Skill-biased labor market reforms and international competitiveness

Schmerer, Hans-Jörg Article Skill-biased labor market reforms and international competitiveness Economics: The Open-Access, Open-Assessment E-Journal Provided in Cooperation with: Kiel Institute for the World Economy – Leibniz Center for Research on Global Economic Challenges Suggested Citation: Schmerer, Hans-Jörg (2012) : Skill-biased labor market reforms and international competitiveness, Economics: The Open-Access, Open-Assessment E-Journal, ISSN 1864-6042, Kiel Institute for the World Economy (IfW), Kiel, Vol. 6, Iss. 2012-37, pp. 1-39, https://doi.org/10.5018/economics-ejournal.ja.2012-37 This Version is available at: https://hdl.handle.net/10419/65284 Standard-Nutzungsbedingungen: Die Dokumente auf EconStor dürfen zu eigenen wissenschaftlichen Zwecken und zum Privatgebrauch gespeichert und kopiert werden. 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If the documents have been made available under an Open Content Licence (especially Creative Commons Licences), you may exercise further usage rights as specified in the indicated licence. http://creativecommons.org/licenses/by-nc/2.0/de/deed.en Skill-Biased Labor Market Reforms and International Competitiveness Hans-Jörg Schmerer IAB Institute for Employment Research, Nuremberg Abstract This paper proposes a multi-industry trade model with integrated capital and goods markets. Labor market imperfections in line with Mortensen and Pissarides (Job Creation and Job Destruction in the Theory of Unemployment, 1994) give rise to unemployment and a channel for the government to influence markets through institutional changes. Labor market interventions feedback into the product market through changes in a country’s competitiveness. Moreover, the distinction between highand low-skill workers facilitates the analysis of skillbiased institutional changes that have stronger impact on certain skill groups. The comparative static exercise in this paper shows that high-skilled benefit from low-skill biased labor market reforms through higher wages. Lower labor costs reduce unemployment of the low-skilled and increases the reforming country’s competitiveness. One-sided labor market interventions have feedback effects through adjustments at the extensive margin, which affect all workers at home and abroad irrespective of their level of skill. Governments in the non-reforming countries may react to this loss in competitiveness by initiating cooperative labor market reforms instead. Special Issue Responding to the Labour Market Challenges of Globalisation JEL F16, E24, J6 Keywords FDI; globalization; search unemployment; labor market institutions Correspondence Hans-Jörg Schmerer, IAB Institute for Employment Research, Nuremberg; e-mail: Hans-[email protected] Citation Hans-Jörg Schmerer (2012). Skill-Biased Labor Market Reforms and International Competitiveness. Economics: The Open-Access, Open-Assessment E-Journal, Vol. 6, 2012-37. http://dx.doi.org/10.5018/economics-ejournal.ja.2012-37 © Author(s) 2012. Licensed under a Creative Commons License - Attribution-NonCommercial 2.0 Germany Vol. 6, 2012-37 | October 4, 2012 | http://dx.doi.org/10.5018/economics-ejournal.ja.2012-37 conomics: The Open-Access, Open-Assessment E-Journal 1 Introduction The establishment of a common currency union fueled a lively debate about labor market reforms and its effects on competitiveness and trade imbalances within the Euro area. Detractors argue that a common currency shuts down one important channel of adjustment, the nominal exchange rate. Countries within a common currency union are unable to restore a loss in international competitiveness - for instance due to labor market reforms in its partner countries - through changes in their monetary policy. This paper contributes to this discussion by analyzing the effects of labor market reforms on international competitiveness in a model that features a continuum of industries and heterogeneous workers. The latter facilitates to distinguish between labor market reforms that have similar effects on highand low-skilled workers and labor market reforms that are skill-biased in that they have different effects on different skill-groups. The aim of this second exercise is to evaluate the spillover effects on income and unemployment in groups that are affected indirectly. Our thought-experiment will focus on the effects of a reform that reduce the lowskill workers’ outside option through lower unemployment benefits. 1 Wages in the low-income group are directly affected by this reform, which leads to a reduction in unemployment. Competitiveness is affected through production costs. Lower unit labor costs at home are associated with increasing competitiveness and an expansion of the production to industries formerly associated with the foreign country. The direct effect on high-skilled is negligible simply because unemployment benefits are less relevant for the skilled workers. However, labor demand is increasing due to the expansion of production to formerly inactive industries. A surge in demand for both types of workers can only be met by lower unemployment and higher wages. For the low-skilled the effect is ambiguous. The unemployment rate decreases through the direct effect which might be already enough to restore the labor market clearing condition. Yet, high-skill workers benefit from the labor market reform due to higher demand for high-skilled labor associated with a surge in wages. 1 Other skill-specific institutional changes could be for instance minimum wages within certain occupational groups or sectors, or employment protection that mainly affect low-skill workers. www.economics-ejournal.org 1 conomics: The Open-Access, Open-Assessment E-Journal There exists a wide range of stylized facts that motivate this study. Krugman (2012) for instance argues that capital flows from Europe’s core to Europe’s South (for instance in form of foreign direct investments) led to wage increases in the South. 2 This soar in capital flows to the South can be explained by an anticipated lower risk for investments into the South after its entry into the European community. Krugman also points out that - at the same time - wages in Germany grew at a much lower rate, associated with a relative shift in competitiveness from the South to Germany. Back in the early 2000s, Germany initiated a huge labor market reform program that affected a broad array of labor market institutions and slowed down wage growth in non-manufacturing sectors. It is unlikely that those reforms had a great impact on high-skill unemployment rates, mainly due to the fact that high-skill unemployment was already low before the government intervention. Furthermore, reemployment in case of job separation is more likely for highthan for low-skilled. Still, those labor market reforms can explain why wages in Germany grew at a much lower rate of 9 percent compared to the 35 percent growth rates found for Southern Europe. This was mainly through its effect on low-skilled workers. But is there any evidence which type of worker was affected mostly? The stylized facts for Germany presented in Dustmann et al. (2009) suggest that wage growth at the bottom of the distribution was stagnant or even negative, whereas wages at the top of the distribution were rising shortly after 2000. A reduced outside option for workers due to a labor market reform is a potential explanation for stagnating or even decreasing wages if workers have to search for employers and if unemployment is high. The less likely reemployment in case of job separation, the more important the outside option gets for a worker. Rising wages at the top of the distribution suggest little impact of those institutional reforms in the high income group. The model in this paper distinguishes between lowand high-skill workers but unemployment benefits for instance are modeled as flow values. Thus, 2 "... there were massive flows of capital from Europe’s core to its booming periphery. These inflows of capital fed booms that in turn led to rising wages: in the decade after the euros creation, unit labor costs (wages adjusted for productivity) rose about 35 percent in southern Europe, compared with a rise of only 9 percent in Germany. Manufacturing in Europe’s south became uncompetitive, which in turn meant that the countries that were attracting huge money inflows began running correspondingly huge trade deficits." (Krugman, 2012, chapter 10) www.economics-ejournal.org 2 conomics: The Open-Access, Open-Assessment E-Journal an equal change in unemployment benefits equally affects both skill groups, which is highly unrealistic. We address this issue by assuming that unemployment benefits of the high-skilled remain unaffected by the labor market reform. Workers at the top of the income distribution may have more assets that are generated outside the firm which should be accounted for in the flow value of being unemployed. This is a shortcoming of the standard search and matching framework with more than two skill-groups. The stylized facts also fit the evolution of skill-specific unemployment. We can observe a massive decrease in low-skill specific unemployment, whereas high-skill specific rates were erratic at a constant low level. This pattern is consistent with labor market reforms that mainly affected low-skilled workers. The analysis of those effects builds on a multi-industry North-South trade model that goes back to Feenstra and Hanson (1996, 1997), FH model henceforth. All monetary variables, such as wages or prices, are expressed in a common currency and the lack of a financial market rules out any kind of exchange rate policy. Thus, changes in wages directly affect production costs and the country’s competitiveness, which is close to a common currency union. The original model features trade in goods and capital (FDI) but labor market institutions are beyond the scope of their study. The extension in this paper enables an analysis of the effects of labor market institutions on capital flows, unemployment, and wage inequality due to search frictions à la Mortensen and Pissarides (1994). The government can affect wages and unemployment through the outside option of workers. More stringent labor market institutions are lower unemployment benefits or less employment protection for instance. Less stringent labor market regulations in the extended FH framework increase competitiveness and thus trade and foreign direct investment at home. The aim of this paper is to assess different channels through which labor market institutions affect foreign direct investment, trade, and wage inequality at home and foreign. Therefore, the paper sorts into a large and emerging literature on spillover effects of labor market institutional changes regarding trade and unemployment between the integrated countries. In his seminal paper, Davis (1998) was among the first researchers who stressed that institutions are crucial for the explanation of different labor market patterns in countries that are internationally interdependent. Egger, Greenaway, and Seidel (2011) distinguish between the longand shortwww.economics-ejournal.org 3 conomics: The Open-Access, Open-Assessment E-Journal run effects of capital mobility in their theoretical and empirical analysis of labor market rigidities and its effects on the share of intra-industry trade measured by a bilateral Grubel-Loyd index. Felbermayr, Larch, and Lechthaler (2009) show that institutional changes in one country equally affect their trading partners’ labor market outcomes. The model presented herein contributs to the literature by developing a model that allows to assess how unilateral changes in labor market institutions affect labor markets not only in the respective but also the integrated countries. The outcome of the model differs in so far that it can explain skill-specific effects due to the assumption of heterogeneous workers along the lines proposed by Feenstra and Hanson (1996, 1997) and Moore and Ranjan (2005). Moreover, an expansion of production to industries formerly associated with foreign leads to a reduction in unemployment at home but increases unemployment at foreign. This contrasts with Felbermayr, Larch, and Lechthaler (2009), where all economies are equally affected. This stems from the fact that adjustments in the non-reforming country are mainly due to the effects at the extensive margin in our multi-industry framework. The model employed in this paper is based on Schmerer (2012), where search frictions are also introduced into a Feenstra and Hanson (1996, 1997) trade model but without distinguishing between skill-specific unemployment rates. The model proposed in this paper is tied closer to the original Feenstra and Hanson (1996, 1997) approach due to the distinction between lowand high-skill workers, which facilitates an analysis of skill-specific institutional spillover effects. A government can increase its country’s competitiveness by influencing wages and unemployment of the low-skilled through less stringent labor market institutions concerning lowskilled workers only. It will be shown that such a policy improves the position of high-skilled workers, while low-skilled loose in terms of wages but benefit in terms of employment through its feedback effects at the extensive margin, where shifts in competitiveness between countries lead to shifts of production from one country to another. Therefore, increasing labor demand at the extensive margin translate into job creation in industries that were formerly inactive within the respective country. Two closely related papers also investigate the link between trade, capital flows and labor market institutions. Beissinger (2001) studies spillover effects of unilateral labor market reforms on capital flows between two countries in a monopolistic competition framework. Beissinger (2001) focuses on reforms that www.economics-ejournal.org 4 conomics: The Open-Access, Open-Assessment E-Journal reduce unemployment benefits or the bargaining power of unions. Whether labor market reforms induce spillover effects on foreign labor market outcomes depends on the assumptions about the degree of capital mobility and the households’ income situation. Mitra and Ranjan (2010) and Davidson, Matusz, and Shevchenko (2008) study the effects of outsourcing on labor market outcomes in trade models with search frictions. Mitra and Ranjan (2010) have a two sector model with labor being the only input factor. In their model, outsourcing decreases equilibrium unemployment. Conversely, Davidson et al. (2008) propose a model where outsourcing forces some of the high-skill workers in the North to search for jobs in the low-skill intermediate sector. This stirs up job competition in that sector and thus triggers a rise in unemployment. Kohler and Wrona (2010) stress the non-monotonic relationship between offshoring and labor demand/unemployment within industries by showing that the sign of the effect in their model may depend on the level of offshoring. 3 Although the theoretical literature on global sourcing and unemployment is sparse, the number of studies focusing on the effects of trade liberalization on unemployment is numerous. Brecher (1974) introduced minimum wages in a classical Heckscher Ohlin environment and analyzed how equilibrium unemployment changes when moving from autarky to free trade. Davidson, Martin, and Matusz (1988, 1999) were among the first to extend canonical trade models by implementing search frictions. Building on their work, Moore and Ranjan (2005) propose a model that permits studying how globalization affects skill specific unemployment in a Heckscher Ohlin world. More recently, researchers started to focus on labor market effects in the popular Melitz (2003) international trade model with heterogeneous firms. Egger and Kreickemeier (2009) incorporate fair wages into the Melitz (2003) model in order to explain the trade and inequality nexus. Helpman and Itshkoki (2010), Helpman, Itskhoki, and Redding (2010 a,b), Felbermayr and Prat (2011) and Felbermayr, Prat and Schmerer (2011) introduce search frictions in the Melitz model. Exit of less productive firms boosts firms’ recruiting efforts and hence 3 Non-monotonic means that outsourcing decreases labor demand when the level of outsourcing is low, but increases labor demand beyond a certain threshold level. www.economics-ejournal.org 5 conomics: The Open-Access, Open-Assessment E-Journal reduces unemployment in the long run in the latter approach. Helpman, Itshkoki and Redding (2010 a,b) address worker heterogeneity. Larch and Lechthaler (2011) distinguish between highand low-skill workers and analyze the effects of trade liberalization on skill-specific unemployment in a model with heterogeneous firms and search frictions. To summarize the stylized facts discussed in the motivation, standard labor market models predict that a higher capital to labor ratio rises labor productivity and thus wages in the South but decreases wages in capital outflow country. This affects prices and therefore competitiveness of the countries iff there are no other channels of price adjustments. Joint labor market interventions within Europe would ease the problem but it remains questionable to what extent such a wage coordination policy can be implemented in the future. Moreover, one-sided labor market policy interventions also affect a country’s competitiveness and the pattern of trade between the integrated countries. Section 2 lays out the benchmark model and discusses the existence of an unique equilibrium. Different scenarios of labor market reforms and their impact on wages, unemployment and competitiveness are discussed in Section 3. Section 4 concludes. 2 The benchmark model The model is general equilibrium and features two countries that are integrated into a common currency union. Thus, all nominal variables are expressed in terms of a common currency and the total GDP generated within the union is normalized to unity. Effects arising through trade with non-members are not studied in the underlying paper. Both countries can produce the same continuum of goods but we will show that countries can also specialize on a certain range of goods and trade them internationally. Final good assemblers or downstream producers use highand low-skill specific intermediates and capital as input for the final good production. High-skill specific intermediates are produced by input of high-skill labor, whereas low-skill specific intermediates are produced by firms that employ low-skill labor only. Intermediate good producers are henceforth called upstream producers. www.economics-ejournal.org 6 conomics: The Open-Access, Open-Assessment E-Journal Workers and upstream producers take expected prices charged by downstream producers into consideration and bargain about wages. The existence of search frictions drives a wedge between labor costs and prices charged by skill-specific upstream producers. The production and consumption side is interacted over all stages since labor and capital costs pin down national income, union income, and (international) goods’ prices together. Consumer preferences. Following Feenstra and Hanson (1996, 1997) preferences for x(z)are modeled by lnY=Z1 0ϕ(z)lnx(z)dz ,(1) where x(z) denotes the amount of goods demanded from industry z and ϕ(z) is industry z ’s Cobb Douglas consumption share. 4 The aggregate consumption good is produced without costs and sold for an aggregate price level P . Prices and wages are jointly determined by upstream producers, workers, and downstream producers. Aggregate demand for the final output good equals total expenditure YP =E . The aggregate demand function (1) implies that a constant fraction ϕ(z) of world expenditure is spent on the consumption of good z . Thus, consumer demand for output generated in industry zreads as x(z) = ϕ(z)E κ(z).(2) The share of expenditure spent for that particular industry z is equal to the revenue generated in the respective industry. Perfect competition implies that total revenue in industry z is equal to the quantity produced, x(z) , times unit costs, κ(z) . One can solve the standard utility maximization problem of the representative consumer who maximizes utility (1) subject to the budget constraint, which depends upon prices, consumption, and income available for consumption. The first order condition of the utility maximization problem implies equation (2). 4Integrating the shares over the whole continuum of industries must equal unity. www.economics-ejournal.org 7 conomics: The Open-Access, Open-Assessment E-Journal We follow Dutt et al. (2009) and introduce We k in order to take into account that workers are randomly matched to firms and therefore have to build expectations about W . This also implies that all firms pay the same wage rate and hence only differ with respect to production. Wages itself are bargained and satisfy the bargaining condition Wk−Uk=βk(Jk+Wk−Vk−Uk).(16) Thus, the distribution of total gains depends on the workers’ bargaining power, β, so that the equilibrium bargaining outcome must satisfy wk=ηUk+βk(ρk(z)−ηUk).(17) It can be shown that the existence of recruitment costs increases wages through the outside option. An unsuccessful match incurs additional recruitment costs which is anticipated by the workers ηUk=bk+βk 1−βk ckρk(z)θk.(18) We obtain a wage condition by combining the equilibrium conditions (18) and (17) as shown in the appendix to solve for wk= (1−βk)bk+βkckρk(z)θk+βkρk(z),(19) which is equivalent to the labor supply curve in the standard Feenstra and Hanson (1996, 1997) model. Equilibrium in the high-skill intermediate sector. In equilibrium, the wage and the equilibrium market tightness θk are determined by interacting the wage curve and the job creation curve so that (1−βh)bh+βhchρk(z)θh+βhρh(z) = ρh(z)−chρk(z) m(θh)(η+λ).(20) Simplifying then yields ρh(z) = bh+chρk(z) 1−βhβhθh+η+λ m(θh) .(21) www.economics-ejournal.org 14 conomics: The Open-Access, Open-Assessment E-Journal Therefore, equation (21) implies that all downstream producers pay the same price for intermediate goods denoted qh(z) = ρh(z) so that qh(z0) = qh(z00) for z06=z00 . Intermediate good prices only depend on exogenous parameters and the equilibrium market tightness, which is common to all firms in all industries. Moreover, we suppose that the discount rate η and the capital rental r are tied to the capital rental and we assume that the discount rate is predetermined by the capital rental. Equilibrium in the low-skill intermediate good sector. Following the same line of reasoning we can derive the equilibrium condition for low-skill intermediate input prices as ρl(z) = bl+clρk(z) 1−βlβlθl+η+λ m(θl) .(22) We denote the price paid by downstream producers for the purchase of low-skill intermediate inputs ql(z) = ρl(z) , which is possible due to the small firm assumption. Each firm employs one worker and produces exactly one unit of the intermediate good. The firm’s revenue is thus equal the intermediate good price paid by the final output good producers. Moreover, the assumption that search costs are paid in terms of intermediate goods prices gives rise to the solution presented in Proposition 1. Part b) of Proposition 1 is easily proved by deriving the first derivative of the labor market equilibrium condition with respect to θk , which is increasing since the vacancy filling rate is decreasing in the equilibrium market tightness ∂m(θk) ∂θk<0 . Thus the first derivative of (8) and (9) with respect to θkis positive. Skill-specific unemployment. Solving the product and labor market equilibrium pins down the lowand high-skill equilibrium market tightness and unemployment in both countries via the skill-specific Beveridge curves u(θki) = λ λ+θkm(θki).(23) The Beveridge curve relates the unemployment-to-vacancy ratio such that the flow into unemployment equals the flow out of unemployment and therefore pins down long-run equilibrium unemployment rates in the economy. The Beveridge curve is www.economics-ejournal.org 15 conomics: The Open-Access, Open-Assessment E-Journal convex due to the concave matching technology. Thus, the magnitude of the relationship between θkand uis stronger for relatively low values of unemployment. Labor market clearing. The labor market clears when labor supply equals labor demand. However, due to search frictions labor supply is the fraction of matched workers outside the pool of unemployed workers. On the other hand, firms adjust their labor demand to the intermediate input prices that now do depend on wages and search costs. Thus, search costs drive a wedge between intermediate input prices and the wage earned by the firms’ workers, but perfect competition still implies that prices are equal to production cost. Final good producers are price takers and base their labor demand decision on the (already optimal) highand low-skill intermediate goods’ prices, given that wages are bargained between intermediate goods producers and workers, and given that those wages are optimal. Therefore, wages map into intermediate goods’ prices. Applying Shephard’s Lemma the demand for produced intermediates is equal to lk(z) = ∂κk(qh,ql,r;z) ∂qk(z)=Dζak(z)(qlal(z)+qhah(z))ζ−1r1−ζ.(24) Domestic labor market equilibrium requires that labor demand at the aggregate level is equal to total labor supply which is satisfied if Ld(1−uld) = Z¯ zd z ¯d Dζrd qldald(z) +qldald(z)1−ζ ald(z)x(z)dz ,(25) and Hd(1−uhd) = Z¯ zd z ¯d Dζrd qhdahd(z)+qhdah(z)1−ζ ahd(z)x(z)dz ,(26) hold. The right hand side is aggregate labor demand obtained by aggregating industry level labor demand over all industries. The specialization pattern under free trade is ex-ante unknown and depends on the unit cost schedule over all industries, where ¯ zi denotes the upper and z ¯i the lower bound of the continuum of active industries in the respective country. www.economics-ejournal.org 16 conomics: The Open-Access, Open-Assessment E-Journal If we allow for free trade both countries are better off by specializing on production in sectors where they have a comparative advantage. A free trade equilibrium requires one unique cutoff z∗∈(0,1) for which each of the four labor markets is in equilibrium and for which the cutoff condition pd(z∗) = pf(z∗)⇔κd(θld,θhd;z∗) = κf(θl f ,θh f ;z∗)(27) is fulfilled. However, each cutoff z∗∈[0,∞] is associated with one unique combination of θl and θh . Thus, a necessary requirement for the free trade equilibrium is a cutoff associated with a combination of equilibrium market tightness parameters for which all labor markets clear and for which domestic equals foreign unit costs. Obviously, there is no upper bound for z which means that - given the exogenous parameters - such a cutoff might be outside the feasible space of industries, which is restricted to lie within the continuum z∈[0,1] . If the cutoff condition is fulfilled for z∗>1 only, we would obtain a corner solution where one country could produce all goods cheaper. In that case there are no incentives for one of the countries to participate in international trade so that both economies remain under autarky and produce the whole continuum domestically. Both cost schedules are increasing in z . Thus, an increase in the capital rental or the intermediate goods shift the unit cost schedules up. This shift in unit costs over the whole continuum will result in a loss of the comparative advantage in some industries located close to the former cutoff, resulting in a shift of z∗. We assume that the input coefficient curves are such that home has a comparative advantage in industries closer to the lower bound of industries, whereas foreign has a comparative advantage in industries closer to the upper bound of industries. This assumption allows us to write the labor market clearing conditions as a function of the cutoff z∗. Prices of highand low-skill intermediates depend on the endogenous equilibrium market tightness, and some exogenous parameters only. q can be substituted in the labor market clearing condition so that this condition only depends on θk . Following Feenstra and Hanson (1996, 1997) we exploit equation (2) and (7) in order to link the labor-, and product-market equilibrium at home and foreign via Ld(1−uld(θld)) = Zz∗ 0ζald(z)ϕ(z)E qld(θld)ald(z) +qhd(θhd)ahd(z)dz ,(28) www.economics-ejournal.org 17 conomics: The Open-Access, Open-Assessment E-Journal Hd(1−uhd(θhd)) = Zz∗ 0ζahd(z)ϕ(z)E qld(θld)ald(z) +qhd(θhd)ahd(z)dz .(29) Lf(1−ul f (θl f )) = Z1 z∗ζal f (z)ϕ(z)E ql f (θl f )al f (z) +qh f (θh f )ah f (z)dz ,(30) Hf(1−uh f (θh f )) = Z1 z∗ζah f (z)ϕ(z)E ql f (θl f )al f (z) +qh f (θh f )ah f (z)dz .(31) Thus, the number of matches equals the number of available intermediate goods. The consumption share for each industry z is constant and by assumption equalized over the whole continuum. Existence of an unique equilibrium. Labor market clearing requires that labor demand equals labor supply in each country and skill group. The labor market clearing conditions therefore determine four θik ’s, and each θik in turn pins down the respective wage and skill-specific unemployment rate. The equilibrium is unique since there exists exactly one pair of equilibrium market tightness in each country that satisfies all 2×2 labor market clearing conditions for a given cutoff z∗. To see that an unique equilibrium exists we let ΓL denote the left-, and ΓR the right hand side of the labor market clearing condition. We further define fk(z) = ϕ(z)Eak(z) ql(θl)al(z)+qh(θh)ah(z). The left hand side of both labor market clearing conditions has its origin in zero and converges to an upper bound. The right hand side is also well behaved. Labor demand is decreasing in θk . An increase in θk triggers an increase in intermediate input good prices, which in turn reduces demand for intermediates. We compute the partial effects by application of the Leibniz rule to the right hand side of the labor market clearing condition and assuming that the bounds of the integral being constant yields ∂ΓdRk ∂qk =Zz∗ 0 ∂f(z,ql,qh) ∂qk dz <0,∂Γf Rk ∂qk =Z1 z∗ ∂f(z,ql,qh) ∂qk dz <0 (32) www.economics-ejournal.org 18 conomics: The Open-Access, Open-Assessment E-Journal where world income is set as numéraire so that E=1 . 10 The first derivative approaches 0 when qk goes to infinity and ∂2ΓR ∂q2 k >0 . Therefore, firms’ labor demand is decreasing in θk and converges to zero. Intermediate good prices converge towards the positive constant bk if θk approaches zero but go to infinity when θ approaches ¯ θk which is defined as β¯ θk+η+λ m(¯ θk)=(1−β) c . Labor demand is thus positive for θk=0 and converges to zero when θ approaches ¯ θk . Figure 1 illustrates the equilibrium. Notice, that there is an interaction between the lowand high-skill labor market clearing condition. The high-skill labor market tightness shifts low-skill labor demand ΓR through the increase in the wage rate that enters both groups’ labor market clearing condition. Labor demand ΓRh Labor demand ΓRl Labor supply ΓLk Equilibrium Market Tightness θ Labor demand ΓR, Labor supply ΓL Figure 1: Labor market clearing condition Figure 2 depicts the left and right hand side of the labor market clearing condition in both skill groups. The focus lies on the interaction between equilibrium market tightness θk and labor demand / supply. For the sake of clarity we assume 10 Note that this normalization helps to solve some ambiguities. However, as shown later on world income does not change by much due to some countervailing effects of FDI on both countries’ wages. www.economics-ejournal.org 19 conomics: The Open-Access, Open-Assessment E-Journal that the labor supply function ΓL are equal in both sectors. 11 A change in one skill group’s equilibrium market tightness also affects the respectively other skill-groups ΓR . The equilibrium is unique since ΓL has its origin at zero and converges to the upper bound whereas ΓRconverges to zero when θkgoes to infinity. Lemma 1. The right hand side of the labor market clearing condition is increasing in z∗ in the country where z∗ determines the upper bound of active industries. Conversely, countries where z∗ pins down the lower bound of industries suffer from a decrease in labor demand if z∗increases. Proof. The proof of Lemma 1 follows directly from the first derivative of the right hand side of the labor market clearing condition with respect of z∗ , which is positive or negative depending on whether z∗ is the upper or lower bound of the integral. Notice, that for each country we ex-ante know whether z∗ is the upper or lower bound from the assumptions about the country’s technology parameters which are exogenous. In the two country scenario, both countries have one constant bound (either 0 or 1) and one variable bound z∗ . We assume that home has a comparative advantage in the production of goods closer to 0 and foreign has a comparative advantage in the production of goods closer to 1. Therefore, for the home country z∗ is the upper bound of active industries. Changing the bounds and deriving the first derivative with respect to z∗therefore yields ∂ΓdRk ∂z∗=akd(z∗)ϕ(z∗)E qldald(z∗) +qhdahd (z∗)>0 (33) for home and ∂Γf Rk ∂z∗=−ak f (z∗)ϕ(z∗)E ql f al f (z∗)+qhd ah f (z∗)<0 (34) for foreign, respectively. An increase in the cutoff industry thus reduces labor demand at the extensive margin due to a reduction in active industries. 11 That would be the case if matching functions and labor endowments are equal for both highand low-skilled. Differences in endowments would shift ΓL without affecting the shape of the curves. Our institutional variables as unemployment benefits, search costs, or the bargaining power of the workers do not affect the labor supply curves directly. www.economics-ejournal.org 20 conomics: The Open-Access, Open-Assessment E-Journal 2.3 General equilibrium To close the model we still have to determine world income and capital returns. Income is normalized to unity and equals world factor payments in country d (domestic) and f(foreign) E=Ld(1−uld)qld +Hd(1−uhd)qhd +rdKd+ Lf(1−ul f )ql f +Hf(1−uh f )qh f +rfKf.(35) The capital rental is determined exploiting the Cobb Douglas shares and Shephard’s Lemma again rdKd= (1−ζ)(z∗)E,(36) rfKf= (1−ζ)(1−z∗)E.(37) Thus, the fraction ζis spent for intermediates which gives us Ld(1−uld)qld +Hd(1−uhd)qhd =ζ(z∗)E,(38) Lf(1−ul f )ql f +Hf(1−uh f )qh f =ζ(1−z∗)E.(39) Both equilibrium conditions can be solved for Ein order to derive rdKd=(1−ζ) ζ(Ld(1−uld)qld +Hd(1−uhd)qhd),(40) rfKf=(1−ζ) ζ(Lf(1−ul f )ql f +Hf(1−uh f )qh f ).(41) Hence, the equilibrium depends on 8 endogenous variables: 4 equilibrium market tightness, capital return in the foreign and home country, one cutoff, as well as world income. We follow Feenstra and Hanson (1996, 1997) setting world income as numéraire so that we can drop one equilibrium condition as suggested by Walras’ law. 3 Comparative statics This section analyzes the effects of unilateral changes in labor market institutions on trade, foreign direct investment, and inequality. Labor market institutional www.economics-ejournal.org 21 conomics: The Open-Access, Open-Assessment E-Journal changes in the extended FH framework affect a country’s competitiveness through production costs. This change in competitiveness not only affects the reforming country’s labor market, it also affects foreign labor markets at the extensive margin. Interest rates are treated as exogenous. A reduction in unemployment benefits for instance shifts the unit cost schedule down, followed by adjustments at the extensive margin through an expansion of production at home. Institutional reforms always affect skill-specific unemployment in both the lowand the high-skill group directly through the wage setting mechanism and/or indirectly through the adjustments at the extensive margin. Moreover, we distinguish between institutional changes that have equal effects on both skill-groups and institutional changes that are skill-biased. Governments for instance may finance special vocational retraining programs that help workers to switch occupations. Skill-biased effects of changes in the replacement rate are less obvious. Here we assume that high-skilled workers do not take unemployment benefits into consideration due to their higher wealth and higher reemployment opportunities in case of separation. 3.1 Non skill-biased effects of institutional reforms As shown in the appendix, all policies that intend to reduce the workers’ labor standards partially increase wages and unemployment in the search and matching framework. This is associated with an downward shift of the unit cost schedule for downstream producers. The direct effect comes along with indirect adjustments in wages through the change of the equilibrium market tightness. It will be shown that the indirect effect will not overcompensate the direct effect although both effects go into opposite directions so that the unit cost schedule shifts down following the direct effect of institutions on wages. Although we assume that changes in labor market institutions are unilateral, spillover effects influence labor markets in countries integrated via trade and FDI. We will focus on the effects of lower unemployment benefits. Proposition 2. a) An unilateral decrease in unemployment benefits Bi directly reduces both skill groups’ wages through the workers’ outside option. Unemployment in country i decreases accompanied by a rise in wages due to the increasing www.economics-ejournal.org 22 conomics: The Open-Access, Open-Assessment E-Journal equilibrium market tightness, which mitigates the direct effect. Lower production costs lead to increased competitiveness at home through a higher z∗ . b) Country j6=i ’s capital outflows and loss in competitiveness will increase its unemployment but reduce employees’ wages in both skill groups. Proof. a) Wages and unemployment are affected through three different channels. The direct effect works through the reduction of the outside option, which directly reduces wages and thus intermediate input good prices as derived in the appendix. To derive the direct effect of the policy intervention, we made the assumption that the equilibrium market tightness and the cutoff remain unchanged. Two indirect effects that also affect wages and intermediate good prices in the second round mitigate this direct effect. Suppose that the cutoff remains unchanged and remember that world income is not affected by assumption. 12 The equilibrium market tightness must increase in order to restore equilibrium through a lower rate of unemployment, which mitigates the direct effect derived in the appendix. However, the indirect effect cannot overcompensate the direct effect as discussed separately in the next paragraph. A third effect arises through the adjustments in the cutoff z∗ . Lower unemployment benefits reduce wages and thus production costs, which boosts the country’s competitiveness and increases the cutoff z∗ . This third effect arises only if the direct effect of the institutional change decreases intermediate good prices, which is the case. Moreover, both effects go into the same direction, which implies that labor demand is increasing at the intensive (direct minus indirect effect) and extensive margin. The effect is thus unambiguous. The direct and the indirect effects. We have seen that a decline in unemployment benefits reduces wages and hence intermediate good prices, which stimulates labor demand through higher demand for intermediates. We can use the labor market clearing conditions to prove that the direct effect must dominate the indirect effects so that the unit cost schedule is still shifting down. We begin by substituting the high-skill specific input coefficient by equation (4). The input coefficients drop out so that the labor market clearing conditions collapse to 12 World income is the numéraire in our setup. www.economics-ejournal.org 23 conomics: The Open-Access, Open-Assessment E-Journal b) An increase in z∗ reduces foreign competitiveness associated with an increase in unemployment of both type of skills and a reduction of wages and intermediate good prices. This leads to an expansion of industries at home associated with the following adjustment processes. Firstly, labor demand for both type of skills increased due to the higher domestic output. Secondly, there is excess capital demand at home but excess capital supply at foreign. Capital owners reallocate capital from foreign to home through foreign direct investment iff capital rentals remain constant. Thirdly, both countries demand goods from the whole continuum of industries. Thus, home will export more but import less. Foreign consumers benefit from lower export prices but home consumers are worse off because of higher import prices. Unemployment in the foreign country must rise in both skill groups as the economy contracts and less labor is used to produce lowand high-skill specific intermediates. 3.3 Cooperative labor market reforms One-sided labor market reforms by one country’s government without interventions in countries that are integrated through trade and foreign direct investment fosters unemployment in the non-reforming country. Reforms that are skill-biased in that mainly the low-skilled are directly affected benefit the high-skilled in the reforming country through the effects at the extensive margin. Those spillover effects can be mitigated by joint labor market reforms implemented by all governments within the community. Suppose that both governments reduce unemployment benefits such that the unit cost schedule in both countries shift such that the cutoff remains unchanged. Wages and unemployment of the low-skilled would be decreasing in both countries but the effects at the extensive margin would be zero without an effect on foreign direct investments or the pattern of trade between both countries. 4 Conclusion In a nutshell, this paper’s main contribution is to extend the Feenstra and Hanson (1996, 1997) international trade model by Pissarides (2000) search frictions in a way that enables the analysis of different types of labor market institutions on www.economics-ejournal.org 30 conomics: The Open-Access, Open-Assessment E-Journal skill-specific wages, unemployment and the pattern of trade and foreign direct investment. This in turn implies that wages and capital flows can be affected by both, trade liberalization and changes in labor market institutions. Moreover, the notion of a continuum of industries not only permits the study of spillover effects across countries, it also gives rise to a new channel through which labor market reforms affect labor demand at the extensive margin through competitiveness. Whole industries are shifted abroad. As a result, it is possible to show that countries benefit from institutional changes in foreign countries through an expansion of their production to industries formerly associated with the reforming country. Put differently, labor market reforms can be associated with a rise in competitiveness if other channels such as exchange rate policies are disregarded like we do in the model studied in this paper. The widening of the production to initially inactive industries, combined with the adjustments at the intensive margin reduce unemployment and increase wages in the new equilibrium. However, the reforming country’s workers suffer from the loss in competitiveness in some of its initially active industries located close to the former cutoff. The effect works through wages. Wages in the original Feenstra and Hanson (1996,1997) model adjust independently from labor market institutions. Though, the novel micro-founded wage setting mechanism in the Feenstra and Hanson model facilitates the analysis of changes in labor market institutions. The fact that workers are heterogeneous facilitates to distinguish between reforms that equally affect all workers and reforms that are skill-biased in that only low-skilled are affected. We are able to show that high-skilled benefit from those skill-based labor market reforms through higher wages but lower unemployment, whereas foreign workers loose in terms of unemployment irrespective their level of skill. It is also possible to show that those institutional changes not only affect workers’ wages and unemployment, those reforms also indirectly affect FDI flows across countries. Surging labor costs render FDI more attractive and therefore lead to an increase in FDI outflows accompanied by higher wages and higher rates of unemployment. One possible policy implication is that high-skilled workers benefit from those skill-biased labor market reforms and that governments should stick to joint labor market intervention in order to avoid negative spill-over effects. www.economics-ejournal.org 31 conomics: The Open-Access, Open-Assessment E-Journal Acknowledgements: I am very grateful to the editor Wolfgang Lechthaler and to three anonymous referees for their helpful suggestions and comments. I am also indebted to Herbert Brücker, Stella Capuano, Hartmut Egger, Gabriel Felbermayr, Danny McGowan, Andreas Hauptmann, Benjamin Jung, Wilhelm Kohler, Mario Larch, Christian Merkl, Thomas Rhein, Marcel Smolka, Jürgen Wiemers, and Jens Wrona. www.economics-ejournal.org 32 conomics: The Open-Access, Open-Assessment E-Journal References BEISSINGER, T. (2001). “The Impact of Labor Market Reforms on Capital Flows, Wages and Unemployment,” IZA Discussion Papers 390. http://ideas.repec.org/p/iza/izadps/dp390.html BRECHER, R. (1974). Minimum Wage Rates and the Pure Theory of International Trade, Quarterly Journal of Economics 88 : 98–116. http://ideas.repec.org/a/tpr/qjecon/v88y1974i1p98-116.html DAVIS, D. (1998). Does European Unemployment Prop Up American Wages? National Labor Markets and Global Trade, American Economic Review 88 : 478– 494. http://ideas.repec.org/a/aea/aecrev/v88y1998i3p478-94.html DAVIDSON, C., MARTIN, M., AND MATUSZ, S.J. (1988). 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Offshoring and Unemployment: The Role of Search Frictions Labor Mobility, Journal of International Economics 81 : 219–229. http://ideas.repec.org/a/eee/inecon/v81y2010i2p219-229.html MOORE, M. AND P. RANJAN (2005). Globalisation vs Skill-Biased Technological Change: Implications for Unemployment and Wage Inequality, Economic Journal 115: 391–422. http://ideas.repec.org/a/ecj/econjl/v115y2005i503p391-422.html MORTENSEN, D., AND C. PISSARIDES (1994), Job Creation and Job Destruction in the Theory of Unemployment, Review of Economic Studies 61 : p. 397–415. http://ideas.repec.org/a/bla/restud/v61y1994i3p397-415.html PISSARIDES, C.A. ( 2000). Equilibrium Unemployment Theory, 2nd edition, Cambridge, Mass: MIT Press. SCHMERER, H.-J. (2012). “Foreign Direct Investment and Search Unemployment: Theory and Evidence,” IAB Discussion Paper 4/2012. www.economics-ejournal.org 35 conomics: The Open-Access, Open-Assessment E-Journal Appendix Proofs Derivation of equation (20). To derive the equilibrium tightness conditions for both highand low-skill intermediate producers we need to derive and interact the wage and the job creation curves. To solve for the job creation curve equation (12) and (11) are combined so that (η+λ)cρk(z) m(θk)=ρk(z)−wk(54) To solve for the wage curve we start with rearranging equation (16) as Wk−Uk=β 1−βJk.(55) Equation (11) can be rewritten as (η+λ)Jk=ρk(z)−wk.(56) Expanding equation (14) by subtracting (η+λ)Ukon both sides gives (η+λ)(Wk−Uk) = wk+λUk−(η+λ)(Uk)(57) (η+λ)(Wk−Uk) = wk−ηUk(58) A solution for the outside option is obtained by combining equation (15), equation (55), and equation (12) as ηUk=bk+θkm(θk)β 1−β cρk(z) m(θk)(59) Combining equation (58), (55), (56), and (59) gives (η+λ)β 1−βJk=wk−ηUk(60) (η+λ)β 1−β ρk(z)−wk η+λ=wk−ηUk(61) (η+λ)β 1−β ρk(z)−wk η+λ=wk−bk−θkm(θk)β 1−β cρk(z) m(θk)(62) βρk(z)−βwk= (1−β)wk−(1−β)bk−θkβcρk(z)(63) wk= (1−β)bk+β(ρk(z)+θkcρk(z)) (64) www.economics-ejournal.org 36 conomics: The Open-Access, Open-Assessment E-Journal To solve for the equilibrium intermediate good price we can interact the wage curve (19) and the job creation curve (54) and solve for ρk(z) (1−β)bk+β(ρk(z)+θkcρk(z)) = ρk(z)−(η+λ)cρk(z) m(θk)(65) ρk(z) = bk+cρk(z) 1−ββθk+η+λ m(θk)(66) We substitute ρ with q due to independence of z . Using the Bellman equations we have shown that wages are independent from industries, which also implies that intermediate goods do not depend on the industry identifier z. Proof of Proposition (1), part b). The first derivative of equations (8) and (9) is positive since ∂q(θk) ∂θk =−−cβ+α(r+λ)mθα−1 k(1−β)bk h(1−β)−c(βθk+η+λ m(θk))i2>0 which is needed to derive ∂ΓR ∂θk<0. Derivation of the Labor Market Clearing condition. We know that firms’ demand for intermediate goods is given by equation (24). Aggregating low-skill labor demand over all industries and equating aggregate labor demand and supply yields Li(1−uli) = Z¯ zd z ¯d l(z)x(z)dz (67) Li(1−uli) = Z¯ zd z ¯d Bζal(z)(qlal(z)+qhah(z))ζ−1r1−ζx(z)dz (68) where we can use (2) to substitute out x(z) and (7) to solve for (25) or (28) in order to derive a simpler version of the LMC and in order to calibrate the whole model. www.economics-ejournal.org 37 conomics: The Open-Access, Open-Assessment E-Journal Existence of an equilibrium. First, notice that the left hand of the LMC curve ΓL is well behaved due to the convexity of the Beveridge curve. For limθ→∞ΓL=L since limθ→∞u(θ) = 0 . Let the equilibrium market tightness go to zero and we find that limθ→0ΓL=0 since limθ→0u(θ) = 1 . Thus, for θ=0 we have full unemployment and no worker is willing to search for a job. The right hand side of the LMC curve is also well behaved. Demand for intermediates hinges on the intermediate goods prices qk and qk depends on exogenous parameters and the equilibrium market tightness. However, equation (20) is asymptotic in θ so that the necessary restriction for θkis βθk+η+λ m(θk)<(1−β) c to secure that qk(θ)>0 . However, this is not a strong assumption for reasonable values of the exogenous parameters. It is enough to apply the Leibniz rule on ΓR in order to derive ∂ΓR ∂qk =Z¯ zd z ¯d −ζϕ(z)E(ak(z))2 [qlal(z)+qhah(z)]2dz <0 (69) which implies that ∂ΓR ∂θk<0 . To derive this proof the assumption that the upper and the lower bound remain constant was made. The intermediate good price for the other skill group is also implicitly assumed constant and optimal. However, there is an interaction between both skill groups. A change in the price of the other intermediate good shifts the regarded labor demand curve ΓR . Therefore, given the upper and lower bounds of z there exists exactly one combination for both market tightness for which both skill group’s LMC curves are jointly satisfied. Proof of Proposition (2) and (3). The first derivative of the Equilibrium tightness curve with respect to bis ∂qk ∂bk =(1−β) (1−β)−c(βθk+η+λ m(θk))>0 (70) This partial effect is accompanied by indirect adjustments as discussed in the main part of the paper, where we show that production costs falling on input of www.economics-ejournal.org 38 conomics: The Open-Access, Open-Assessment E-Journal intermediates must be lower after the reform. This shifts the respective unit cost curve down. Again the former equilibrium z∗ is not optimal anymore and has to adjust. The unit cost schedules at home and foreign. The following graph, Figure 4, illustrates the shifts in the unit cost schedules at home (red figures) and at foreign (black figures) in a unilateral reduction of unemployment benefits. The unit cost schedule shifts down and becomes flatter at home, illustrated by a shift of the unit cost schedule from κ0 d(z) to κ00 d(z) . The new unit cost schedule intersects κ0 f(z) at a higher cutoff. This increase in z∗ reduces foreign competitiveness so that unemployment is increasing and intermediate good prices are decreasing. The unit cost schedule shifts up and becomes steeper at foreign, illustrated by a shift of the unit cost schedule from κ0 f(z) to κ00 f(z) . The cutoff increases from z0 to z00 due to the labor market reform. The scenario holds for both non skill-biased and skill-biased labor market reforms.  (  )    ′ (  )   ′ ′ (  )   ′ (  )   ′ ′ (  )  ∗ ′′  ∗ ′ Figure 4: The effects of the reform on home and foreign unit cost schedules www.economics-ejournal.org 39