian model that:
1
everyone wins from trade,
there is only one factor of production (labour),
outcome is complete specialization,
differences in technology are the underlying mechanism.
Too simple right?!

In HOS, we assume:
1
2 2 2 Model: 2 Countries, 2 Goods (Outputs), 2 Factors

(Inputs),
No productivity differences. All countries share the same

technology.
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Output can be produced with different input mixes,
Factors are mobile across sectors but not across countries,
Countries differ in their relative abundance of factors.
Assumption (5) is the source of comparative advantages in the HOS

model1 .
AKA Factor proportions theory
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Rybczynski Theorem
An expansion in one factor (input) leads to an absolute decline in

the output of the commodity that uses the other factor more intensively.
Assuming that:
a
aLM
> LF M is more labour intensive than F
aTM
aTF
If L increases, then F will decrease.
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Stolper-Samuelson Theorem
Assume M is more labour intensive than F, and pF is constant. An

increase in pM raises the return to the factor used intensively in the
production of M by an even greater relative amount2 .
M is labour intensive and pM increases =
dpM
dw
>
w
pM
Jones (1965), Journal of Political Economy. Great paper!
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Generalization
Input endowment magnification effect. General Rybczynski theorem.

aLF
a
dL
dT
dF
dL
dT
dM
> LM
>
=
>
>
>
aTF
aTM
L
T
F
L
T
M
Output price magnification effect. General Stolper-Samuelson theorem.
aLF
dpF
a
dpM
dw
dpF
dpM
dr
> LM
>
=
>
>
>
aTF
aTM
pF
pM
w
pF
pM
r
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PPF in HOS
QT
QC
Why the PPF is not a straight-line?
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PPF in HOS
QT
QC
Why the PPF is not a straight-line?
Exactly! Imperfect substitutability across sectors.
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Open to trade
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Factor Price Equalization
This model leads to:

Relative factor prices converge across countries even
though factors are immobile across countries!
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Factor Price Equalization
This model leads to:

Relative factor prices converge across countries even
though factors are immobile across countries!
Factors of production are immobile across countries but goods are
mobile. Trade in goods is enough to lead to factor price convergence.
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Heckscher-Ohlin-Vanek Model
The setup is as follows:

1
Many countries, indexed by i {1, . . . , C},
Many sectors, indexed by j {1, . . . , N},
Many factors, indexed by k {1, . . . , M},
Technologies and preferences are identical across countries,
FPE prevails under free and frictionless trade.
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Empirical Evidence
How does HOV model perform?
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Empirical Evidence

Quoting Davis et al. (NBER 5625). Empirically... it is a flop.
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Empirical Evidence

Quoting Davis et al. (NBER 5625). Empirically... it is a flop.
Quoting Davis again ... relaxing the assumption of FPE yields a
dramatic improvement...
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Technology, Human Capital And Unemployment
In this section we discuss some of the ideas in:

Davis (1998) Technology, unemployment, and relative wages
in a global economy, European Economic Review, and
Davis et al. (2000) Human capital, unemployment, and relative wages in a global economy, Federal Reserve.
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So far, we have always assumed full employment of factors and nonmarket rigidities. However, there are two factor market developments of interest that we would like to understand.
1
The growing skilled-to-unskilled wage gap in the United

States,
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1

States,
The rise and persistence of unemployment in Europe.
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1

States,
The rise and persistence of unemployment in Europe.
To understand this the usual approach was looking at each region

separately, but Davis (1998) had the idea of looking at the problem
in a unified model of a trading world. We are in a global economy
and hence the dynamic system is integrated more than ever before.
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Technology and Unemployment
The structure of this economy is the HOS model, except that employment of unskilled labour will be subject to a binding minimum
wage. We (they) assume that skilled labour is fully employed. Thus,
HX + HY = H
(1)
while the unskilled labour factor market constraint due to the minimum wage regulation is,
NX + NY + U = N + U = L
(2)
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Define the relative goods price as P pX /pY and the relative world
endowment as h H/L. So,
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For the United States (flexible wage),
US
US
LUS
X + LY = L
(3)
For Europe (regulation min. wage),

NXE + NYE + U = N E + U = LE
(4)
Figure: Trading equilibrium

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Neutral technical progress in X at fixed prices
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American labour(unskilled) saving technical

progress in X
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Human Capital and Unemployment
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Human Capital and Unemployment
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Firm Heterogeneity, search unemployment and trade

liberalization
by Felbermayr, Prat, and Schmerer.
Working paper at The European Trade Study Group (2007).
In this paper, they introduce unemployment a` la Pissarides (2000)
into Melitz (2003).
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The Model
Assumptions:
I HHs utility follows U = ln C + U 0 ,
I Perfect financial markets,
I r is exogenous,
I Labour only factor of production,
I Labour is inelastically supplied,
I Perfect competition for final consumption good,
I Monopolistic competition, at the intermediate inputs level,
firms produce each a unique variety.
They focus in the long-run, excluding the short-run dynamics.
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The Model
Production function:

Z
1
1
1
q() d
,
Y= M
>1
(5)
where is the elasticity of substitution between any two varieties

and is the mass M of intermediate inputs.
The price index dual is:

1
P=
M
p()
1/(1)
(6)
where p() is the price of input .
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The Model
Quantities of intermediates inputs are:

q() =
Y
p()
M
(7)
Total production costs are:

c() = w()
q()
+f
()
(8)
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The Model
The labour market is characterized by search frictions. The aggregate matching function exhibits CRS.
Firms Workers
Some definitions:
= v/u: vacancy-unemployment ratio,
c: cost of posting vacancies
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Pricing Behaviour
The market value of an intermediate producer with productivity
is:

1
p(q)q w(l, )l cv + (1 )J(l0 , )
J(l, ) = Max
v
1+r
subject to
1
Y 1
q
p(q) =
(9)
M
q = l
l0 = (1 )l + m()v
some firms will exit, and some worker-firm matches will be destroyed (probabilities).
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Pricing Behaviour
The market value of an intermediate producer with productivity
is:

1
p(q)q w(l, )l cv + (1 )J(l0 , )
J(l, ) = Max
v
1+r
subject to
1
Y 1
q
p(q) =
demand
M
q = l
firm production function
l0 = (1 )l + m()v
law of motion
some firms will exit, and some worker-firm matches will be destroyed (probabilities).
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Pricing Rule
After some algebra:

w(l, )
c
r+s
1
w(l, ) +
l+
(10)
p(l, ) =
1
l
m() 1
Second term is the over-employment effect, and third term is the
recruitment cost.
s + + is the rate of job destruction.
Melitz (2003) was:

1
w
p(l, ) =
w(l, ) =
1
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Wage Bargaining
The bargaining process is summarized in an exogenous parameter .
However, this could endogenized.
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Wage Bargaining
However, this could endogenized. Combining the Nash-bargaining
condition and using the envelope theorem for the pricing problem
leads to:
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Wage Bargaining
leads to:
Job Creation equation:

1
r+s
c
w(l, ) = p(l, )
1 m()
(11)
Wage Curve equation:

r+s
c
w(l, ) = rU +
1
1 m()
(12)
(12) strikingly shows that wages are constant across firms! Why?
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Wage Bargaining
leads to:
Job Creation equation:

1
r+s
c
w(l, ) = p(l, )
1 m()
(11)
Wage Curve equation:

r+s
c
w(l, ) = rU +
1
1 m()
(12)
(12) strikingly shows that wages are constant across firms! Why?
Firms exploit their monopsony power till workers are paid their outside option.
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Entry, Exit And Autarky Equilibrium
As in Melitz (2003), the entry process is in two stages.

1
Develop new variety. Sunk cost fE , fixed costs f .
Firm learns its productivity and decides {stay, exit}
Similar math to the one in Melitz leads to the next to graphical relations.
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Equilibrium Threshold Productivity
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Equilibrium Labour Market Tightness
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Trade Liberalization
Next, we study the effects of trade liberalization on productivity

and unemployment. They run the following comparative statics:
1
Falling transport costs,
Rising number of trade relations,
Rising fixed costs for export.
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Fall in Transport Costs
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Rise Trade Relations
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Rise Fixed Costs for Export
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Inequality: The famous Gini index
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A Quick Look at Inequality
Since 1947, when the General Agreement on Tariffs and Trade (GATT)
was created, the world trading system has benefited from multilateral
trade liberalization (IMF website)
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Gini World Today
Source: World Bank
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Poverty $2 a day (PPP) Today
Source: World Bank
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Inequality and Unemployment
In this section we look at the model developed in:

Helpman, Elhanan, Oleg Itskhoki, and Stephen Redding. (2010).
Inequality And Unemployment In A Global Economy,
Econometrica, 78(4), pp: 1239-1283.
This model introduces search and matching frictions into a Melitz
(2003) framework.
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Inequality and Unemployment
We will study the determinants of wage distributions, namely:

1
Within-industry reallocation,
Labour market frictions,
Differences in workforce composition across firms.
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Preview
I The opening of trade enhances wage inequality, but can either

raise or reduce unemployment,
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Preview
I The opening of trade enhances wage inequality, but can either

raise or reduce unemployment,
I Wage inequality is higher in a trade equilibrium than in autarky. BUT, gradual trade liberalization first increases and later
decreases inequality.
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Preview
A trade friction can either raise or reduce wage inequality depending
upon the initial condition.
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What is new here?
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What is new here?
In this paper the new key feature is that they allow for an endogenous measure of matched workers for each firm rather than assuming one-to-one matching between firms and workers.
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The Model
Assumptions:
1
Two countries, Home and Foreign (*),
Continuous of workers ex-ante identical,
Workers are risk-neutral (later they extend this to risk-averse

ones),
Demand within the sector is defined over the consumption of a

continuum of horizontally differentiated varieties + CES.
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The Model
Real consumption index for the sector is:
Z
Q=
q(j) dj
1/
,
(0, 1)
(13)
jJ
controls for the elasticity of substitution between varieties.

Demand function for a given variety j is,
q(j) = A1/(1) p(j)1/(1) ,
A is a demand shifter
(14)
The equilibrium revenue of a firm is,

r(j) = p(j)q(j) = Aq(j)
(15)
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Firms actions
fe > 0
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Firms actions
fe > 0
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Firms actions
fe > 0
ac
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Firms actions
Exit
fe > 0
ac
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Firms actions
Exit
fe > 0
ac
Domestic
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Firms actions
Exit
fe > 0
Domestic
D&E markets
ac
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Firms actions
Exit
fe > 0
Domestic
Bargaining over surplus
D&E markets
ac
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Firms actions
Where:
fe : fixed entry cost (sunk)
is i.d. following a Pareto Distribution

min z
, min > 0,
G () = 1
z>1
ac : screening threshold
Tractable and a good approximation to observed data.

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Other costs in the model
fd > 0: fixed cost of production,
fx > 0: fixed cost of exporting,
> 1: iceberg variable trade cost, basically, we need to ship

so the foreign market gets 1 unit of our good.
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Production Technology
) ,
y = (h a
(0, 1)
(16)
where:
y: output of each variety,
: firms productivity,
h: workers hired,
: average ability of these workers.
a
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Production Technology
) ,
y = (h a
(0, 1)
(16)
where:
y: output of each variety,
: firms productivity,
h: workers hired,
: average ability of these workers.
a
Also, a Ga (a) with parameter k > 1. A key feature here is complementarity in worker ability. The productivity of a worker is
increasing in the abilities of other workers employed by the firm.
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Screening Technology
We (they) assume that all firms have the same screening technology. Worker ability cannot be costlessly observed when firms and
workers are matched.
Screening imprecise signal about a

Screening cost is assumed to be:
sc(ac ) = c
ac
,
c, > 0
(17)
Intuitive sense that higher ability higher cost of screening.
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Workers hired
a ac
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Workers hired

a ac h = n
amin
ac
k
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Workers hired

a ac h = n
amin
ac
k
=
a
k
ac
k1
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Workers hired

a ac h = n
amin
ac
k
=
a
k
ac
k1
This average ability into the production function yields,

y = y n ac1k ,
y =
k
ak
k1 c
(18)
The knife-edge condition such that firms screen is k (0, 1)
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Firms revenues
r() rd () + rx ()
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Firms revenues
r() rd () + rx ()
r() Y()1 Ay()
where Y() is the firms market access.
Y() 1 + Ix ()
/(1)
A
A
1/(1)
where Ix () is an indicator function for exporting.
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Bargaining problem
The outcome is:

I Firms fraction is
1
(1 + )
I Each worker gets

1
1
(1 + )
The firm can perfectly anticipate this while maximizing profits.
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The Firms optimization problem

Max ()
s.t.
Production technology
Total Revenue
Firms market access
or,
"
1/(1) #1
A
1
1 + Ix /(1)
() = Max
A
n,ac ,Ix 1 +
c
A(y n a1k
) bn ac fd Ix fx
c
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Access Market
The presence of fixed production costs imply a zero-profit cutoff such

that:

Y() =
1
Yx
if
if
d < < x
x
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FOCs firm
ac
n
(a) Measure of workers sampled
(b) Screening a threshold
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Revenues and Wages

The higher the productivity, the larger the revenues and the larger
the size of the firm. This depends on > k. We now that the share
of workers is /(1 + ). Hence,
w() =
r()
=
1 + h() |{z}
subs.
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Revenues and Wages

The higher the productivity, the larger the revenues and the larger
the size of the firm. This depends on > k. We now that the share
of workers is /(1 + ). Hence,
w() =
r()
=
1 + h() |{z}

b
subs.
ac ()
amin
k
(19)
In addition, the expected wage conditional on being sample is the

same across all firms, so
w()h()
= b = search cost
n()
(20)
Thus, workers have no incentive to direct their search.
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Revenues and Wages
Combining the above with FOCs, we get:

ln w() = Constant +
k
ln h()
k
(21)
If > k, then there is an employer-size wage premium.
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Revenues and Productivity

Using the FOCs into the revenue function, we get:
h
i1/
r() = r c(1k)/ b Y()A
(22)
From (22) we see that relative revenues of any two firms depend only
on:
1
relative productivities,
relative market access.

/

r(i )
i
Y(i ) /
=
r(j )
j
Y(j )
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Labour market tightness

Search cost is assumed to be increasing in labour market tightness
(x),
b = 0 x 1 ,
0 > 1, 1 > 0
labour market tightness is,

x=
N
L
where N is workers sampled and L is workers searching for employment in the sector. Thus, expected income in the sector is,
= Expected wage prob. being sampled = bx
(23)
(23) uses risk-neutrality of workers.

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Wages as a function of firm productivity
So, more productive firms NOT only have higher revenues, profits
and employment, as in the benchmark model of firm heterogeneity
of Melitz (2003), BUT ALSO pay higher wages.
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Wage Inequality in the Closed Economy

w Gw (w) = 1
w
min
1+1/
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w Gw (w) = 1
w
min
1+1/
Proposition
In the closed economy, is a sufficient statistic for sectoral wage
inequality. In particular,
p
i. the coefficient of variation of wages is / 1 2
ii. the Lorenz curve is represented by sw = 1 (1 sh )1/(1+) , where
sh is the fraction of workers and sw is the fraction of their wages
when workers are ordered from low-to-high-wage earners,
iii. the Gini coefficient is /(2 + ),
iv. the Theil index is ln(1 + ).
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Proposition
In the closed economy, inequality in the sectoral distribution of wages
is increasing in firm productivity dispersion (lower z) and increasing
in worker ability dispersion (lower k) if and only if
z1 + 1 + > 1
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Open versus Closed Economy
Figure:
Cumulative distribution function of wages
Proposition
i. Sectoral wage inequality in the open economy when some but
not all firms export is strictly greater than in the closed economy,
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Proposition
ii. Sectoral wage inequality in the open economy when all firms
export is the same as in the closed economy.
This proposition highlights a new mechanism for wage inequality
due to trade that is not present in HOS...
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Proposition
ii. Sectoral wage inequality in the open economy when all firms
export is the same as in the closed economy.
This proposition highlights a new mechanism for wage inequality
due to trade that is not present in HOS...
Participation of some but not all firms in exporting
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Corollary
An increase in the fraction of exporting firms,
I raises sectoral wage inequality when the fraction of exporting firms is sufficiently small,
I reduces sectoral wage inequality when the fraction of exporting firms is sufficiently large.
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Proposition
The opening of the closed economy to trade amplifies differences in
workforce composition across firms.
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Sectoral Unemployment
Workers may be unemployed mainly for two reasons,
1
They are not matched with a firm,
Their match-specific ability draw a < ac
(1) and (2) are frictional elements since workers cannot immediately
achieve another match or another ability level.
Sectoral unemployment rate u is defined as,
u=
H N
LH
=1
= 1 x
L
N L
|{z}
(24)
where H is the measure of hired workers, N matched workers, L

workers seeking for employment in the sector, and is the sectoral
hiring rate.
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They smartly derived,

= (, Yx ) aut
(25)
then they analyze the () function,

(0, Yx ) = 1
0 < (, Yx ) < 1,
(0, 1] since Yx > 1 > k
Thus, they get the next proposition.
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Proposition
The opening of the closed economy to trade has an ambiguous
overall effect on the sectoral unemployment rate:
i. The tightness of the labour market can either remain constant
or rise following the opening of trade, which leaves unchanged
or reduces the rate of unemployment,
ii. The hiring rate is strictly lower in the open economy than in the
closed economy, which raises the rate of unemployment.
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Extensions of this model

1
Heterogenous workers ex-ante

The results on within-group wage inequality hold,
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1

Wage inequality between different groups may increase or decrease,
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1

The rise of within-group inequality dominates, hence trade liberalization raises overall wage inequality.
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1

Risk-averse workers
Predictions for wage inequality are the same as for risk-neutral
workers,
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1

Risk-averse workers
workers,
The opening of trade has two effects,
increases expected worker income (),
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1

Risk-averse workers
workers,
The opening of trade has two effects,
increases expected worker income (),
increases labour market tightness (x) and search costs (b).
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THANKS!
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Why do we care?
Figure: President Salvador Allende (1971) with Chilean workers
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Why do we care?
Figure: Coup detat (1973) in Chile. A democratic government was

overthrown!
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Why do we care?
Figure: Some of us were lucky. Others still do not know where their
relatives are!
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Why do we care?
Figure: Some advised the new government.
Without Equality of Opportunity, Freedom is the privileged of a few

and Oppression the reality of everyone else.
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Trade, Unemployment and Inequality

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Inequality & Unemployment