5 Conclusions
In this paper, we have introduced search and matching unemployment into a multi-country
single-sector trade model with firm-level increasing returns to scale and product differ-
entiation. Firms are heterogeneous with respect to their (constant) productivities, and
trade liberalization affects economies through selection effects as in Melitz (2003).
Allowing for asymmetric country sizes, labor market institutions, and trade costs, we
ask how an institutional change in one country affects labor market outcomes in other
countries. Countries are linked via trade on the product markets and maintain multilateral
trade balance. We find that an increase of the tax wedge (unemployment benefits plus
tax rate on wages) unambiguously increases unemployment in the country that enacts
the institutional change. In the trading partner countries, unemployment goes up as well.
Other labor market variables such as the efficiency of the search process or search costs
have similar effects. Hence, an exogenous shock on labor market institutions triggers a
positive correlation between countries’ unemployment rates.
We emphasize three key mechanisms that drive these results, namely, a market size
effect, a competitiveness effect, and a selection effect. A deterioration of labor market
institutions, such that domestic unemployment goes up, reduces the domestic market size.
The world market shrinks, and this implies lower exports for all countries. This anti-size
effect drives down labor demand and leads to higher unemployment in all countries in
the world that are at least partially open to international trade. This pure size effect
reverses the Krugman-type gains from trade that rely on the existence of larger markets.
However, even in absence of external economies of scale a smaller global market leads
to higher unemployment. The reason is that market size and selection effects interact:
with smaller global markets and less foreign competition, it is easier for inefficient firms
to maintain their market presence at home, which makes the average firm less productive.
This also drives up aggregate unemployment.
Bad domestic labor market institutions also affect foreign countries via the competi-
tiveness channel. For example, if improved outside options of workers drive up the real
wage so that exporters become less competitive internationally, the unemployment rate at
home goes up. On the other hand, trading partners become relatively more competitive,
which tends to decrease unemployment. However, the gain in competitiveness also has its
backside: as import competition is less fierce, inefficient firms find it easier to survive, the
average firm is less productive, and hence, the rate of unemployment in foreign countries
tends to increase.
We also find that the adverse effects of bad institutions depend on the degree of
geographical centrality of the “bad” country: the more central it is, the more strongly
other countries are exposed to the “bad” country, and the more severe are the adverse
spill-overs on their own labor market outcomes. By the same token, the larger the “bad”
country is, the more strongly other countries are affected: again, the reason is their
relatively larger exposure to that country.
Our calibrated model suggests that international spill-overs across countries are small
when wage are flexible. However, when real wages are rigid the effects are by at least one
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