Country 1, Unemployment
40
35
30
25
20
15
10
0.8
60
0
τ (%)
Country 2, Unemployment
13
12.5
12
11.5
11
10.5
10
0.8
60
0
15
30
45
τ (%)
Figure 7: Country 1 labor market regulation and unemployment in countries 1 and 2
(=3), when ν = 1 and firms are homogeneous. This corresponds to a Krugman (1980)
economy. [Rate of unemployment on the vertical axis.]
Hence, as it is always profitable for some firms to enter the market, spill-overs do not
vanish. Rather, there is another effect at work, namely, the market potential effect.
One may ask the question, what would happen in a world with homogeneous firms, if
the market potential effect where not at work? This case is summarized in Result 6b:
Result 6b [Spill-overs in the Krugman economy without external economies
of scale]
If firms are homogeneous and there are no external economies of scale (ν = 0), an increase
in unemployment benefits in one country will increase unemployment in that country while
unemployment in all other countries is (almost) unaffected.
As you can see in Figure 8, if we shut down the external economies of scale channel
when firms are homogeneous, no spill-overs are left on the unemployment rate in country
2 when τ = 1, and the effects are very small if τ > 1. If τ = 1, all varieties in the world
enter the price index and utility symmetrically. As absolute size differences do not matter
with ν = 0 and the competitiveness effect is not at work if firms are homogeneous, changes
in unemployment benefits in country 1 do not affect the unemployment rate in country 2.
However, if τ > 1, one channel is still at work, namely changes in the relative composition
of the consumption bundle. With changing unemployment benefits in country 1, the price
for varieties abroad changes. Hence, when varieties do not enter perfectly symmetric, as
is the case with τ > 1, there will be a compositional change in the consumption bundle.
Varieties produced at home become relatively cheaper, hence, consumers will switch from
foreign varieties to home varieties, which will lead to more production at home and less
but due to the homogeneity of firms, either all firms export or no firm does. There is no co-existence of
exporting firms and domestic firms as in the case with heterogeneous firms.
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