Selection, Trade, and Employment: the Strategic Use of Subsidies. Policy Paper no 21

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1 Selection, Trae, an Employment: the Strategic Ue of Subiie Policy Paper no 21 Author: Haan Molana (Univerity of Dunee), Catia Montagna (Univerity of Abereen) February 2015 Thi project ha receive funing from the European Union Seventh Framework Programme for reearch, technological evelopment an emontration uner grant agreement no

2 Author: Haan Molana (Univerity of Dunee), Catia Montagna (Univerity of Abereen) Selection, Trae, an Employment: the Strategic Ue of Subiie Policy Paper no 21 Thi paper can be ownloae from The WWWforEurope Policy Paper erie i a working paper erie that i open to policy maker, NGO repreentative an acaemic that are interete in contributing to the objective of the project. The aim of the paper erie i to further the icuion on the evelopment of a new an utainable growth path in Europe. THEME SSH Socio-economic Science an Humanitie Europe moving towar a new path of economic growth an ocial evelopment - Collaborative project Thi project ha receive funing from the European Union Seventh Framework Programme for reearch, technological evelopment an emontration uner grant agreement no

3 Selection, Trae, an Employment: the Strategic Ue of Subiie Haan Molana Catia Montagna Univerity of Dunee Univerity of Abereen Scottih Intitute for Reearch in Economic Scottih Intitute for Reearch in Economic Tuborg Reearch Centre for Globaliation GEP, Nottingham an Firm, Aarhu Tuborg Reearch Centre for Globaliation an Firm, Aarhu February 2015 Abtract: We tuy how the interaction between economic openne an competitive election affect the effectivene of employment (an entry) ubiiation. Within a twocountry heterogeneou-firm moel with enogenou labour upply, we fin that optimal employment ubiie are alway poitive even though they can have pro- or anti-competitive effect on inutry election epening on whether the economy i open or not. We alo fin that election effect reulting from international competition an fical eternalitie may imply that non-cooperative policie entail uner-ubiiation of employment. Whilt alway having procompetitive election effect on the inutry, entry ubiie are hown to be le effective in raiing employment an welfare than employment ubiie. JEL claification: E22, E64, F12, F41 Keywor: optimal policy, employment ubiie, competitive election, international trae Acknowlegment: Funing from the European Union Seventh Framework Programme for reearch, technological evelopment an emontration uner grant agreement no i gratefully acknowlege. Correponing Author: Catia Montagna, Economic, Univerity of Abereen Buine School, Ewar Wright Builing, Dunbar Street, Ol Abereen AB24 3QY; Tel: +44 (0) ; c.montagna@abn.ac.uk

4 1. Introuction In recent year, welfare tate reform have tene to be characterie by a hift in emphai from the ue of paive labour market policie to that of active labour market policie (ALMP). Thee programme, often combine with reuction in employment protection within the fleicurity moel, conit of intervention aime at reucing earch friction (e.g. public employment ervice) an increaing employability (e.g. training cheme), but alo of irect job creation meaure uch a wage an employment ubiie. 1 Thi type of ubiie accounte on average for about 25% of total ALMP in the OECD in 2003 an their ue intenifie uring the Great Receion. In aition, whilt they have often been introuce to upport pecific type of worker (uch a the young or the long-term unemploye), they have increaingly been perceive a a mean to accelerate job recovery 2 an eman for targeting them towar pecific type of firm (a oppoe to type of worker) an/or ector have aboune. 3 The literature on the aement of the effectivene of ALMP typically aopt partial equilibrium approache in which the focu i place on microeconomic incentive (for iniviual worker, e.g. in eeking work, an for iniviual firm, e.g. in hiring). Thee policie, however, have implication that go beyon iniviual agent behaviour an affect aggregate performance via aggregation effect that tart from the inutry level. In aition to being influence by the etent of international openne, thee effect alo work through comple channel that are hape by competitive election force within inutrie an that thu turn out to be an important eterminant of the aggregate general equilibrium impact of policy. The fact that epoure to international competition enhance competitive election within inutrie an the role of the latter in etermining aggregate prouctivity an growth are now acknowlege by policy maker: whilt helping firm to protect an create job in a globalie environment by upporting their cot competitivene i increaingly een a an important complement to growth trategie, there i alo an awarene that prouctivity growth require contant reallocation of reource from le to more efficient prouce (Blanchar et al., 2014). 1 Thee policie are central to the European Employment Strategy to are tructural unemployment an to increae labour participation an are a cornertone of the Social Invetment moel of the welfare tate. See Aneren an Svarer (2012) for a icuion of the Danih cae. The 2013 EU Annual Growth urvey, available at encourage the member tate to tep up ALMP. 2 The ue of employment an wage ubiie to raie employment uring the recent receion wa enore by the ILO-IMF (2010) Conference on The Challenge of Growth, Employment an Social Coheion an have recently been avocate by the IMF (2013). Employment ubiy cheme were introuce, e.g. in Germany (Kurzarbeitergel, ee OECD, 2009), an in Irelan, while Japan augmente her eiting Employment Ajutment Subiy Programme by multiple timulu package (Kluve, 2010). 3 For intance, Marzinotto et al. (2011) ugget that unue EU tructural fun coul be ue to target wage ubiie to promote job creation in the eportable ector a a mean to reucing eternal ebt buren. In a imilar vein, the Irih Eporter Aociation argue that the [2009] Employment Subiy Scheme Secon Roun i too little an that preaing the [ue of the] Employment Subiy Fun will inevitably ilute [it] impact to upport eport, key route to balancing the Echequer an riving the economy out of receion 1

5 In thi paper we aim to invetigate how the interaction between economic openne an competitive election hape the effectivene of ALMP an government incentive in aopting them. In particular, we ak whether employment ubiie can help achieve the type of reallocation that can lea to aggregate prouctivity an employment growth, an how their effectivene i affecte by international policy pill-over. To thi en, we focu on the optimal etermination of employment ubiie in a two-country two-ector moel characterie by firm heterogeneity an enogenou labour upply. From a theoretical perpective, an employment ubiy can be jutifie if it correct itortion that rener the market equilibrium uboptimal. Dating back to the pioneering work of Pigou (1933) an Kalor (1936), an etenive literature ha eamine the impact of employment ubiie an the taation require to finance them. A ignificant tran of thi literature, however, oe not rely on general equilibrium framework characterie by imperfectly competitive goo market, 4 an/or limit the analyi to cloe economy etting. 5 A notable eception i Molana et al. (2012) who tuy the role of employment ubiie a fical timuli in the open economy. 6 They how that the effectivene of ubiie in raiing the level of economic activity i hape by a country trae openne an that government can act trategically in etting ubiie in the preence of international policy eternalitie. However, their paper oe not allow for heterogeneity acro firm an hence cannot account for the role of competitive election in etermining thee effect. Our reearch i alo relate to a tran of the literature that highlight the impact of intra-inutry reallocation on aggregate performance. Di Giovanni an Levchenko (2013) fin that the ize compoition of inutrie interact with trae openne in etermining aggregate output volatility. Several tuie ocument how miallocation acro heterogeneou prouction unit can affect aggregate prouctivity an the tranmiion of hock (e.g., Baily et al., 1992; Retuccia an Rogeron, 2010). Of particular interet i the fact that ifferent firm ehibit ifferent cyclical pattern of net job creation (Mocarini an Potel-Vinay, 2012; Elby an Michael, 2013). Thee paper, however, o not conier the interaction between competitive election on the one han, an labour market policie aime at increaing employment an trae openne on the other. 4 The ue of employment ubiie to raie employment ha been avocate in Johnon (1980), Jackman an Layar (1980), Layar an Nickell (1980), Dreze an Malinvau (1994), Phelp (1994) an Arti an Sinclair (1996) among other. Search an matching moel, bae on Mortenen an Piarie (1994), provie an alternative framework within which the effect of employment ubiie have been analye for eample, ee Mortenen an Piarie (2003), Boone an van Our (2004) an Carullo an van er Linen (2006) among other. More recently, Brown et al. (2011) have contructe a Markov moel of a labour market to compare the effectivene of ifferent employment ubiie. 5 Within a imple cloe economy macroeconomic moel with monopolitically competitive market á la Diit an Stiglitz (1977), Fleurbaey (1998) how that employment ubiie finance by profit taation take the economy cloer to the Walraian equilibrium by countering the negative impact of market power on the level of economic activity. 6 The open economy literature ha typically focue on trae policy intrument ee, e.g. Braner an Spencer (1985), Venable (1987). Bettenorf an Heijra (2004) analye the ue of prouction ubiie (in the preence of import tariff) but their analyi i limite to the cae of a mall open economy an abtract from itortionary tae on labour income. More recently, Bilbiie et al. (2008) have tuie the effectivene of labour, ale an other ubiie a counter-cyclical tabiliation policy tool in raiing employment an output within ynamic tochatic general equilibrium moel, but o not allow for intra-inutry election effect. 2

6 Another (till fairly mall) tran of the literature to which our work i relate concern the effect of policy on competitive election. Demiova an Roriguez-Clare (2009) focu on the effect of trae policy in a mall open economy, whilt Felbermayr et al. (2013) conier non-cooperative tariff policie within a two-country etting. Contrary to our moel, both of thee paper aume a one ector economy an an eogenou labour upply, an their focu i not on employment creation policie. Pflüger an Sueekum (2013) evelop a twocountry moel to analye trategic interaction between government in etting entry ubiie finance via lump-um taation. Thi paper eten the moel evelope by Molana et al. (2012) to allow for intrainutry prouctivity heterogeneity among firm. We how that not only o employment ubiie affect the level of economic activity, but they alo have an impact on aggregate efficiency via reallocation effect acro countrie, ector, an firm within ector. Ultimately, by ubiiing employment, the government control the electivity of competition an contribute to correcting the market itortion (ariing from ifference in mark-up between the monopolitic goo on the one han an leiure, an outie goo, an the importe varietie on the other) that reult in an uner-conumption of the ifferentiate goo. Crucially, international openne alter the effect of the policy on election an aggregate prouctivity. Whilt in autarky the optimal employment ubiy, by oftening competition, ha anti-competitive effect on the economy, in the open economy it ha procompetitive effect an reult in a higher average prouctivity of firm. International pillover, coniting of election an fical eternalitie, lea to non-cooperative an cooperative policy equilibria that are characterie by poitive ubiie. Whether the noncooperative olution entail level of ubiiation that ecee or are hort of thoe characteriing the cooperative outcome hinge, however, on the nature of the eternality between countrie which in turn epen on how the ubiy i targete. Finally, reform of prouct market particularly aime at facilitating entry are coniere a an effective mean to increae aggregate prouctivity an employment. 7 Our analyi of an entry ubiy reveal that whilt it alway ha pro-competitive election effect on the inutry, it i le effective in raiing employment an welfare than an employment ubiy. Thi i ue to the fact that the latter enable the government to tackle the monopolitic itortion more irectly. The ret of the paper i organie a follow. Section 2 analye the cloe economy cae. Section 3 eten the moel to a two-country etting, an Section 4 analye the trategic ubiy game between government. Section 5 eamine the role of trae liberaliation an prouctivity hock. Section 6 compare the impact of employment an entry ubiie, an Section 7 conclue the paper. 7 A Blanchar et al. (2014) tate, Structural reform in prouct market particularly lowering barrier to entry of new firm i likely to prouce a larger growth payoff than reform in labor market. 3

7 2. Cloe economy Conier an economy coniting of two ector, one imperfectly an one perfectly competitive, repectively proucing a horizontally ifferentiate goo an a homogeneou commoity. Labour upply i enogenou an a government employment ubiy in the ifferentiate ector i finance via proportional income taation Deman an technology The population of conumer i characterie by a repreentative houehol with N ientical member which are either employe or unemploye. We aume that an employe worker i require (by legilation) to upply a fie number of work hour (which i normalie to unity), a fraction h of houehol member are employe, an the total houehol income i equally hare amongt it member (unemploye member are inure in thi ene even if there i no unemployment benefit per e; ee e.g., Anolfatto, 1996; Merz, 1995). The correponing utility function an the buget contraint, written at the houehol level, are 1 1 A Y Nh U, 0 1, 0, 0, N 0, (1) 1 1 P A PY N 1 t wh, (2) A Y where A an P A are quantity conume an price of the homogenou commoity, Y an P Y are the quantity conume an price of the ifferentiate goo, w i the wage rate, an t i the proportional income ta rate. 8 The aggregate labour upply function an the eman function for the two goo are, repectively, 1/ t w t wl t wl L Nh N, A an Y, P PA PY (3) where P P P i the conumer price ine. Y i aume to be a CES bunle of 1 A Y ifferentiate varietie with ual price ine P Y, repectively given by / 1 11/ 1 Y im Y y( i) i an P p( i) i, im (4) where M i the et of available varietie, y(i) an p(i) are the quantity conume an the price of variety i repectively, an >1 i the contant elaticity of ubtitution between varietie. The eman for each variety i then pi () yi () Y PY, i M. (5) 8 Given the itributional concern with lump-um taation, we concentrate on proportional income taation which account for the bulk of ta revenue from the peronal ector in avance inutrial economie. 4

8 The homogenou goo i prouce uner perfectly competitive conition uing a contant return to cale technology with a unit labour requirement of one, i.e. A, where L A an A enote the labour eman an the quantity upplie by thi ector, repectively. Given the aume technology, the zero-profit conition an free mobility of labour acro the two ector imply w P. We ue thi goo a the numeraire an normalie A PA 1, which in turn implie w 1 an P P Y. In the ifferentiate goo ector, each firm employ labour a the only input to prouce one variety of the goo uing a linear technology with increaing return to cale. Dropping the variety inicator i an itinguihing firm by their prouctivity parameter 1, LA, the labour requirement to prouce an market a quantity y of the goo i l, where y i the fie labour requirement. A firm profit i p y 1 l, where [0,1) i the employment ubiy rate that the firm receive from the government. Profit maimiation uner tanar monopolitically competitive aumption then yiel the 1 familiar mark-up rule: p. Given thi, an revenue r py, 1 operating profit are: r/ 1. A in Melitz (2003), before they can et up an tart proucing, a large pool F of ientical potential entrant each pay a fie entry unk cot f, meaure in term of the numeraire goo, that enable them to raw a prouctivity parameter from a common population with a known p..f. ( ) g, efine over upport 1, with a continuou cumulative itribution G( ). A firm urvival in the market will epen on the magnitue of it in relation to the threhol c firm; firm with which atifie 0 c an efine the marginal 1, c will not enter ince they woul make a lo, while thoe with c, fraction G c of F will be unucceful, while a fraction 1 c will make non-negative profit. Prior to entry, therefore, it i known that a M G F will uccee an tart prouction. Thu, e-pot, M i the ma of varietie available to conumer. We can g therefore reefine the p..f. of the urviving firm over [ c, ) by, 1 G c which can then be ue to obtain a meaure of the aggregate prouctivity of the inutry a the weighte average of operating firm prouctivity level [ c, ), To ee thi, efine y( )/ y( ) ( ) an note that the weight y y i given by / which can be ubtitute back in the efinition of to obtain (6). 5 /

9 1 1 1 c. (6), y( )/ y( ) / Uing p( )/ p( ) / c c c c an r( ) p( ) y( ), we obtain 1 1 r( ) r( ) 1. r( c) c c All the relevant variable can then be written in term of c an. In particular, the inutry price level, operating profit an labour eman are repectively given by 1/(1 ) 1 PY M 1, (7) 1 ( ) 1 1, (8) c 1 l( ) 1 1. (9) c Finally, the inirect per capita utility can be written a U u N 1 h, (10) 1 which i monotonically increaing in h. Thu, maimiing u i equivalent to maimiing h General equilibrium an policy analyi Entry continue until the epecte net entry profit i zero, i.e. MFf 0 we write a, which M r 1 l Ff 0. (11) The aggregate market clearing conition for the labour, ifferentiate goo an homogeneou goo market are, repectively A L Ml L, (12) Mr 1 t L, (13) A ff A, (14) where A 1 1 t L, an A L A. 6

10 Finally, the government buget contraint i 10 Ml tl. (15) The above equation complete the moel, which conit of 14 equation an 14 unknown: F, M, L, L A, l, A, A, P Y, r, y,,, c an either the ta rate t or the ubiy rate. 11 In orer to obtain eplicit olution, we aopt the Pareto itribution an let G (1 ) g 1 an, 1,, (16) where the hape parameter provie an invere meaure of iperion. 12 Then, an (17) imply 1 G c c 1 1 c. (18) 1 Making ue of (18), we rewrite (11) a 1 M 1 Ff 0. (19) 1 Given (16), 1 c M G F implie M c F which can then be ubtitute into (19) to obtain the equilibrium value of the prouctivity cut-off, c 11 f 1 1/. (20) A i clear from (20), c 0 : the minimum prouctivity require to urvive in equilibrium c i poitively relate to the egree of heterogeneity between firm. Moreover, 0 : a higher ubiy often competition, making it eaier to urvive in equilibrium. For a given, an treating t a enogenou, the moel can be olve (ee the Appeni for etail) to epre all enogenou variable in term of. The correponing equilibrium ta rate i given by 10 We aume that the government et a uniform ubiy rate common to all firm in the inutry. Thi aumption reflect the fact that, ue to the informational requirement of firm-pecific intervention, government often chooe to ue fairly blunt policy intrument, targete to group or categorie of agent. Note, however, that with CES preference (where firm mark-up, an hence the monopolitic itortion aree by the ubiy, oe not epen on their prouctivity) the ubiy houl be the ame for all firm contrary to the cae of firm-pecific market power where it i well known that firt-bet policie epen on firm prouctivity ee e.g., Leahy an Montagna (2001) an Nocco et al. (2014). 11 Note that in general equilibrium one of the market clearing conition, e.g. the homogeneou goo market equilibrium in (14), can be obtaine from the ret an i therefore reunant. 12 In the Pareto itribution, both mean an variance are negatively relate to the hape parameter Thu, the maller i, the higher i the average firm efficiency an the higher i the prouctivity iperion. To obtain meaningful reult we impoe >-1. 7

11 1 1 1 t. (21) The inirect utility function in (10) i a monotonic function of h which, from (3), i in turn given by 1 t h PY 1/. Thu, a ubiy affect welfare via three channel: the ta rate an, through P Y, the ma of varietie an the average inutry prouctivity. Uing (21) an the olution for P Y to evaluate h, we obtain the olution h which can be hown to be c trictly concave in. Thu, given that 0 alo hol, it i welfare-improving to ubiie employment an to often competitive election in the monopolitic ector. Furthermore, h reache a unique maimum at opt 1 0, (22) 1 opt where 0. Hence: the lower i the egree of prouctivity heterogeneity between firm, the larger i the optimal ubiy ince, at higher value of, the ubiy ha a lower marginal opt effect. Conitently, ubtitution of (22) into (20) implie c 0, i.e. the optimal value of the prouctivity cut-off i lower (an o i the optimal average prouctivity in the inutry) 1 the more homogeneou are firm. In fact, lim opt opt an limc 1. Thu, given that 1 w opt p, p 1 c w : when all firm raw the ame prouctivity level with probability one, the optimal ubiy eliminate the mark-up margin ( 1), thu fully correcting the monopolitic itortion. More generally, the etent to which the ubiy aree thi itortion i irectly relate to the ize of, i.e. it increae in the egree of homogeneity of firm. The monopolitic itortion, ue to the fact that the ifferentiate goo i price at a mark-up while leiure an the homogenou goo are not, reult in a wege between the marginal rate of ubtitution an the marginal rate of tranformation between leiure an the homogenou goo on the one han an the ifferentiate goo on the other. Conequently, the market outcome i characterie by a ub-optimal level of the conumption of the ifferentiate prouct an an eceive conumption of the homogenou goo an 8

12 leiure. In contributing to correct thi itortion, the ubiy reuce the hare of employment in the homogenou goo ector 13 L A 1 1, (23) L 1 which i negatively relate to. Intuitively, by reucing firm cot an making it eaier for them to urvive in equilibrium, the ubiy often competition an thi epite worening the efficiency compoition of the inutry work towar increaing entry. A hown in the Appeni, the ma of firm i concave in, but reache a maimum at a ubiy level that ecee the value that maimie employment. Thu, increaing the ubiy up to it optimum level epan the ma of firm in the inutry, which contribute towar raiing welfare an aggregate employment. A i clear from (21), an increae in ubiy, however, raie the ta rate, which reuce labour upply an welfare. In aition, the lower average prouctivity in the inutry contribute to offetting the initial price-reucing effect of the ubiy. Taken together, thee force unerpin the concavity of h. 14 In um, by reucing the electivity of competition in the monopolitic inutry, the ubiy trigger a reallocation of reource acro the two prouction ector, away from leiure an within the monopolitic ector away from the mot efficient an towar le efficient firm. Depite it anti-competitive effect, an optimally choen ubiy lea to welfare gain. 3. A two-country etting In thi ection we eten the moel to a two-country etting. Both economie (home an foreign) are characterie by the ame conumer preference an technologie icue in the autarkic moel above. The homogenou goo (that we retain a the numeraire) i freely trae whilt the ifferentiate goo i trae at a per-unit iceberg trae cot, >1. We hall enote the foreign country variable by an aterik an focu the icuion of the twocountry moel on the home country. 13 See Bilbiie et al. (2008) an Molana et al. (2013) for further icuion. The effect of cot heterogeneity on the optimality of the market olution ha been eamine by Dhingra an Morrow (2015) for the CES an VES cae an by Nocco et al. (2014) for quai-linear eman. Dhingra an Morrow (2015) how that in a oneector-heterogeneou-ces worl, the market olution correpon to the firt bet i.e. how the market allocate reource acro firm oe not matter (an the optimal policy i laiez faire). When, a in our cae, mark-up iffer acro ector, the monopolitic itortion lea to inefficient market allocation that can be correcte by policy to an etent that, a we how, epen on the egree of heterogeneity among firm prouctivitie. 14 Note that a higher value of i aociate with a lower ma of firm an a lower aggregate employment. Thu, the kewene of the prouctivity itribution matter in etermining the effectivene of the ubiy opt opt opt opt opt 2 opt opt opt L L L L L policy i.e. L L,, where 0, 0 opt 2. Hence, ceteri paribu, a fall in prouctivity heterogeneity (i.e. a higher value of ) will reult in a lower aggregate employment in equilibrium, epite a higher optimal ubiy rate. 9

13 The ifferentiate prouct aggregator an it price ine are now repectively given by / 1 11/ 11/ 1 1 Y im M im im M Y y () i i y () i i, P p () i i p () i i, im (24) where the ubcript an refer to ometically conume an eporte varietie, repectively thu, e.g., y an p are the quantity an price of foreign eporte varietie conume in the home country. Deman for the ometic an foreign varietie of the ifferentiate goo are repectively given by () () PY PY p i p i y() i Y, y () i Y. (25) The poibility of trae implie that firm in the monopolitic ector will have to ecie after entry whether to prouce for the ometic market only or whether to alo eport. In aition to the fie entry cot f an the fie cot require for prouction of y, an eporting firm alo incur a fie cot (alo in term of labour) for proucing an marketing the output y it ell abroa. Given the higher compleity of operating in foreign market, it i plauible to aume <. A in the autarkic cae, we hall aume that the government oe not et firm-pecific ubiie. However, the openne of the economy reult in the poibility of broa categorie of firm/activitie to be targete e.g. conitent with the preure for ome form of employment upport to be irecte to eporter or high quality job firm uring the recent receion. Hence, we hall briefly eamine an eport-only ubiy,, for labour employe in the prouction for eport, an a ometic-only ubiy, for labour employe in prouction for ometic ale, in aition to the uniform employment ubiy cae,. A firm profit from ometic an foreign ale are then given repectively by p y wl p y wl 1, 1, (26) where l y y, l. (27) Maimiation of (26) ubject to the eman function in (25) an labour requirement in (26) implie the following optimal price rule for a firm with prouctivity erving both market: p 1 w 1 w, p. 1 1 (28) 10

14 3.1. The general equilibrium The competitive election proce that follow entry will reult in the emergence of two up : ( ) 0 up : ( ) 0, that prouctivity cut-off, efine by an repectively correpon to the prouctivity of the marginal firm that urvive in the ometic market an to that of the marginal eporter. Thu, the poibility of international trae, an the fact that trae i cotly, will reult in a partitioning between eporting an non-eporting firm. Only relatively more prouctive firm will affor to eport an etermine the partition between the two type of firm: for a given ma of entrant F, a ma M 1G F F of firm with prouctivity, for the ometic market an a ubet of thee, with ma 1 with prouctivity, will urvive an prouce M G F F an, will alo prouce an eport to the foreign country. Following the ame proceure a in autarky, for any given an we obtain the correponing average prouctivitie, 1/( 1) 1/( 1),. (29) 1 1 The zero epecte net entry profit conition implie that 0 M M P f F alway hol in equilibrium. The labour market clearing A conition i, L Ml M l L (30) A 1t w where, a in autarky, LA A an L N 1 P A P. The balance government buget Y contraint an the trae balance equation are, repectively w Ml M l twl, (31) P A A f F M r M r. (32) A Finally, the moel i cloe by noting that, ince the homogenou goo i freely trae, wp w P 1. A hown in the Appeni, we reuce the moel to 12 equation which A A can be olve to etermine 1/,,,, F, F, P, P, h, h, t, t. Uing thee equation, Y Y the following relationhip can be hown to hol in general equilibrium between the two countrie prouctivity cut-off: /( 1) 1/( 1) /( 1) 1/( 1) ,. (33) 11

15 Thee imply that, for any given level of an, ubiy policie in the two countrie trigger election effect that will reult in change in the efficiency compoition of the inutry (an hence in market tructure) in both countrie The effect of employment ubiie The moel can be olve recurively to firt etermine the two countrie prouctivity cut-off,,, by coniering four equation coniting of (33) above an the zero epecte net profit of entry equation which can be written a (ee the Appeni): 1 f 1 1, 1 1 f We now impoe full ymmetry, i.e.,, f,, =,, f,, (34), on (32) an (33). Focuing on a uniform ubiy (by letting an ) an allowing for the two countrie ubiie to iffer (i.e. ), we obtain the olution for the prouctivity cutoff for the home country: /( 1) 1 [ /( 1) 1] 1/ 11 /( 1) 1 /( 1) 1 f /, (35) /( 1) 1 [ /( 1) 1] 1/ 11 1 /( 1) 1 [ /( 1) 1] f 1 1 1/. (36) Thee can be ubtitute into (33) to obtain the correponing epreion for the foreign country. Inpection of the cut-off reveal that with full ymmetry an for any given, a unilateral rie in increae an, an. 15 (which rie even more than oe) an reuce 15 Thi hol for the unilateral cae a long a, for the given value of,, 12, the value of i ufficiently large to enure poitivity of the enominator of (34) an (35). However, thi qualification i not require for ymmetric olution ince the enominator of (34) an (35) are poitive for all 1 given that an 1.

16 Equation (35), (36) an the correponing equation etermining the foreign prouctivity cut-off can then be ue to obtain the ma of firm characteriing the equilibrium. While thi coul not be one analytically, our etenive numerical analyi how that an increae in uniform ubiy in the home country will lea to greater entry (F), a larger ma of urviving firm (M) characterie by a higher average efficiency ( ), an a larger etenive margin of eport M / M. It will alo have the oppoite effect on the foreign country, which eperience a reuce entry F, a maller ma of urviving firm M characterie by a lower average efficiency eport M / M., an a maller etenive margin of Thu, contrary to what happen in autarky, a unilateral increae in uniform employment ubiy to all home firm ha a pro-competitive election effect on the monopolitic inutry. Intuitively, to begin with, the policy ha an anti-competitive effect on the monopolitic ector: by lowering labour cot, it will initially work towar a reuction of both the ometic an the eport prouctivity cut-off. However, by oftening competition an making it eaier to urvive in the ometic market an to eport, the higher ubiy will trigger entry an reuce the ale of incumbent, which will then make it more ifficult to urvive in the inutry. In aition, a i reflecte in the poitive relationhip between an, the initial impact of the ubiy (by working towar a reuction of ) make it eaier for foreign eporter to penetrate the ometic market. Thi further toughen the egree of import competition for ometic firm an work towar an increae in. Thee effect ominate an reult in the ubiy increaing the ometic prouctivity cut-off an the ize of the monopolitic inutry. Moreover, the ubiy ha an avere election effect on the foreign country, which reult from an epeniture witching acro countrie, with conumption of importe varietie falling in favour of ometic one an effect that, together with the increae in the ma of home country eporter, unerpin a contraction of the monopolitic ector in the foreign country. 4. Welfare an optimal policy in the ymmetric cae Retaining the aumption of ymmetry between countrie, in thi ection we tuy the optimal policy. A in autarky, utility i monotonically increaing in employment which we continue to ue to proy welfare. Given the compleity of the algebra involve, however, we now ue numerical olution to illutrate the optimal policy an it effect Our calibration of the parameter i conitent with thoe wiely ue in the literature for thi type of moel, ee, e.g., Felbermayr et al. (2011). See Table A3 in the Appeni for the parameter value ue in our olution. 13

17 4.1. Uniform ubiie Letting an, we inicate the olution for employment in the home an foreign country by h, an h, which can be hown to be concave in (for any given ) an in (for any given ), repectively. In Figure 1 we plot, for a few ifferent value of value of, ection of,, h, h in, h pace which how that, for all relevant i trictly concave in an ha a unique maimum at ome 0<<1. Thu, each country ha a unilateral incentive to et a poitive employment ubiy. Figure 1. Section of home country welfare function, (for ifferent value of ) h in, h pace Uniform Subiy in Home Country, =0.0 =0.04 = Uniform Subiy in Home Country, = =0.145 =0.20 Note: The curve are truncate at each ean to reuce the cale effect. The concavity of a country welfare function with repect to it own ubiy tem from the poitive election effect of the policy icue in the previou ection together with negative fical effect: the welfare function ehibit a trae-off between the combine effect of the larger ma of firm an their higher average prouctivity (which implie that conumer gain both at the etenive an at the intenive margin becaue of a higher variety an lower average price) an the higher ta rate require to finance the increae in the ubiy. 17 Clearly, the eternalitie of a unilateral change in ubiy by the home country government will affect the foreign country policy incentive. When both government are policy active, their reaction function an the reulting Nah equilibrium can be obtaine uing the iterative numerical olution metho by maimiing (equentially an in turn) h, an, h, We fin h, which are ymmetric, holing the other country ubiy contant. 0 an h, 0 which imply that the two countrie ubiie are trategic complement an the two reaction function are upwar loping in, pace. We 17 Other thing equal, the increae in a country ta rate i higher the larger i it ma of firm. 14

18 alo fin that the welfare function are ale-hape, implying that the policy eternality i non-monotonic. To eplain thi, conier the effect of increae in the foreign ubiy rate on home welfare. A increae, while the optimal value of rie, the correponing maimum value of, h fall initially an then rie a ecee a threhol value. Figure 1 illutrate thi property. The left panel how the negative eternality region for : a h, hift own an it maimum move to the right; thu whilt the i raie, policy choice ehibit trategic complementarity throughout, in thi region the raiing of an unfrienly move by the foreign country. There i however a threhol for i at which the raiing of become a frienly move. Thi i hown in the right panel of Figure 1: a i raie, h, hift up an it maimum till move to the right. Figure 2 how the home government reaction function RF, 0 an the correponing io-welfare contour in the, pace. Figure 2. The io-welfare contour an the reaction function for the home country with uniform employment ubiy Home Subiy, negative eternality h h h h 2 h1 h 3 poitive eternality h h h h 6 h 5 h 7, 45 o line RF, 0 ŝ Foreign Subiy, Note: (i) ŝ i the threhol at which eternality witche; (ii) 0 i the unilateral optimal ubiy when 0 ; (iii) RF i approimate by a traight line for implicity to emphaie it monotonicity an lope relative to the 45 o line. While the reaction function i upwar loping in the 15, pace, the hape an hierarchy of the io-welfare loci change at the threhol level of enote by ŝ. Thi occur at the interection of the RF with the 45 o egree line which, given the aume ymmetry, correpon to the Nah equilibrium olution N, N. Figure 3 epict both government reaction function an how that the cooperative olution C, C lie above the Nah equilibrium, i.e. C, C N, N, ince it occur in the poitive eternality region. Hence, the non-cooperative behaviour entail uner-ubiiation from a global welfare point

19 of view. Table A3 in the Appeni provie a comparion of the non-cooperative an cooperative olution with the no-policy benchmark olution (ee column labelle Initial Cae ). Home Subiy, Figure 3. Nah an cooperative olution with uniform employment ubiy Io-Welfare Contour RF, 0, 45 o line Cooperative Solution C RF, 0 N Nah Solution N C Foreign Subiy, A icue in the previou ection, a unilateral increae in ubiy in one country ha negative election an variety effect on it competitor inutry that amount to an international reallocation of reource acro countrie within the monopolitic ector. 18 Thi can be een by comparing the Employment Subiy an No Policy Benchmark column of Table A4 in the Appeni which how that a unilateral increae in raie a well a an reult in lower F,, an M. In aition, the policy ha a poitive fical eternality on the foreign country: ince an increae in negatively affect the ma of foreign firm an eporter, it can be hown to reuce the foreign government ubiy bill (for a given 0 ), thu enabling the foreign government to reuce it ta rate for a given level of ubiy (or to increae the ubiy rate for a given ta rate). Overall, the traing partner initially eperience a fall in welfare that give rie to an incentive to retaliate. Conitently, thi retaliation by the foreign country ha a welfare reucing (an anticompetitive) effect on the home country. A i evient from Table A3, welfare at the Nah equilibrium i higher than in the nopolicy cae, even though both countrie eperience a worening of their firm prouctivity itribution (reflecte in a fall in the ometic cut-off relative to the no-policy cae). Up to 18 Thee two effect combine to prouce an increae in the foreign price ine P Y. Thi negative pill-over i partially mitigate by the fact that the average prouctivity of home country eporter i lower a a reult of the ubiy an hence the average price of importe varietie in the foreign country i now higher, oftening competition for foreign firm in their ometic market. 16

20 N, N, there are negative policy eternalitie, a the negative election an variety effect ominate the poitive fical-pill-over effect. The Nah equilibrium occur where the negative election an variety effect are eactly offet by the poitive fical pill-over effect. However, when etting their policie non-cooperatively, the two government fail to internalie the fact that raiing ubiie above the Nah equilibrium level woul generate a poitive eternality ince the negative election an variety effect woul then be ominate by the poitive fical-pill-over effect. The cooperative behaviour, where thee poitive eternalitie are jointly eploite, lea to an equilibrium at C, C N, N higher welfare level. which yiel 4.2 Targete employment ubiie Given that eport performance i often een a crucial to employment growth, we now briefly conier the effect of an eport-only employment ubiy (i.e. 0, 0 ). If ue unilaterally, thi policy ha the ame qualitative effect on the two countrie prouctivity cut-off a a uniform ubiy: by increaing the ometic cut-off an reucing the eport prouctivity cut-off it ha pro-competitive effect on the ometic inutry an trigger a reallocation of reource towar relatively more efficient firm. However, ince, by icriminating in favour of the eport activity of firm, the eport-only ubiy i biae towar relatively more efficient firm in the inutry, the reallocation effect i relatively tronger in thi cae. A with the uniform ubiy, an employment ubiy targete to eport ha a negative efficiency pill-over an a poitive fical pill-over effect on the traing partner. In thi cae, however, the latter i maller (ue to the relatively maller ubiy bill ariing from ubiiing only eporting activitie) an never ominate, o that the overall eternality effect i alway negative. Thi cae i illutrate in Figure 4 where, imilar to the uniform ubiy cae, the reaction function of the two countrie are upwar loping. Figure 4. Nah an cooperative olution with eport-only employment ubiy Home Subiy, RF, 0, 45 o line RF, 0 N Nah Solution Cooperative olution C C N Foreign Subiy, 17

21 However, ue to the monotonic nature of the inter-country negative eternality, the cooperative olution now lie below the Nah equilibrium level of ubiy: by failing to internalie the negative eternality, the non-cooperative behaviour of the government entail over-ubiiation from a global welfare point of view. It i alo intereting to briefly conier the effect of a ometic-only ubiy (i.e. 0, 0 ) where the employment ubiy i targete towar the ometic operation of firm. Thi policy, which i clearly biae towar relatively le efficient firm, often election in the home market (i.e. contrary to the previou two cae, it reuce the ometic prouctivity cut-off) an thu reallocate reource away from more efficient an towar relatively le efficient firm. In o oing, thi policy achieve the tronget home-market effect an lea to the larget negative eternality on the foreign country (via it tronget market tealing effect). In thi cae, a hown in Figure 5, the two government reaction function are ownwar loping, ince the ubiie are trategic ubtitute an the negative eternality inuce government to over-ubiie when acting non-cooperatively, with the cooperative olution lying below the Nah equilibrium. Figure 5. Nah an cooperative olution with ometic-only employment ubiy Home Subiy, RF, 0, 45 o line N C RF, 0 C N Foreign Subiy, 5. Trae liberaliation an prouctivity hock A i well etablihe in the literature, in thi type of moel trae liberaliation (i.e. a reuction in trae cot) typically ha pro-competitive effect on an inutry, an reallocate reource towar more efficient firm. In our moel, trae liberaliation alo trengthen the pro-competitive effect of an employment ubiy. Figure 6 illutrate the effect of a 5% reuction in trae cot on the effectivene of unilateral increae in uniform employment ubiy by the home government when the 18

22 foreign government i policy inactive: a the graph in the left panel how, increae in raie an thi effect i tronger the lower are trae cot. Thu, the tanar competitive election force triggere by trae liberaliation trengthen the pro-competitive effect of the ubiy icue earlier. A a reult, the unilateral optimal ubiy i lower an it welfare effect are higher at lower trae cot, a illutrate in the right panel of Figure 6. Figure 6. Impact of unilateral uniform employment ubiy policy by home country ( = 0) a trae cot fall by 5% Uniform Subiy in Home Country, Uniform Subiy in Home Country, = = 1.34 = = = = 1.34 = = Home ometic prouctivity cut-off, Home welfare h, A can be een from Table A3, trae liberaliation alo reult in a lower Nah equilibrium ubiy an hence in a much higher egree of uner-ubiiation relative to the cooperative olution therefore uggeting much tronger policy eternalitie beyon the Nah equilibrium when trae barrier are lower. Thi i becaue whilt the Nah equilibrium ubiy fall in, the optimal ubiy in the ymmetric cooperative cae i unaffecte by trae cot. To ee thi, conier that the equilibrium olution for ubiy an ta level in the cooperative cae cannot be itinguihe from the correponing olution in the autarkic cae given by equation (19), (20) an (21) ee alo Table A3 for our numerical olution. h, ;, h, ;, h ; Specifically, the (reuce form) objective function are which can be written a h h where h i the correponing autarkic (reuce form) employment equation an i a monotonically ecreaing function with 0, 1 >1 an 1. Table A3 alo report the effect of a 5% reuction in on the Nah an cooperative equilibria. A fall in correpon to an increae in the egree of heterogeneity of firm prouctivity, an can hence be thought of a a poitive prouctivity hock. In the no-ubiy equilibrium thi lea, a we woul epect, to an increae in welfare an to a reallocation of 19

23 reource towar the monopolitic ector riven by an increae in both ometic an eport prouctivity cut-off that raie the average prouctivity in that ector. With policy active government, the ame prouctivity hock reult in the non-cooperative equilibrium being characterie by higher ubiie. Thu, whilt in autarky we foun a negative relationhip between the optimal ubiy an the egree of heterogeneity of firm, the cooperative equilibrium i characterie by the oppoite relationhip. 19 The egree of uner-ubiiation relative to the cooperative olution woul alo be higher at lower value of i.e. with more efficient prouctivity itribution, ubiiing above the Nah level woul generate larger poitive policy eternalitie which non-cooperative policie fail to internalie. 6. Entry ubiie: a comparion Given the role of entry in facilitating reallocation towar more efficient proucer, the reuction of entry barrier i een a an effective way to increae aggregate prouctivity an employment. To thi en, government implement policie (ranging from implifying re tape proceure to tart-up grant) to upport entrepreneurhip an inuce the etting up of new firm. In thi ection we briefly eamine the effect of entry ubiie on aggregate prouctivity an employment againt thoe of employment ubiie icue above. In orer to allow for a irect comparion between the two type of ubiie, we moify our moel to replace employment ubiie with an a-valorem entry ubiy (i.e. proportional to a firm entry cot f) which i again finance via proportional income taation. Thu, etting = 0 in the autarkic moel evelope in Section 2 an introucing intea, the government buget contraint in equation (15) become ff tl. (37) Since the ubiy reuce the effective cot of entry, the epecte zero-profit entry conition in (11) i now given by (1 ) 0 M r l ff. (38) Note that becaue the entry ubiy oe not affect firm marginal conition, the average inutry revenue an profit are not affecte by the ubiy. The autarkic prouctivity cut-off i now given by c f /, (39) 19 Conitently, we have verifie numerically that if the home country ha a prouctivity itribution characterie by a higher heterogeneity than it traing partner (i.e. < a unilateral ubiy when the foreign government i not policy active woul be more effective in raiing welfare an employment an hence the optimal ubiy woul be lower than when countrie prouctivity itribution are ymmetric. 20

24 which i increaing in v. Thu, a in Pflüger an Sueekum (2013) an contrary to the employment ubiy cae icue above, an entry ubiy ha a pro-competitive effect, an thi effect i tronger the higher i the egree of heterogeneity among firm (i.e. the lower i ). The welfare function in (10) can be hown to be trictly concave in v with the correponing optimal entry ubiy in autarky given by opt 1 1, (40) which i poitive an ecreaing in. Hence, in contrat to the employment ubiy cae, the more homogenou are firm the lower are the optimal entry ubiy an inutry average prouctivity. A comparion between equation (22) an (40) an the correponing welfare level reveal that opt opt opt opt h h : ceteri paribu, (i) the optimal entry ubiy an rate i maller than the optimal employment ubiy rate, an (ii) the optimal employment ubiy i aociate with higher employment an welfare level. To ee thi conier that the procompetitive effect of the entry ubiy can be hown to reult in a fall in the ma of urviving firm. 20 Intea, an increae in the ma of firm contribute to eplain why the optimal employment ubiy, epite it anti-competitive effect on the inutry in autarky, lea to higher level of welfare than an entry ubiy. More generally, unerpinning thee reult i the fact that an employment ubiy offer a more irect way, than an entry ubiy, to tackle the monopolitic itortion in thi moel. 21 Moving to the two-country etting, the olution for the unilateral, Nah an cooperative policy equilibria are given in Table A4. A can be een from the table, government have a unilateral incentive to ubiie the entry of firm. However, contrary to autarky, the unilateral (i.e. when the traing partner government i policy inactive) optimal entry ubiy rate i higher than the unilateral optimal employment ubiy rate but it aociate level of welfare continue to be lower than that achieve via an employment ubiy. In a two-country worl, both ubiie have procompetitive effect on the inutry but thee are tronger with an entry ubiy that lea to a larger entry. The reulting tougher election force lea to a maller increae in the equilibrium ma of firm in the inutry (an even in a fall in the etenive margin of eport). It i the maller increae in prouct variety that rive the lower welfare achieve with thi type of ubiy. The reaction function of the two government when they are both policy active, which are illutrate in Figure 8, are upwar loping in, pace with the Nah equilibrium entailing a poitive entry ubiy rate. The Nah equilibrium, however, lie above the 20 Pflüger an Sueekum (2013) fin that the ma of firm oe not change in autarky. The ifference in reult between the two paper mainly hinge on their aumption of (i) quai-linear preference (an hence the lack of income effect); (ii) the ue of lump-um ta an ubiy; an (iii) fie labour upply. 21 The monopolitic itortion i reflecte in the wege between the marginal rate of ubtitution an tranformation between the monopolitic goo an leiure an/or the outie goo: an entry ubiy will affect the marginal rate of ubtitution only via it impact on the proportional income ta rate (an, if finance via lump-um taation a in Pflüger an Sueekum (2013), it will only affect the marginal rate of tranformation). 21

25 cooperative olution, hence non-cooperative behaviour lea to over-ubiiation in thi cae. Figure 8. Nah an Cooperative olution with entry ubiy Home Subiy, RF v, v 0 v v, 45 o line RF v, v 0 v N Nah olution Cooperative olution v C v C v N Foreign Subiy, The intuition behin thee reult i conitent with that provie by Pflüger an Sueekum (2013): an increae in entry ubiy by one government ha a election an a fical eternality effect on it traing partner. Whilt the latter i poitive, the former i negative an ominate. Thi give an incentive to retaliate that reult in the non-cooperative equilibrium being characterie by over-ubiiation from a global welfare point of view. 22 A i clear from Table A4, although the non-cooperative entry ubiy i larger than the correponing employment ubiy, the former lea to a lower level of welfare than the latter. Thu, epite it irect (an hence tronger) pro-competitive effect, an entry ubiy i le effective in increaing employment an welfare than an employment ubiy. 7. Concluion Employment ubiie are an important component of active labour market police an their ue by government ha increae in recent year in an attempt to raie (or retore) employment level in the face of an avere economic climate. Thi paper ha tuie their effect within a general equilibrium framework characterie by an enogenou level of employment an cot heterogeneity among firm. We have hown that intra-inutry competitive election i an important channel in the tranmiion of the effect of employment ubiie on the level of economic activity an aggregate efficiency. Importantly, an arguably counterintuitively, international openne alter the nature of the effect of the ubiy on intra-inutry election: whilt the ubiy ha an anti-competitive effect in autarky, it ha pro-competitive effect in the open economy 22 A can be een from Table A4, although qualitatively the nature of the international pill-over effect of an entry ubiy are imilar to thoe of an employment ubiy, the latter ha a tronger negative eternality. 22

26 (akin to thoe of trae liberaliation) which reult in higher average prouctivity an in a larger etenive margin of eport. Given the implication of the policy for market entry, aggregate efficiency an welfare, an in light of the international eternality effect of the policy, government have an incentive to ue employment ubiie trategically. When government ubiie firm uniformly, we how that international pillover conit of both election an fical eternalitie that reult in non-cooperative an cooperative policy equilibria that are characterie by poitive ubiie. Whether the non-cooperative olution entail level of ubiiation that ecee or fall hort of thoe characteriing the cooperative outcome epen, however, on the nature of the eternality between countrie which in turn i affecte by how the ubiy i targete. Importantly, epite tronger pro-competitive effect on inutry, an entry ubiy i hown to be le effective in increaing employment an welfare than an employment ubiy. Thi i becaue it offer a le irect way to tackle the monopolitic itortion than oe an employment ubiy. 23

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28 Felbermayr G., B. Jung an M. Larch (2013). Optimal Tariff, Retaliation, an the Welfare Lo from Tariff War in the Melitz Moel. Journal of International Economic, 89, Fleurbaey, M. (1998). Employment Subiie, Unemployment an Monopolitic Competition. Working Paper, Pari X - Nanterre, U.F.R. e Sc. Ec. Get. Math Infor., paper.repec.org/repec:fth:pnegmi:9824 ILO-IMF (2010). The challenge of growth, employment an ocial coheion, proceeing of the joint International Labour Organization an International Monetary Fun Conference (in cooperation with the office of the Prime Miniter of Norway), 13 September 2010, Olo, Norway available at IMF Report (2013). Job an Growth: Analytical an Operational Conieration for the Fun. Jackman, R.A. an Layra, P.R.G. (1980). The Efficiency Cae for Long-Run Labour Market Policie, Economica, 47, Johnon, G.E. (1980). The Theory of Labour Market Intervention, Economica, 47, Kalor, N. (1936). Wage Subiie a a Remey for Unemployment. Journal of Political Economy, 44, Kluve, J. (2010). The effectivene of European Active Labor Market Program. Labour Economic, 17, Layar, R. an S. Nickell (1980). The Cae for Subiizing Etra Job. Economic Journal, 90, Leahy D. an C. Montagna (2001). Strategic Trae Policy with Heterogeneou Cot. Bulletin of Economic Reearch, 53, Marzinotto, B., J. Piany-Ferry, an G.B. Wolff (2011). An Action Plan for Europe Leaer. Bruegel Policy Contribution 2011/09, July. Bruell: Bruegel. Melitz, M.J. (2003). The Impact of Trae on Intra-Inutry Reallocation an Aggregate Inutry Prouctivity. Econometrica, 71, Merz, M. (1995). Search in the Labour Market an the Real Buine Cycle. Journal of Monetary Economic, 36, Molana, H., C. Montagna, an C.Y. Kwan (2012). Subiie a Optimal Fical Stimuli. Bulletin of Economic Reearch, 64:S1, Mortenen, D.T. an C.A. Piarie (1994). Job Creation an Job Detruction in the Theory of Unemployment. Review of Economic Stuie, 61, Mortenen, D.T. an C.A. Piarie (2003). Tae, Subiie an Equilibrium Labour Market Outcome. In E.S. Phelp (e): Deigning Incluion: Tool to Raie Low-En Pay an Employment in Private Enterprie. Cambrige Univerity Pre, Cambrige, pp

29 Mocarini, G. an F. Potel-Vinay (2012). The Contribution of Large an Small Employer to Job Creation in Time of High an Low Unemployment. American Economic Review, 102, Nocco, A., G.I.P. Ottaviano, an M. Salto (2014). Monopolitic Competition an Optimum Prouct Selection. American Economic Review, Paper an Proceeing, 104, OECD (2009). Employment Outlook. OECD Employment Analyi an Policy Diviion. Phelp, E.S. (1994). Structural Slump, the Moern Equilibrium Theory of Unemployment, Interet, an Aet. Cambrige, MA: Harvar Univerity Pre. Pflüger, M. an J. Sueekum (2013). Subiizing Firm Entry in Open Economie. Journal of Public Economic, 97, Pigou, A. (1933). The Theory of Unemployment. Macmillan, Lonon. Retuccia, D. an R. Rogeron (2010). Policy Ditortion an Aggregate Prouctivity with Heterogeneou Etablihment. Review of Economic Dynamic, 11, Venable, A.J. (1987). Trae an Trae Policy with Differentiate Prouct: A Chamberlinian-Ricarian Moel. Economic Journal, 97,

30 Appeni Table A1. Notation ue in the moel etup (for autarky an the home country only) Decription Notation Fie cot of prouction of the ifferentiate goo (cloe economy) Fie cot of prouction of the ifferentiate goo (ometic & eport) 27 & Buget hare of Y & A & 1- Labour upply elaticity (invere of real wage elaticity of upply) Prouctivity itribution hape parameter (Pareto) Firm Level Prouctivity (ifferentiate goo ector) prouctivity cut-off for marginal firm (cloe economy) prouctivity cut-off for marginal firm (non-eporting & eporting) Average prouctivity (cloe economy) Average prouctivity (non-eporting & eporting) Scale coefficient of labour upply CES elaticity of ubtitution Profit of a firm proucing the ifferentiate goo (cloe economy) Profit of a firm proucing the ifferentiate goo (ometic & eport) Iceberg trae cot for eporting firm Per capita eman for homogenou goo Aggregate eman for homogenou goo Aggregate upply of homogenou goo Ma of entrant Employment ratio Fie entry cot Labour requirement for proucing the ifferentiate goo (cloe economy) Labour requirement for proucing the ifferentiate goo (ometic & eport) Aggregate labour upply (employment) Conumer population ize Ma of varietie of ifferentiate goo prouce (ma of urviving firm) Ma of varietie of ifferentiate goo prouce an eporte Conumer price ine price of the homogeneou goo CES price ine for Y Variety price et by a firm proucing the ifferentiate goo (cloe economy) Variety price et by a firm proucing the ifferentiate goo (non-eporting & eporting) Revenue of a firm proucing the ifferentiate goo (cloe economy) Revenue of a firm proucing the ifferentiate goo (ometic & eport) Labour ubiy receive by ifferentiate goo proucer Labour ubiy receive by ifferentiate goo proucer (ometic & eport) Income ta rate Wage rate Deman for a variety of ifferentiate goo (cloe economy) Dometic an foreign eman for a ometically prouce variety of ifferentiate goo Aggregate eman for ifferentiate goo (CES) Total an per capita utility c & & & a A A F h f l l & L Nh N M M P P P A Y p p & l p r r & r & t w y y & Y u y

31 A1. Solution of the cloe economy moel Ue 1 to write r( ) c 1 l( ) 1 1 c repectively a r( ) 1 1 an c an 1 1 l( ), which are then ubtitute in (13) an (15) to obtain 1 M 1 1 1tL an M tl. For any given M an L L thee olve for t, given by equation (20), an alo imply M 1 1 Subtituting wp A 1 an the epreion for P Y in (7), the labour upply function in (3) i written a 1 t L N 1/(1 ) 1 M 1 which, upon replacing L uing the reult erive above, yiel 1/ 1 1 t M N 1 1 1/(1 ) 1 M 1, Subtituting for an t uing (17), (19) an (20), we obtain the following olution: ( 1) ( 1) (1 ) ( 1) ( 1) (1 )( 1) ( 1) M , ( 1) (1 ) ( 1) ( 1) 1/ ( 1) ( 1) L , N ( 1) ( 1) ( 1) ( 1) where 1/ / an / f 1 / 1. /. Inpection of thee reveal that both M an L are concave in, with L reaching a maimum at a lower value of than oe M. It i traightforwar to how that the value of in equation (21) maimie L an hence welfare U which i a monotonically increaing function of L.. 28

32 Note that equation (22) i obtaine uing (12), the epreion for L an M an 1 l( ) obtaine above. 1 Table A2. Two-country moel etup No Decription Equation for the home country (A1) (A2) (A3) (A4) (A5) (A6) (A7) (A8) (A9) (A10) (A11) (A12) Conumer utility function Aggregate labour upply Aggregate eman for homogenou goo Aggregate eman for ifferentiate goo Conumer price ine Prouction function for the homogenou goo Prouctivity itribution in the 1 1 a y h U 1 1 1/ 1 t w L Nh N P N1 1t wh A Na PA N 1 t wh Y Ny PY 1 P P P A A L A Y (1 ) G 1 an g, 1, ifferentiate goo ector Ma of varietie of ifferentiate goo (ma of urviving firm) Ma of varietie of ifferentiate goo eporte Average prouctivity cut-off are proportional to marginal firm cut-off Prouctivity itribution of the urviving firm in the ifferentiate goo ector CES aggregation of ifferentiate goo conume (ometically prouce an importe) ; M F,, M G F 1 1 ; M F,, M G F 1 g 1 G, 1 1, (A13) CES price ine for Y (A14) (A15) (A16) Deman for a ometically prouce ifferentiate goo facing a firm with a given prouctivity Deman for an importe ifferentiate goo facing a firm with a given prouctivity Labour requirement for proucing the ifferentiate goo by a firm with a given prouctivity for it ometic prouction 1 g 1 G / 11/ Y M y My,, 1 1 PY M p M p,, p ( ) y( ) Y,, PY p( ) Y P Y y ( ),, l y,, 1 11/

33 Table A2 continue No Decription Equation for the home country (A17) Profit an revenue of a firm r 1 wl, with a given prouctivity for it ometic prouction r p y ;, (A18) Price et by a firm with a 1 w given prouctivity for it p,, ometic prouction 1 Labour requirement for (A19) proucing the ifferentiate y goo by a firm with a given l,, prouctivity for it eport prouction (A20) Profit an revenue of a firm r 1 wl, with a given prouctivity for it eport prouction r py;, (A21) Price et by a firm with a 1 w given prouctivity for it p,, eport prouction 1 (A22) Aggregating ometic price of M p Mp ifferentiate goo (A23) (A24) (A25) (A26) (A27) (A28) (A29) Aggregating importe price of ifferentiate goo CES price ine for ifferentiate goo in term of aggregate Aggregating revenue of ometic ale of ifferentiate goo Aggregating revenue of eport of ifferentiate goo Aggregating profit of ometic ale of ifferentiate goo Average profit for ometic, M p Mp, P Mp M p Y, M r Mr, M r M r, ale Aggregating profit of eport of ifferentiate goo M M r 1w, (A30) Average profit for eport (A31) (A32) (A33) Labour ue in the ifferentiate ector for ometically ue prouction Labour ue in the ifferentiate ector for eport prouction Labour ue in the ifferentiate ector for eport prouction M M r 1w, M l Ml, M l Ml M l Ml, 30

34 A2. Derivation of the equation of the two-country moel ue in the numerical analyi r Uing equation (A16) an (A18), (A17) in Table A2 can be written a 1 w. Then the zero profit conition of marginal non-eporting an eporting firm in home an foreign country imply 0 1 r w (E1) 0 1 r w, (E1 ) 0 1 r w, (E2) 0 1 r w. (E2 ) The zero epecte profit of entry for the home an foreign country require M M FP f, (E3) 0 A M M F P f 0. (E3 ) A The balance government buget contraint (equating the ubiy bill with ta revenue) for the home an foreign country are wml wm Ntwh, (E4) wm l wm l Ntwh. (E4 ) The CES price inice in (A13) an the aggregation in (A22) an (A23) imply Y P M p M p, (E5) Y P M p M p. (E5 ) Per-capita labour upplie, given by (A2), are 1/ 1 tw h, (E6) PY h 1 t P Y w 1/. (E6 ) The other equilibrium conition which houl hol are the labour market equilibrium conition, LA Ml Ml Nh, (E7) 31

35 L Ml Ml Nh, (E7) A the global market equilibrium conition for the homogenou goo P A Ff P A F f PA PA, (E8) A A A A an the global trae balance, P A A Ff M r M r. (E9) A It can be hown that (E8) an (E9) are atifie by the implication of Walra law if (E1) to (E7) hol. Finally, ince the homogeneou goo i competitively prouce uner contant return to cale conition, i freely trae an i ue a numeraire, we have P P 1, w P A 1 an w P A 1. Taking account of the latter normaliation an making ome ubtitution to eliminate a many variable a poible, equation in (E1)-E(6 ) can be hown to be epree in the form of (E1)-E(6 ) below which atify labour reource conition in (E7)-(E7 ) an can be olve to etermine the 12 unknown,,,, PY, PY, F, F, h, h, t, t on the aumption that the ubiy rate are treate a eogenou policy intrument N t h P Y A A (E1) Y N t h P N t h P Y Y N t h P 1 N 1 t h PY N 1 t h PY 1 f N 1 t h PY P 1 f N 1 t h 1 Y (E1 ) (E2) (E2 ) (E3) (E3 ) 32

36 1 1 F N1thPY F N t h PY 1 Nth F N1t h PY F N 1 thp 1 Nt h Y (1 ) 1 PY F 1 11 (1 ) 1 1 F 1 1 (1 ) 1 PY F t h PY h 1 t P 1/ Y (1 ) 1 1 F 1 1 1/ (E4) (E4 ) (E5) (E5 ) (E6) (E6 ) The above 12 equation are ue a in our numerical analyi. To ee the recurive nature of the moel an to erive equation (32) an (33), note that (E1) an (E1) can be ue to eliminate N t h P Y an N 1 t h P Y an f 1 in (33) an 1 1 from (E2)-(E3 ) to obtain which yiel (32), an 1 f 1 which are 33

37 Table A3. Comparing the equilibrium olution of the two-country moel for ifferent cae: the role of an Variable Benchmark Equilibrium with no Subiy Cooperative Equilibrium with Uniform Subiy Nah Equilibrium with Uniform Subiy Initial Cae = 3.4 = 1.3 fall by 5% = 3.23 = 1.3 fall by 5% = 3.4 = Initial Cae = 3.4 = 1.3 fall by 5% = 3.23 = 1.3 fall by 5% = 3.4 = Initial Cae = 3.4 = 1.3 fall by 5% = 3.23 = 1.3 fall by 5% = 3.4 = t h F M M P Y L Ml L Ml L L / L See Table A4 for the cae of unilateral policy by the home country when the foreign country i policy inactive. The parameter value ue in the calibration are: N = 1000, = 0.8, = 2, = , = 3.8, =2.5, =5.0 an f =3.36. The olution were obtaine uing the MCP/PATH engine in GAMS; the robutne of thee olution are confirme by etenive enitivity analye. The olution value for all other variable are available from the author on requet. 34

38 Table A4. Comparing the Optimal Policy Value of Variable in Different Cae: the role of ifferent ubiie No Policy Unilateral Policy Cooperative Policy Nah Policy Variable Employment Benchmark Subiy,, [0] t [0] h [ ] [ ] [ ] F [ ] M [ ] M [ ] PY [ ] L Ml [ ] L Ml [ ] L L/ L [ ] Entry Subiy, [0] [0] [ ] [ ] [ ] [ ] [ ] [ ] [ ] [ ] [ ] [ ] Employment Entry Employment Entry Subiy, Subiy, Subiy, Subiy, The column in the Unilateral Policy refer to the cae in which the home country act unilaterally while the foreign country remain policy inactive. Figure in quare bracket are the correponing value for the foreign country. The parameter value ue in the calibration are a reporte in Table A3, with = 3.4 an = 1.3. The olution were obtaine uing the MCP/PATH engine in GAMS; the robutne of thee olution are confirme by etenive enitivity analye. 35

39 Project Information Welfare, Wealth an Work for Europe A European reearch conortium i working on the analytical founation for a ocio-ecological tranition Abtract Europe nee change. The financial crii ha epoe long-neglecte eficiencie in the preent growth path, mot viibly in the area of unemployment an public ebt. At the ame time, Europe ha to cope with new challenge, ranging from globaliation an emographic hift to new technologie an ecological challenge. Uner the title of Welfare, Wealth an Work for Europe WWWforEurope a European reearch conortium i laying the analytical founation for a new evelopment trategy that will enable a ocio-ecological tranition to high level of employment, ocial incluion, gener equity an environmental utainability. The fouryear reearch project within the 7 th Framework Programme fune by the European Commiion wa launche in April The conortium bring together reearcher from 34 cientific intitution in 12 European countrie an i coorinate by the Autrian Intitute of Economic Reearch (WIFO). The project coorinator i Karl Aiginger, irector of WIFO. For etail on WWWforEurope ee: Contact for information Kritin Smeral WWWforEurope Project Management Office WIFO Autrian Intitute of Economic Reearch Arenal, Objekt Vienna wwwforeurope-office@wifo.ac.at T: Domenico Roetti i Valalbero DG Reearch an Innovation European Commiion Domenico.Roetti-i-Valalbero@ec.europa.eu

40 Partner Autrian Intitute of Economic Reearch WIFO Autria Buapet Intitute Buapet Intitute Hungary Nice Sophia Antipoli Univerity UNS France Ecologic Intitute Ecologic Germany Univerity of Applie Science Jena FH Jena Germany Free Univerity of Bozen/Bolzano FUB Italy Intitute for Financial an Regional Analye GEFRA Germany Goethe Univerity Frankfurt GUF Germany ICLEI - Local Government for Sutainability ICLEI Germany Intitute of Economic Reearch Slovak Acaemy of Science IER SAVBA Slovakia Kiel Intitute for the Worl Economy IfW Germany Intitute of Worl Economic, RCERS, HAS KRTK MTA Hungary KU Leuven KUL Belgium Menel Univerity in Brno MUAF Czech Republic Autrian Intitute for Regional Stuie an Spatial Planning OIRG Autria Policy Network policy network Unite Kingom Ratio Ratio Sween Univerity of Surrey SURREY Unite Kingom Vienna Univerity of Technology TU WIEN Autria Univeritat Autònoma e Barcelona UAB Spain Humbolt-Univerität zu Berlin UBER Germany Univerity of Economic in Bratilava UEB Slovakia Haelt Univerity UHASSELT Belgium Alpen-Aria-Univerität Klagenfurt UNI-KLU Autria Univerity of Dunee UNIVDUN Unite Kingom Univerità Politecnica elle Marche UNIVPM Italy Univerity of Birmingham UOB Unite Kingom Univerity of Pannonia UP Hungary Utrecht Univerity UU Netherlan Vienna Univerity of Economic an Buine WU Autria Centre for European Economic Reearch ZEW Germany Coventry Univerity COVUNI Unite Kingom Ivory Tower IVO Sween Aton Univerity ASTON Unite Kingom