Optimal Trade Policy, Equilibrium Unemployment and Labor Market Inefficiency Wisarut Suwanprasert University of Wisconsin-Madison December 2015 Wisarut Suwanprasert (UW-Madison) Optimal Trade Policy and Unemployment December 2015 1 / 72
Motivation Puzzle: Why do small open economies use trade protections to prevent job losses despite the fact that trade protections are not economically sensible in neoclassical trade models? Wisarut Suwanprasert (UW-Madison) Optimal Trade Policy and Unemployment December 2015 2 / 72
Motivation Why is it a puzzle? 1) Reality: Jobs are lost! has always been a political criticism of trade liberalization.... Let us protect American jobs. A 40 percent tariff will protect our domestic industry and provide security to American families.... Max Sandlin, Democratic Congressman from Texas (2002) Protectionism happens to be Congress s job. Ernest F. Hollings, Democratic U.S. Senator from South Carolina (2004) Wisarut Suwanprasert (UW-Madison) Optimal Trade Policy and Unemployment December 2015 3 / 72
Motivation Only two countries have no trade protection On average, agricultural (Labor-intensive) sectors receive greater trade protections than non-agricultural sectors. Figure: Average MFN applied tariffs of WTO members in 2011 Wisarut Suwanprasert (UW-Madison) Optimal Trade Policy and Unemployment December 2015 4 / 72
Motivation Why is it a puzzle? 2) Theory: Based on traditional trade models with fixed total employment, conventional wisdom is that trade protections of a small open economy generate distortions and worsen social welfare. Only large countries that can manipulate world prices will use a trade policy One possible explanation for a small open country is a political-economy argument (Grossman& Helpman, 1994) Lobbyists pay a government to protect some specific sectors Wisarut Suwanprasert (UW-Madison) Optimal Trade Policy and Unemployment December 2015 5 / 72
Why Trade Policy? Why do countries use trade policies to solve an issue in a labor market? Bhagwati (1971): a trade policy is normally a second-best policy and a first-best policy is a domestic policy aiming directly at the inefficiency Direct labor market policies are impractical 1 A first-best policy is a direct tax-cum-subsidy on the vacancy postings Potentially has asymmetric information problems and commitment problems 2 The strongest case of my results is developing countries where their informal sector are large and their labor market has not yet been fully developed 3 Tariffs generate income for the government Wisarut Suwanprasert (UW-Madison) Optimal Trade Policy and Unemployment December 2015 6 / 72
What I do in this paper Develop a simple, analytically tractable model based on Dutt et al. (2009) that incorporates a frictional labor market into an otherwise standard Heckscher-Ohlin model of international trade Endogenous unemployment Redistribution effects between capital income and labor income Study impacts of trade on unemployment and welfare gains from trade Provide a welfare-based argument for optimal trade policy in a small open economy Wisarut Suwanprasert (UW-Madison) Optimal Trade Policy and Unemployment December 2015 7 / 72
Preview of Results Result 1: When the relative price of labor-intensive good increases (decreases), (Stolper Samuelson theorem): Real wages increase (decrease) and real returns to capital decrease (increase) Employment increases (decreases) The expanding export sector may NOT create enough new jobs to cover job losses in the contracting import-competing sector. Wisarut Suwanprasert (UW-Madison) Optimal Trade Policy and Unemployment December 2015 8 / 72
Preview of Results Key feature: A labor market may generate an inefficient level of unemployment Two sources of inefficiencies Hold-up problem: Firms underinvest when they get only a fraction of output Inefficiently high unemployment Congestion externality: Posting an additional vacancy reduces other firms profit through a lower chance of getting a vacancy filled Inefficiently low unemployment The Hosios efficiency condition: Efficiency requires two sources of inefficiencies are offset perfectly. I focus on labor market inefficiency when the Hosios condition is violated. Wisarut Suwanprasert (UW-Madison) Optimal Trade Policy and Unemployment December 2015 9 / 72
Preview of Results Result 2: Welfare gains from trade Labor market inefficiency can reinforce or weaken welfare gains from trade. Interesting empirically relevant cases: 1 Developing countries with inefficiently high unemployment are likely to have extra welfare gains from trade. 2 Developed countries with inefficiently high unemployment are likely to have small welfare gains from trade and may have welfare losses from trade. Wisarut Suwanprasert (UW-Madison) Optimal Trade Policy and Unemployment December 2015 10 / 72
Preview of Results Result 3: Optimal trade policy for a small-open economy Only when the labor market is generating the efficient level of employment, free trade is optimal. When a labor market is generating inefficiently high/low employment, trade policy can improve welfare by reducing labor market inefficiency. To the best of my knowledge, this is the first paper that links optimal trade policy and labor market inefficiency. Wisarut Suwanprasert (UW-Madison) Optimal Trade Policy and Unemployment December 2015 11 / 72
Policy Implications Policy Implications: 1 Rationale: to reduce labor market inefficiency 2 If employment is inefficiently low, the government of that small open economy uses trade policy to raise the domestic price of labor-intensive goods Summary Regardless of a country s comparative advantage Sector Total Employment Too Low Efficient Too High Labor intensive Increases - Decreases Capital intensive Decreases - Increases Wisarut Suwanprasert (UW-Madison) Optimal Trade Policy and Unemployment December 2015 12 / 72
Literature Review Optimal trade policy and equilibrium unemployment Costinot (2009), Brecher (1974a, 1974b), Matschke (2006) Frictional labor market and trade openness Davidson, Martin, Matusz (1988, 1999), Helpman, Itskhoki (2010), Helpman, Itskhoki, Redding (2010) Mitra, Ranjan (2007), Dutt, Mitra, Ranjan (2009) Felbermayr, Prat, Schmerer (2011a,2011b) Wisarut Suwanprasert (UW-Madison) Optimal Trade Policy and Unemployment December 2015 13 / 72
Model Model Wisarut Suwanprasert (UW-Madison) Optimal Trade Policy and Unemployment December 2015 14 / 72
Model Model A small open economy with population L and capital stock K Two goods: labor-intensive X and capital-intensive Y Normalize p y = 1. Terms-of-trade p x /p y = p is given from the world market Gov uses a trade policy to change the domestic price of good X from p to (1 + t) p. t > 0: import tariff or export subsidy 1 < t < 0: import subsidy or export tax Domestic prices are (1 + t) p and 1 Wisarut Suwanprasert (UW-Madison) Optimal Trade Policy and Unemployment December 2015 15 / 72
Model Representative household Preference: Budget Constraint: U (x, y) = x α y 1 α α α (1 α) 1 α (1 + t) px d + Y d = I (t) Wisarut Suwanprasert (UW-Madison) Optimal Trade Policy and Unemployment December 2015 16 / 72
Model Production (Brief Timeline) 1 Single-worker firms must create a costly vacancy Vacancies are randomly matched with population L 2 If the vacancy is filled, the firm and the worker bargain on wage 3 The firm rents capital k i for the worker Capital moves freely across sectors Rental price r is given by a perfectly competitive market 4 Output is produced and sold Solve backward Wisarut Suwanprasert (UW-Madison) Optimal Trade Policy and Unemployment December 2015 17 / 72
Model Production function For each job, the production function in sector i {x, y} is g i (k i )=k φ i i k i is the capital per worker in sector i φ i is the capital intensity of goods i such that 0 <φ x <φ y < 1 The total production in sector i is k φ i i L i L i is total employed workers in sector i Wisarut Suwanprasert (UW-Madison) Optimal Trade Policy and Unemployment December 2015 18 / 72
Model Firm s profit maximization problem Rental price π x = (1 + t) pk φx x π y = k φy y rk y w y rk x w x A perfectly competitive market for capital K Wage determination Surplus of a job Nash bargaining S x = (1 + t) pk φx x S y = k φy y rk y rk x w i = argmax (S i w i ) β (w i ) 1 β Wisarut Suwanprasert β: Firms (UW-Madison) bargaining Optimal power Trade Policy and Unemployment December 2015 19 / 72
Model Vacancy cost Firms must use a combination of x V units of goods X and y V units of goods Y as intermediate inputs to produce one new vacancy The input requirement for delivering one vacancy is x α V y 1 α V = α α (1 α) 1 α f A nominal cost of producing one vacancy is (1 + t) px V (p, t)+y V (p, t) Wisarut Suwanprasert (UW-Madison) Optimal Trade Policy and Unemployment December 2015 20 / 72
Model Matching function Let V be the total economy-wide vacancy Employment E = M (V, L) =min V λ L 1 λ, L Expected profit Prob (a vacancy is filled) = E/V Eπ i = E π V i Profit Prob(a vacancy is filled) [(1 + t) px V + y V ] Vacancy Cost Wisarut Suwanprasert (UW-Madison) Optimal Trade Policy and Unemployment December 2015 21 / 72
Model Resource Markets Labor market Capital market L x + L y = E k x L x + k y L y = K Wisarut Suwanprasert (UW-Madison) Optimal Trade Policy and Unemployment December 2015 22 / 72
Equilibrium Equilibrium Wisarut Suwanprasert (UW-Madison) Optimal Trade Policy and Unemployment December 2015 23 / 72
Competitive Equilibrium Definition: A competitive equilibrium is a vector of factor prices, consumptions, final outputs, an allocation of endowments, intermediate inputs, and vacancy level w, r, X d, Y d, X s, Y s, k x, k y, L x, L y, x V, y V, V given the world price ratio, a trade policy, and initial endowments {p, t, K, L}. The vector satisfies the following conditions: the production cost of vacancy is minimized; firms maximize their profit; wage divides surplus according to Nash bargaining; rental price is given by a perfectly competitive market; firms enter and exit freely; endowment markets are cleared; the representative consumer maximizes his utility. Wisarut Suwanprasert (UW-Madison) Optimal Trade Policy and Unemployment December 2015 24 / 72
Competitive Equilibrium Vacancy cost A vacancy is produced from a combination of intermediate inputs x V and y V Firms s.t. Min x V,y V x α V y 1 α V (1 + t) px V + y V f α α (1 α) 1 α The minimum cost of delivering one vacancy is (1 + t) px V (p, t)+y V (p, t) =((1 + t) p) α f Wisarut Suwanprasert (UW-Madison) Optimal Trade Policy and Unemployment December 2015 25 / 72
Competitive Equilibrium Returns to factors Rental price r is equal to value of marginal product of capital Wage bargaining outcome: Wages: w i =(1 β) S i Profit: π i = βs i Wisarut Suwanprasert (UW-Madison) Optimal Trade Policy and Unemployment December 2015 26 / 72
Competitive Equilibrium The zero-profit condition, Eπ i = 0, implies βs i E =((1 + t) p) α fv Thus, and S x = S y = S w x = w y = w π x = π y = π Wages and profits are identical across sectors Wisarut Suwanprasert (UW-Madison) Optimal Trade Policy and Unemployment December 2015 27 / 72
Competitive Equilibrium The country s budget constraint is (1 + t) px d + Y d Expenditure Equivalently, =(1 + t) px s + Y s ((1 + t) px V + y V ) V GDP Vacancy cost + tp X d + x V V X s. Tax Revenue/Subsidy Cost px d (p, t)+y d (p, t) =px c (p, t)+y c (p, t) Net Income I (p, t) where X c (p, t) X s (p, t) x V (p, t) V (p, t) and Y c (p, t) =Y s (p, t) y V (p, t) V (p, t) are net outputs. Wisarut Suwanprasert (UW-Madison) Optimal Trade Policy and Unemployment December 2015 28 / 72
Model Utility maximization Demand: Welfare: X d 1 (p, t) = (α +(1 α)(1 + t)) Y d (p, t) = U (p, t) = Define P (p, t) = αi (p, t) p (1 + t) (1 α) I (p, t) (α +(1 α)(1 + t)) (1 + t) 1 α I (p, t) (α +(1 α)(1 + t)) pα (1+t) 1 α (α+(1 α)(1+t))p α as an inverted price level Wisarut Suwanprasert (UW-Madison) Optimal Trade Policy and Unemployment December 2015 29 / 72
Constrained Efficient Equilibrium Definition: A constrained efficient equilibrium is a vector of consumptions, final outputs, an allocation of endowments, intermediate inputs, and vacancy level X d, Y d, X s, Y s, K x, K y, L x, L y, x V, y V, V that maximizes social welfare, given the world price ratio and initial endowments {p, K, L}. The vector satisfies the production technologies, matching technology, and endowment constrained. Wisarut Suwanprasert (UW-Madison) Optimal Trade Policy and Unemployment December 2015 30 / 72
Constrained Efficient Equilibrium The social planner s welfare maximization problem X Gov Max U X d, Y d d α Y d 1 α = X d,y d,k x,k y,l x,l y,x V,y V,V α α (1 α) 1 α s.t. L x + L y = V λ L λ K x + K y xv αy V 1 α px d + Y d The Lagrangian equation X d α Y d 1 α L = = K α α (1 α) 1 α + µ 1 = f α α (1 α) 1 α = pkx φx L 1 φx x V λ L λ L x L y + Ky φy L 1 φy y (px V + y V ) V +µ 2 (K K x K y )+µ 3 xv α yv 1 α f α α (1 α) 1 α +µ 4 pkx φx L 1 φx x + Ky φy L 1 φy y (px V + y V ) V px d + Y d Wisarut Suwanprasert (UW-Madison) Optimal Trade Policy and Unemployment December 2015 31 / 72
Constrained Efficient Equilibrium Solution MPK and MPL are equalized Vacancy cost pxv + yv = p α f Shadow price φy φx µ 1 =Φ 2 px = S t=0 Substitute µ 1 into dl /dv = 0 λse = p α fv φy Wisarut Suwanprasert (UW-Madison) Optimal Trade Policy and Unemployment December 2015 32 / 72
Efficiency of Competitive Equilibrium Competitive equilibrium under free trade: Constrained Efficient Equilibrium: βse = p α fv λse = p α fv Lemma 1: A competitive equilibrium under free trade coincides with a constrained efficient equilibrium if and only if λ = β. Wisarut Suwanprasert (UW-Madison) Optimal Trade Policy and Unemployment December 2015 33 / 72
Efficiency of Competitive Equilibrium Recall λ is the elasticity of job matching function with respect to vacancy β is the firm s wage bargaining power The so-called Hosios efficiency condition When λ>β,unemploymentisinefficientlyhigh When λ<β,unemploymentisinefficientlylow Define labor market inefficiency as λ β. Efficiency requires two sources of inefficiencies are offset perfectly, λ = β. Wisarut Suwanprasert (UW-Madison) Optimal Trade Policy and Unemployment December 2015 34 / 72
Constrained Efficient Equilibrium 3-D Consumption Possibility Frontier Wisarut Suwanprasert (UW-Madison) Optimal Trade Policy and Unemployment December 2015 35 / 72
Efficiency of Competitive Equilibrium 2-D Consumption Possibility Frontier Wisarut Suwanprasert (UW-Madison) Optimal Trade Policy and Unemployment December 2015 36 / 72
Impacts of Trade The impacts of price changes on unemployment and welfare gains from trade Wisarut Suwanprasert (UW-Madison) Optimal Trade Policy and Unemployment December 2015 37 / 72
Impacts of Trade Factor Prices Real wages and real returns are Equilibrium employment is r p α =Φ 1p w p α =(1 β)φ 2p βφ2 E = p f 1 φy φy φx α φy φy φx α φy α λ 1 λ φy φx L Wisarut Suwanprasert (UW-Madison) Optimal Trade Policy and Unemployment December 2015 38 / 72
Impacts of Trade Proposition 1: When the price of labor (capital)-intensive good increases, 1 Real wages increase (decrease) and real returns to capital decrease (increase) 2 Employment increases (decreases) 3 A labor-intensive sector expands (contracts) while a capital-intensive sector contracts (expands) Wisarut Suwanprasert (UW-Madison) Optimal Trade Policy and Unemployment December 2015 39 / 72
Impacts of Trade Corollary 1: To increase (decrease) employment, a government can either raise (reduce) the domestic price of labor-intensive goods or reduce (raise) the domestic price of capital-intensive goods. The elasticity of employment with respect to the relative price is dlog (E) dlog (p) = φy α φ y φ x λ 1 λ Wisarut Suwanprasert (UW-Madison) Optimal Trade Policy and Unemployment December 2015 40 / 72
Impacts of Trade Adjustments in a labor market Wisarut Suwanprasert (UW-Madison) Optimal Trade Policy and Unemployment December 2015 41 / 72
Impacts of Trade Adjustments in a labor market Wisarut Suwanprasert (UW-Madison) Optimal Trade Policy and Unemployment December 2015 42 / 72
Impacts of Trade Adjustments in a labor market Wisarut Suwanprasert (UW-Madison) Optimal Trade Policy and Unemployment December 2015 43 / 72
Impacts of Trade Adjustments in a labor market Wisarut Suwanprasert (UW-Madison) Optimal Trade Policy and Unemployment December 2015 44 / 72
Impacts of Trade Adjustments in a labor market Wisarut Suwanprasert (UW-Madison) Optimal Trade Policy and Unemployment December 2015 45 / 72
Impacts of Trade Adjustments in a labor market Wisarut Suwanprasert (UW-Madison) Optimal Trade Policy and Unemployment December 2015 46 / 72
Impacts of Trade Adjustments in a labor market Wisarut Suwanprasert (UW-Madison) Optimal Trade Policy and Unemployment December 2015 47 / 72
Impacts of Trade How does aggregate income respond to a price change? I I = rk rk + we r r + we rk + we w w + E E Conclusion: Labor income in this model is more volatile than it is in a traditional Heckscher-Ohlin model Other variations E E w w w w = 0 in models without unemployment = 0 in Brecher (1974a, 1974b) = 0, K = 0 in Helpman and Itskhoki (2010) + E E Wisarut Suwanprasert (UW-Madison) Optimal Trade Policy and Unemployment December 2015 48 / 72
Impacts of Trade Proposition 2: The employment effects reinforce the real income effects and make the labor income more volatile than in the standard Heckscher-Ohlin model. Wisarut Suwanprasert (UW-Madison) Optimal Trade Policy and Unemployment December 2015 49 / 72
Impacts of Trade Gains From Trade Excess demand: p ED X (p) =α (px c (p)+y c (p)) px c (p) Consumption Net output The autarky price p A satisfies ED X (p A )=0 The welfare function is U (p) = r (p) p α K + w (p) p α E (p) Wisarut Suwanprasert (UW-Madison) Optimal Trade Policy and Unemployment December 2015 50 / 72
Impacts of Trade Proposition 3: The welfare change due to price change is λ β φ y w (pw ) E (p w ) dlog (U (p w )) = γ + α dlo (1 λ)(1 β) φ y φ x I (p w ) where γ = Export x (p W ) /I (p w ) is the share of total output on the net export of good X. If the labor market is efficient λ = β: dlog (U (p w )) = γdlog (p w ) Export X (γ >0) and the price of X increases (dp w > 0) Export Y (γ <0) and the price of Y increases (dp w < 0) Conditional on having the same trade share γ Labor-abundant country with λ>β Capital-abundant country with λ<β Wisarut Suwanprasert (UW-Madison) Optimal Trade Policy and Unemployment December 2015 51 / 72
Impacts of Trade Corollary 1: Given the same observed trade share, a labor-abundant (capital-abundant) country with inefficiently high (low) unemployment has substantially larger gains from trade than a labor-abundant (capital-abundant) country with efficient unemployment. Arkolakis et al. (2012) provide the condition summarizing the welfare gains from reduction of trade costs as Welfare = (1 γ ) 1/, where 1 γ is the share of domestic expenditure, <0isan elasticity of imports with respect to variable trade costs Wisarut Suwanprasert (UW-Madison) Optimal Trade Policy and Unemployment December 2015 52 / 72
Impacts of Trade Proposition 4: A country s welfare is minimized at p MinU = 1 λ 1 β 1 φy φy φx α λ 1 λ + 1 φy φx p A Corollary 2: A capital-abundant (labor-abundant) country with inefficiently low (high) employment may experience welfare loss from trade if the world price is not sufficiently different from the country s autarky price Wisarut Suwanprasert (UW-Madison) Optimal Trade Policy and Unemployment December 2015 53 / 72
Impacts of Trade Graphical example Wisarut Suwanprasert (UW-Madison) Optimal Trade Policy and Unemployment December 2015 54 / 72
Optimal Trade Policy: Small Open Economy Optimal Trade Policy: Small Open Economy Wisarut Suwanprasert (UW-Madison) Optimal Trade Policy and Unemployment December 2015 55 / 72
Optimal Trade Policy: Small Open Economy Gov chooses t to maximize U (p, t) =I (p, t) P (p, t) No political-economy motives Tradeoffs: 1 Production distortion 2 Consumption distortion 3 Employment Wisarut Suwanprasert (UW-Madison) Optimal Trade Policy and Unemployment December 2015 56 / 72
Optimal Trade Policy: Small Open Economy Graphical explanation: inefficiently low employment, λ>β Wisarut Suwanprasert (UW-Madison) Optimal Trade Policy and Unemployment December 2015 57 / 72
Optimal Trade Policy: Small Open Economy dlogu (p, t) dt = t=0 (λ β) αφx +(1 α) φ y w (p, 0) E (p, 0) (φ y φ x ) (1 λ)(1 β) I (p, 0) Proposition 5: Beginning at free trade, a trade policy improves a country s welfare if β = λ, and free trade is optimal if β = λ. Lessons: A trade policy aims to reduce labor-market inefficiency. A country with an efficient labor market needs no protection. The marginal benefit depends on the income share Wisarut Suwanprasert (UW-Madison) Optimal Trade Policy and Unemployment December 2015 58 / 72
Optimal Trade Policy: Small Open Economy Proposition 6: In the Heckscher-Ohlin model, the optimal trade policy t in sector X has the same sign as the sign of (λ β) / (φ y φ x ). Optimal trade policy t depends on 1 λ β :Labormarketinefficiency 2 φ y φ x :relativecapitalintensitybetweensectorx and Y Summary Sector X λ>β β = λ λ<β Labor intensive Increases Ø Decreases Capital intensive Decreases Ø Increases Wisarut Suwanprasert (UW-Madison) Optimal Trade Policy and Unemployment December 2015 59 / 72
Optimal Trade Policy: Small Open Economy Corollary 4: In the Heckscher-Ohlin model, a small open economy concerned about inefficiently high unemployment should use a trade policy to raise the domestic price of labor-intensive goods, regardless of its comparative advantage. Wisarut Suwanprasert (UW-Madison) Optimal Trade Policy and Unemployment December 2015 60 / 72
Empirical Fact Tariffs in an agricultural (labor-intensive) sector are generally higher than tariffs in a non-agricultural sector. Y-axis: t Agriculture t Non-Agriculture ;X-axis:log (K/L) (Source: World Tariff Profiles 2012 by WTO) Wisarut Suwanprasert (UW-Madison) Optimal Trade Policy and Unemployment December 2015 61 / 72
Employment Compare 3 situations 1 Employment in competitive equilibrium under free trade E FT 2 Employment when government maximizes net labor income E LI 3 Efficient level of employment E Eff For λ>β, For λ<β, E FT < E LI < E Eff E FT > E LI > E Eff Labor market inefficiency is NOT fully eliminated because of price distortions Second-best policy Wisarut Suwanprasert (UW-Madison) Optimal Trade Policy and Unemployment December 2015 62 / 72
Optimal Trade Policy: Small Open Economy Numerical example 1 U 1 : λ = β Free Trade 2 U 2 : λ>β t > 0 3 U 3 : λ<β t < 0 Wisarut Suwanprasert (UW-Madison) Optimal Trade Policy and Unemployment December 2015 63 / 72
Two-Country Model Suppose there are 2 countries called Country 1 and Country2 Same structures, technologies, etc Different endowments K j, L j and labor market structures λ j, β j Market clearing condition ED1 X (p w (t 1, t 2 ), t 1 )+ED2 X (p w (t 1, t 2 ), t 2 )=0 Terms-of-trade effect dp w (t 1, t 2 ) dt 1 < 0and dp w (t 1, t 2 ) dt 2 < 0 Wisarut Suwanprasert (UW-Madison) Optimal Trade Policy and Unemployment December 2015 64 / 72
Optimal Trade Policy: Large Open Economy Unilaterally optimal trade policy du 1 (p w (t 1, t 2 ), t 1 ) = U 1 (p w (t 1, t 2 ), t 1 ) dt 1 t 1 Labor-market inefficiency + U 1 (p w (t 1, t 2 ), t 1 ) p w (t 1, t 2 ) p w t 1 Terms-of-trade manipulation Two motives 1 Reduces labor-market inefficiency 2 Alters world prices Wisarut Suwanprasert (UW-Madison) Optimal Trade Policy and Unemployment December 2015 65 / 72
Optimal Trade Policy: Large Open Economy Proposition 7: A unilaterally optimal trade policy of a large open economy with labor market inefficiency may benefit the country s trading partners. Unilaterally optimal trade policy t1 can be Pareto-improving Example: a labor-abundant country with inefficiently high unemployment: du 2 (p w (t 1, t 2 ), t 2 )= U 2 (p w (t 1, t 2 ), t 2 ) p w (t 1, t 2 ) dt 1. p w t 1 Corollary 5: World free trade is not efficient if labor market inefficiency exists. Wisarut Suwanprasert (UW-Madison) Optimal Trade Policy and Unemployment December 2015 66 / 72
Alternative model: Ricardian model Alternative: a Ricardian model No capital Labor is the only factor of production Wisarut Suwanprasert (UW-Madison) Optimal Trade Policy and Unemployment December 2015 67 / 72
Alternative model: Ricardian model One factor of production: Labor Linear production function: A job produces h x units of X or h y units of Y In autarky, p A = h y /h x Free trade Assume the country has a comparative advantage in X p w > p A = h y /h x Complete specialization Wisarut Suwanprasert (UW-Madison) Optimal Trade Policy and Unemployment December 2015 68 / 72
Alternative model: Ricardian model Export subsidy s The zero-profit condition: β (1 + s) ph x E =((1 + s) p) α fv. Proposition 8: In the Ricardian model, the optimal export subsidy s has the same sign as the sign of λ β. Import tariff t The zero-profit condition: βph x E =(1 + t) 1 α p α fv. Proposition 9: In the Ricardian model, the sign of the optimal import tariff t is opposite to the sign of λ β. Wisarut Suwanprasert (UW-Madison) Optimal Trade Policy and Unemployment December 2015 69 / 72
Alternative model: Ricardian model Corollary 6: In the Ricardian model, a small open economy that is concerned about inefficiently high unemployment should use either an export subsidy or an import subsidy. Need to expand production activities Raise the output price Reduce the price of imports Wisarut Suwanprasert (UW-Madison) Optimal Trade Policy and Unemployment December 2015 70 / 72
Fully Available Policy Instruments Direct subsidy or tax on vacancy posting is available E (π i )= E V π i (((1 + t) p) α f θ) =0 The optimal policy is θ = λ β λ pα f, t = 0. Use the direct tax-cum-subsidy to completely remove labor market inefficiency Wisarut Suwanprasert (UW-Madison) Optimal Trade Policy and Unemployment December 2015 71 / 72
Conclusion This paper studies an optimal trade policy in an economy with a frictional labor market I develop a general equilibrium model that includes a frictional labor market into a standard Heckscher-Ohlin model Ishowthatlabormarketinefficiencyreinforcesorweakenswelfare gains from trade I rationalize the sufficient condition when unemployment matters to a trade policy Free trade is the optimal trade policy for a SOE, only when a labor market is efficient Variations: two-country model and Ricardian model Wisarut Suwanprasert (UW-Madison) Optimal Trade Policy and Unemployment December 2015 72 / 72