are the most productive ones, and thus reduces average productivity. The third channel
reduces the competitiveness of the country whose labor market institutions worsen. This
alleviates competitive pressures on domestic producers in the other countries, which im-
plies that firms with low productivity, that could not enter the market before, are now
profitable. This again reduces average productivity abroad and thus demand for labor,
thereby generating a positive correlation between unemployment rates.
Our paper features the last three channels; the well-understood comparative advan-
tage link being absent due to the one-sector structure of the model. We show that the
most straightforward combination of the Krugman/Melitz-framework with the search-
unemployment mechanism `a la Pissarides implies a positive conditional correlation of
unemployment rates across countries. Firm heterogeneity is not crucial for this result if
market size is important but it turns out to magnify the strength of the spill-overs and
is therefore quantitatively important. We document these findings in simulations of the
calibrated model and confirm their empirical validity in an econometric exercise.
Related literature. A large number of papers studies the effect of cross-country differ-
ences in labor market institutions on the pattern of trade, and subsequently, on welfare,
the factor income distribution, and unemployment. Early contributions built on frame-
works of comparative advantage, in particular on the two-country, two-factor, two-good
(2 × 2 × 2) Heckscher-Ohlin model. Brecher (1974) was the first to study minimum wages
in such a framework. Davis (1998) has generalized the Brecher model. In this framework,
minimum wages in a capital-abundant country can lead to higher wages in the labor-
abundant country and trade exacerbates the adverse effects of minimum wages. David-
son, Martin, and Matusz (1988, 1999) introduce search frictions and wage bargaining into
multi-sector models of international trade governed by comparative advantage.3 These
more general models yield very similar conclusions as the Davis (1998) setup. Hence,
within the Heckscher-Ohlin trade model, predictions are robust to different wage setting
assumptions.
The recent literature focuses on firm-level increasing returns to scale and product
differentiation featured by the Krugman (1979, 1980) model and its generalization to
heterogeneous firms by Melitz (2003). Two labor market paradigms have been most
extensively used: fair wage preferences (and the closely related efficiency wage approach)
and the search and matching approach. A central limitation of Krugman-type models with
asymmetric trade costs consists in the absence of closed form solutions due to the fact
that labor market clearing conditions are transcendental. Hence, Egger and Kreickemeier
(2008, 2009), Eckel and Egger (2009) and Felbermayr, Prat, and Schmerer (2008) focus on
perfectly symmetric cases so that equilibrium outcomes can be completely characterized
analytically. This practice makes it impossible to address the effect of asymmetries in labor
market institutions and their cross-country implications, which lies at the heart of our
3More recently, Cunat and Melitz (2007) study the effect of cross-country differences in firing restric-
tions on patterns of comparative advantage in a Ricardian setting, but they do not address the issue
of unemployment. Cunnat and Melitz (2007) contains an excellent discussion of papers that address the
effect of labor market institutions on trade patterns.