unemployment. Recent econometric evidence supports this view, see Dutt, Mitra, and
Ranjan (2009) or Felbermayr, Prat, and Schmerer (2009). Moreover, to the extent that
labor market institutions affect the volume and pattern of trade between countries, it is
likely that trade acts as a vehicle through which institutional features of one country also
affect labor market outcomes in the other.
Conceptually, one may distinguish between four potential channels through which
trade in goods leads to interdependence of countries’ labor market outcomes. The first and
best understood link is the effect of labor market institutions on the pattern of comparative
advantages. If labor market institutions in one country deteriorate, unemployment in that
country increases. This increases the relative capital-labor abundance of the country.
Hence, a relatively capital-rich economy will specialize more strongly on the capital-
intensive good while the trading partner produces more of the labor-intensive good. Labor
demand in the partner country goes up and the marginal value product of labor increases.
Firms find it optimal to create more vacancies, which leads to a fall of unemployment.
However, if the country with the deteriorating institutions is labor-rich, the opposite
logic applies and unemployment in the partner country will rise. Hence, the sign of the
correlation of unemployment rates between countries is ambiguous. It depends crucially
on the comparison of capital-labor ratios across countries.
The second channel is an income effect. If labor market institutions in one country
worsen, unemployment in that country goes up. This reduces the income of that country,
which leads to a decreasing demand for partner countries’ exports. The income channel,
thus, leads to a positive correlation of unemployment rates induced by labor market
changes between countries. Effects of this type operate in the new economic geography
literature2 but have hardly been explored in models of trade and unemployment. The
effect relies crucially on the use of a full-fledged general equilibrium model. One reason
why the literature has so far down-played this channel is that its existence gives rise to
complications that frustrate closed-form analytical solutions and require to simulate the
model.
A third potential link operates through a competitiveness effect. It is most visible
in partial equilibrium models of strategic interaction where income effects are typically
absent. Bad labor market institutions in one country drive up labor costs, thereby de-
creasing the degree of international competitiveness for all firms from that country. Hence,
consumers switch to foreign suppliers, reducing derived labor demand at home and in-
creasing it abroad. This channel tends to decrease unemployment in the trading partners
and therefore generates a negative correlation of unemployment rates across countries.
A fourth link, strongly related to the existence of firm selection, lies in the compo-
sition of active firms in the trading partners and is an indirect effect of the second and
the third links discussed above. The second channel (the income effect) reduces the ex-
port demand of the trading partners. This lowers the weight of exporting firms, which
Nickell and Layard (1999); Blanchard and Wolfers (2000); Ebell and Haefke (2009) and Felbermayr and
Prat (2009).
2See for an overview Fujita, Krugman, and Venables (1999) or Baldwin, Forslid, Martin, Ottaviano,
and Robert-Nicoud (2003).