Country 1, ∆ Real wages
9"T
8-.
7-. .
6-. .
5
4
3
2
τ (%)
σ
10 60
Country 2, ∆ Real wages
0-.
-0.5-. .
-1 - .
-1.5-. .
-2.5
10
30
15
45
3.8
0
σ
τ (%)
Figure A3: Change in real wages [on the vertical axis] as a function of trade costs and
the elasticity of substitution for a given change of b1 from 0.4 to 0.8.
country 1 is larger, home demand is more important, making it harder to spill-over bad
labor market institutions to foreign countries. However, for the foreign countries a larger
country 1 means a more important trading partner, leading to a higher sensitivity on the
economic performance of this country.
A2.3 The role of the elasticity of substitution and external economies
of scale
Result A3 [The elasticity of substitution and spill-overs]
The higher the elasticity of substitution, the smaller are the changes in real wages in all
countries following a rise of country 1’s unemployment benefits.
As discussed in the main text, an increase in the elasticity of substitution leads to a
weakening of the income effect and to a strengthening of the competitiveness effect and
thus lowers the spill-over effects of bad labor market institutions. As illustrated in Figure
A3 this implies that the wage drops in countries 2 and 3 become smaller.
Result A4 [External economies of scale and spill-overs]
Stronger external economies of scale result in smaller decreases in real wages for all trading
partner countries. The results for country 1 are ambiguous.
The result is illustrated in Figure A4. For real wages, two things are important: the
nominal wage, and the price level for the aggregated final output good. Both, the nominal
wage and the price level for the aggregated final output good change the sign when ν varies.
For low ν’s the change is positive for both, whereas the change is negative for high ν’s.44
44Note that P1 = 1 due to our normalization. Hence, a decrease of P2 implies a higher relative price
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