The first part of this literature review illustrated the fact that full employment models are widely used to treat the effects of trade in final goods and offshoring. Davidson and Matusz (2010, p. 15) point out that “by and large the importance of labor market structure and labor market institutions has not [...] received the attention that it deserves”. Early exceptions that analyze trade in final goods and unemployment include Brecher (1974) on minimum wages, Matusz (1986) on implicit contracts, Copeland (1989) on efficiency wages, Agell and Lundborg (1995) on fair wages, Davidson et al. (1988) on search and matching, and Grossman (1984) on unionized labor markets. In recent years, however, the interest in this topic has resurged, and several trade papers with labor market imperfections and unemployment have been published.
Most of the recent contributions incorporate search unemployment. Davidson and Matusz (2010) provide a comprehensive summary of their seminal research. In a series of papers
starting with Davidson et al. (1988), they study various effects of search induced unem-ployment in trade models.42 In the following, we review two recent contributions on search unemployment and trade introducing heterogeneous firms of the Melitz (2003) type. Trade liberalization leads to inter-firm reallocations towards more productive firms in the Melitz (2003) model (see Section 7.1). Jobs are lost at some firms and new jobs are created at other firms, but there is no aggregate employment effect. Yet, this changes if labor market frictions are considered.
Helpman and Itskhoki (2010) analyze the effects of labor market frictions and trade cost on welfare, trade flows, productivity, and unemployment. Using a static model43 with two countries and two sectors, they embed search and matching frictions of the Diamond-Mortensen-Pissarides type44 and individual wage bargaining45 into both sectors. In addition to a homogeneous good sector, there is a differentiated good sector with heterogeneous firms of the Melitz (2003) type, which pay the same wage. This setup implies that trade liberalization affects the productivity distribution in the differentiated good sector. Labor market frictions, which can vary across sectors, are the only difference between the two countries. Changes in these frictions (e.g., higher efficiency of matching or lower cost of hiring) affect the trading partner. Helpman and Itskhoki (2010) show that labor market frictions act as a source of comparative advantage and that both countries gain from trade.
Concerning trade liberalization, they find the following: a fall in trade cost may raise or reduce a country’s aggregate unemployment, depending on whether its relative labor market frictions in the differentiated good sector are low or high.46
The second contribution presented in the context of search frictions and heterogeneous firms is by Felbermayr et al. (2011). In contrast to Helpman and Itskhoki (2010), these authors use a generalized version of the Melitz (2003) trade model with symmetric countries. Concerning the labor market, they integrate the same type of search and matching frictions as well as individual bargaining. In their one-sector model, labor market frictions do not affect average productivity. One key result is that trade liberalization leads to lower unemployment
42Building on this work, Moore and Ranjan (2005) analyze the impact of trade liberalization on unem-ployment. They find that both trade liberalization and skill-biased technological change lead to rising wage inequality, but their impact on unemployment may be quite different.
43The static analysis is consistent with the steady state of a dynamic model (Helpman and Itskhoki, 2009).
44A detailed description of this approach is provided by Pissarides (2000).
45It is assumed that the wage is bargained between a worker and his firm because the search and matching frictions lead to bilateral monopoly power.
46In related models, Helpman et al. (2010a,b) study the impact of trade liberalization on unemployment and wage inequality within industries. Helpman and Itskhoki (2010) and Helpman et al. (2010a,b) illustrate that labor market frictions may act as a source of comparative advantage. A detailed review of this approach is provided by Helpman (2010).
and higher real wages if, and only if, it improves average productivity. To examine under which circumstances trade liberalization and average productivity are positively linked, they calibrate the model towards US data. Interestingly, they find that different trade liberalization scenarios all reduce unemployment.47 As a robustness check, they consider firm-level collective bargaining48instead of individual bargaining, and their main results still hold.
In recent years, search frictions have been widely used to incorporate unemployment in trade models, but other noteworthy approaches also exist. Egger and Kreickemeier (2009) include the fair wage approach of Akerlof and Yellen (1990) in a trade model with heterogeneous firms. Whether workers consider a wage fair depends on the productivity of the firm they work for. In this setup, trade liberalization leads to increasing within-group wage inequality and higher unemployment. Hence, their result concerning the effect on unemployment contrasts with Felbermayr et al. (2011).49
Like Egger and Kreickemeier (2009), Davis and Harrigan (2011) consider the labor market effects of trade liberalization in a Melitz (2003) type trade model. However, they incorporate the efficiency wage model of Shapiro and Stiglitz (1984). One key result is that trade liberalization may destroy a large fraction of good jobs which pay above average wage, although the impact on aggregate employment is very small in their model.
To analyze the link between trade and unemployment, the literature mainly uses setups that do not consider economic growth and dynamic trade patterns. An exception constitute dynamic North-South trade models of the product cycle with labor market frictions. Arnold (2002) studies the impact of imitation on Northern frictional unemployment in a model based on Helpman (1993). He shows that labor market flexibility, modeled by the outflow rate of unemployment, crucially affects the growth effects of North-South trade. In contrast, Mondal and Gupta (2008b) introduce efficiency wages for low-skilled Southern workers into the Grossman and Helpman (1991a) model. They find that stronger IPR protection either lowers or raises the level of unemployment in the South, depending on the North-South wage differential. While the focus of these two contributions differs from the other papers in this section, the contribution by Grieben and S¸ener (2009) also deals with the labor market effects
47In a closely related model, Janiak (2006) shows that trade liberalization increases equilibrium unemploy-ment, but he imposes rather restrictive and implausible assumptions.
48Concerning the modeling of firm-level collective bargaining, they apply the efficient bargaining approach, in which the two parties bargain over both wages and employment. See Cahuc and Zylberberg (2004, Chapter 7, Section 3.2) for more information on this approach.
49Another trade paper with unemployment due to fair wages is Kreickemeier and Nelson (2006). It examines the impact of global and national technological change on relative wages and unemployment levels.
of trade liberalization. Concerning the modeling of production activity, trade, and growth, Grieben and S¸ener (2009) deviate from the standard North-South endogenous growth models in several ways. In addition, they assume that the Northern labor market is characterized by firm-level collective bargaining as well as a minimum wage. The labor union’s objective is to maximize the expected wage in excess of the given minimum wage. In this model, unilateral Northern trade liberalization leads to increasing Northern unemployment and lower per-capita welfare in both countries, whereas unilateral Southern trade liberalization leads to the opposite effects. Grieben and S¸ener (2009) consider union wage setting as a source of labor market frictions in a trade context. In the next section on offshoring, we treat this source of labor market frictions more extensively.
To sum up, this section illustrates that there is a small but growing literature on final good trade and unemployment. Among other things, the models analyze the general equilibrium effects of trade liberalization on unemployment, and further research on offshoring and unemployment may be inspired by this work. The next section reviews the existing literature on offshoring and labor market frictions.