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International trade, unemployment, income inequality, wage inequality, Seminar Review, University of Washington.

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Ricardo

HOS

HOV

Technology & Human Capital

Melitz meets Pissarides

Inequality & Unemployment

University of Washington

**Trade, Unemployment and Inequality
**

A quick review

Jorge Rojas-Vallejos

2015

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Ricardo

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HOS

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Technology & Human Capital

Melitz meets Pissarides

Inequality & Unemployment

Index

Ricardo

HOS

HOV

Content

Ricardo

HOS

HOV

Technology & Human Capital

Melitz meets Pissarides

Inequality & Unemployment

Index

Ricardo

HOS

HOV

Technology & Human Capital

Content

Ricardo

Technology

HOS

HOV

Melitz meets Pissarides

Inequality & Unemployment

Index

Ricardo

HOS

HOV

Technology & Human Capital

Melitz meets Pissarides

Content

Ricardo

Technology

HOS

HOV

Human Capital

Inequality & Unemployment

Index

Ricardo

HOS

HOV

Technology & Human Capital

Melitz meets Pissarides

Inequality & Unemployment

Content

Ricardo

Technology

HOS

Melitz meets Pissarides

HOV

Human Capital

Index

Ricardo

HOS

HOV

Technology & Human Capital

Melitz meets Pissarides

Inequality & Unemployment

Content

Ricardo

Technology

HOS

Melitz meets Pissarides

HOV

Human Capital

Inequality & Unemp.

Index

Ricardo

HOS

HOV

Technology & Human Capital

Melitz meets Pissarides

Inequality & Unemployment

Content

Detour

Ricardo

Technology

HOS

Melitz meets Pissarides

HOV

Human Capital

Inequality & Unemp.

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Inequality & Unemployment

Trade

International Trade −→

1

Allocation of resources across economic activities,

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Technology & Human Capital

Melitz meets Pissarides

Inequality & Unemployment

Trade

International Trade −→

1

Allocation of resources across economic activities,

2

Distribution of incomes across factors of production.

Jorge Rojas-Vallejos (UW)

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2015

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Ricardo

HOS

HOV

Technology & Human Capital

Melitz meets Pissarides

Inequality & Unemployment

Ricardian Model

The Ricardian Assumptions:

1

Two countries, two goods, one factor (labor),

Jorge Rojas-Vallejos (UW)

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2015

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Ricardo

HOS

HOV

Technology & Human Capital

Melitz meets Pissarides

Inequality & Unemployment

Ricardian Model

The Ricardian Assumptions:

1

Two countries, two goods, one factor (labor),

2

Labor is immobile across countries and mobile across sectors,

Jorge Rojas-Vallejos (UW)

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2015

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Ricardo

HOS

HOV

Technology & Human Capital

Melitz meets Pissarides

Inequality & Unemployment

Ricardian Model

The Ricardian Assumptions:

1

Two countries, two goods, one factor (labor),

2

Labor is immobile across countries and mobile across sectors,

3

Constant returns to scale (CRS) production,

Jorge Rojas-Vallejos (UW)

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2015

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Ricardo

HOS

HOV

Technology & Human Capital

Melitz meets Pissarides

Inequality & Unemployment

Ricardian Model

The Ricardian Assumptions:

1

Two countries, two goods, one factor (labor),

2

Labor is immobile across countries and mobile across sectors,

3

Constant returns to scale (CRS) production,

4

Identical and homothetic preferences,

Jorge Rojas-Vallejos (UW)

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2015

4 / 89

Index

Ricardo

HOS

HOV

Technology & Human Capital

Melitz meets Pissarides

Inequality & Unemployment

Ricardian Model

The Ricardian Assumptions:

1

Two countries, two goods, one factor (labor),

2

Labor is immobile across countries and mobile across sectors,

3

Constant returns to scale (CRS) production,

4

Identical and homothetic preferences,

5

Perfect Competition (all agents are price takers).

Jorge Rojas-Vallejos (UW)

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2015

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Ricardo

HOS

HOV

Technology & Human Capital

Melitz meets Pissarides

Inequality & Unemployment

Ricardian Model

The Ricardian Assumptions:

1

Two countries, two goods, one factor (labor),

2

Labor is immobile across countries and mobile across sectors,

3

Constant returns to scale (CRS) production,

4

Identical and homothetic preferences,

5

Perfect Competition (all agents are price takers).

Remark

The basic idea applied is opportunity cost. In a two-goods economy

a country will produce the one that requires less unit labour.

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Ricardo

HOS

HOV

Technology & Human Capital

Melitz meets Pissarides

Inequality & Unemployment

Qwine

LChile

aChile

w

LChile

aChile

m

What do we know it’s true in Autarky? PPF = BC

Qmeat

Index

Ricardo

HOS

HOV

Technology & Human Capital

Melitz meets Pissarides

Inequality & Unemployment

Qwine

LChile

aChile

w

LChile

aChile

m

What do we know it’s true in Autarky? PPF = BC

Qmeat

Index

Ricardo

HOS

HOV

Technology & Human Capital

Melitz meets Pissarides

Inequality & Unemployment

Qwine

LChile

aChile

w

LChile

aChile

m

What do we know it’s true in Autarky? PPF = BC

Qmeat

Index

Ricardo

HOS

HOV

Technology & Human Capital

Melitz meets Pissarides

Inequality & Unemployment

Qwine

LChile

aChile

w

LChile

aChile

m

What do we know it’s true in Autarky? PPF = BC

Qmeat

Index

Ricardo

HOS

HOV

Technology & Human Capital

Melitz meets Pissarides

Inequality & Unemployment

Qwine

LChile

aChile

w

CChile

= QChile

m

m

LChile

aChile

m

What do we know it’s true in Autarky? PPF = BC

Qmeat

Index

Ricardo

HOS

HOV

Technology & Human Capital

Melitz meets Pissarides

Inequality & Unemployment

Qwine

LChile

aChile

w

CChile

= QChile

w

w

CChile

= QChile

m

m

Jorge Rojas-Vallejos (UW)

Trade, Unemployment & Inequality

LChile

aChile

m

Qmeat

2015

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Ricardo

HOS

HOV

Technology & Human Capital

Melitz meets Pissarides

Inequality & Unemployment

Qwine

LChile

aChile

w

CChile

= QChile

w

w

CChile

= QChile

m

m

LChile

aChile

m

Qmeat

**What do we know it’s true in Autarky?
**

Jorge Rojas-Vallejos (UW)

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2015

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Ricardo

HOS

HOV

Technology & Human Capital

Melitz meets Pissarides

Inequality & Unemployment

Qwine

LChile

aChile

w

CChile

= QChile

w

w

CChile

= QChile

m

m

LChile

aChile

m

Qmeat

**What do we know it’s true in Autarky? PPF = BC
**

Jorge Rojas-Vallejos (UW)

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2015

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Ricardo

HOS

HOV

Technology & Human Capital

In a trading equilibrium, assume

**Melitz meets Pissarides
**

aCh

Pmeat

meat

Pwine

aCh

wine

Inequality & Unemployment

>

Qwine

LCh

aCh

w

uaut

LCh

aCh

m

Qmeat

Index

Ricardo

HOS

HOV

Technology & Human Capital

In a trading equilibrium, assume

**Melitz meets Pissarides
**

aCh

Pmeat

meat

Pwine

aCh

wine

Inequality & Unemployment

>

Qwine

P

slope=− Pmeat

wine

LCh

aCh

w

uaut

LCh

aCh

m

Qmeat

Index

Ricardo

HOS

HOV

Technology & Human Capital

In a trading equilibrium, assume

**Melitz meets Pissarides
**

aCh

Pmeat

meat

Pwine

aCh

wine

Inequality & Unemployment

>

Qwine

P

slope=− Pmeat

wine

LCh

aCh

w

utrade

uaut

LCh

aCh

m

Qmeat

Index

Ricardo

HOS

HOV

Technology & Human Capital

In a trading equilibrium, assume

**Melitz meets Pissarides
**

aCh

Pmeat

meat

Pwine

aCh

wine

Inequality & Unemployment

>

Qwine

P

slope=− Pmeat

wine

LCh

aCh

w

utrade

uaut

CCh

m

LCh

aCh

m

Qmeat

Index

Ricardo

HOS

HOV

Technology & Human Capital

In a trading equilibrium, assume

**Melitz meets Pissarides
**

aCh

Pmeat

meat

Pwine

aCh

wine

Inequality & Unemployment

>

Qwine

P

slope=− Pmeat

wine

LCh

aCh

w

CCh

w

utrade

uaut

CCh

m

Jorge Rojas-Vallejos (UW)

LCh

aCh

m

Trade, Unemployment & Inequality

Qmeat

2015

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Ricardo

HOS

HOV

Technology & Human Capital

Melitz meets Pissarides

Inequality & Unemployment

Ricardian Model

Question

Some argue that high relative wages in the “North” relative to the

“South” are evidence of Northern exploitation of Southern workers.

What can we say about it in this framework?

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Ricardo

HOS

HOV

Technology & Human Capital

Melitz meets Pissarides

Inequality & Unemployment

Ricardian Model

Question

Some argue that high relative wages in the “North” relative to the

“South” are evidence of Northern exploitation of Southern workers.

What can we say about it in this framework?

Yes, in this model wages are larger in the trading equilibrium than

in the autarky one.

multi-goods extension ⇒ continuum of goods

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Technology & Human Capital

Melitz meets Pissarides

Inequality & Unemployment

A Continuum of Goods

The Dornbusch, Fischer, and Samuelson model (1977).

1

A continuous of goods index by j ∈ [0, 1],

2

**ac (j) is the amount of labour required in country c to produce
**

one unit of good j,

B

3

(j)

A(j) = aaA (j)

is a downward slope monotonic function representing the ratio of these ac (j) in the two countries of the model.

This model facilitates the analysis of the range of goods that a country will export and import.

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HOS

HOV

Technology & Human Capital

Melitz meets Pissarides

Inequality & Unemployment

DFS model

Remark

An expansion of the labour endowment of one country relative to

other will cause it to expand its exports, NOT JUST by exporting

more of what it already exported, BUT ALSO by exporting goods

that it previously imported.

wA

wB

< aB (j)wB ⇒ good j is produce in A and exported to B

ω =

aA (j)wA

So, we have:

**A(j) > ω ⇒ good j is produce in A and exported to B
**

A(j) < ω ⇒ good j is produce in B and imported by A

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HOS

HOV

Technology & Human Capital

Melitz meets Pissarides

Inequality & Unemployment

DFS model

Putting everything together gives:

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Ricardo

HOS

HOV

Technology & Human Capital

Melitz meets Pissarides

Inequality & Unemployment

DFS model

**With this framework many comparative statics can be done. DFS
**

also include transport costs explaining non-traded goods. Thus,

Remark

Each country has a fraction of goods that it will be able to produce

as long as they cost less than imported goods including the transport

cost.

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Technology & Human Capital

Melitz meets Pissarides

Inequality & Unemployment

Many countries and Ricardo

Please see:

Eaton and Kortum (2002) “Technology, Geography, and Trade”,

Econometrica, pp: 1741-1779.

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Ricardo

HOS

HOV

Technology & Human Capital

Melitz meets Pissarides

Inequality & Unemployment

**Heckscher-Ohlin-Samuelson Model
**

We just saw in the Ricardian model that:

1

everyone wins from trade,

2

there is only one factor of production (labour),

3

outcome is complete specialization,

4

differences in technology are the underlying mechanism.

Too simple right?!

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Ricardo

HOS

HOV

Technology & Human Capital

Melitz meets Pissarides

Inequality & Unemployment

**Heckscher-Ohlin-Samuelson Model
**

We just saw in the Ricardian model that:

1

everyone wins from trade,

2

there is only one factor of production (labour),

3

outcome is complete specialization,

4

differences in technology are the underlying mechanism.

**Too simple right?!
**

In HOS, we assume:

1

**2 × 2 × 2 Model: 2 Countries, 2 Goods (Outputs), 2 Factors
**

(Inputs),

2

**No productivity differences. All countries share the same
**

technology.

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Technology & Human Capital

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Inequality & Unemployment

Heckscher-Ohlin-Samuelson Model

3

Output can be produced with different input mixes,

4

Factors are mobile across sectors but not across countries,

5

Countries differ in their relative abundance of factors.

**Assumption (5) is the source of comparative advantages in the HOS
**

model1 .

1

AKA Factor proportions theory

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Technology & Human Capital

Melitz meets Pissarides

Inequality & Unemployment

Rybczynski Theorem

**An expansion in one factor (input) leads to an absolute decline in
**

the output of the commodity that uses the other factor more intensively.

Assuming that:

a

aLM

> LF ⇔ M is more labour intensive than F

aTM

aTF

If L increases, then F will decrease.

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Inequality & Unemployment

Stolper-Samuelson Theorem

**Assume M is more labour intensive than F, and pF is constant. An
**

increase in pM raises the return to the factor used intensively in the

production of M by an even greater relative amount2 .

M is labour intensive and pM increases =⇒

2

dpM

dw

>

w

pM

Jones (1965), Journal of Political Economy. Great paper!

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Technology & Human Capital

Melitz meets Pissarides

Inequality & Unemployment

Generalization

**Input endowment magnification effect. General Rybczynski theorem.
**

aLF

a

dL

dT

dF

dL

dT

dM

> LM ∧

>

=⇒

>

>

>

aTF

aTM

L

T

F

L

T

M

Output price magnification effect. General Stolper-Samuelson theorem.

aLF

dpF

a

dpM

dw

dpF

dpM

dr

> LM ∧

>

=⇒

>

>

>

aTF

aTM

pF

pM

w

pF

pM

r

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Technology & Human Capital

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Inequality & Unemployment

PPF in HOS

QT

QC

Why the PPF is not a straight-line?

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HOS

HOV

Technology & Human Capital

Melitz meets Pissarides

Inequality & Unemployment

PPF in HOS

QT

QC

Why the PPF is not a straight-line?

Exactly! Imperfect substitutability across sectors.

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HOS

HOV

Technology & Human Capital

Melitz meets Pissarides

Inequality & Unemployment

Open to trade

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Ricardo

HOS

HOV

Technology & Human Capital

Melitz meets Pissarides

Inequality & Unemployment

Factor Price Equalization

**This model leads to:
**

Relative factor prices converge across countries even

though factors are immobile across countries!

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Ricardo

HOS

HOV

Technology & Human Capital

Melitz meets Pissarides

Inequality & Unemployment

Factor Price Equalization

**This model leads to:
**

Relative factor prices converge across countries even

though factors are immobile across countries!

Factors of production are immobile across countries but goods are

mobile. Trade in goods is enough to lead to factor price convergence.

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Ricardo

HOS

HOV

Technology & Human Capital

Melitz meets Pissarides

Inequality & Unemployment

Heckscher-Ohlin-Vanek Model

**The setup is as follows:
**

1

Many countries, indexed by i ∈ {1, . . . , C},

2

Many sectors, indexed by j ∈ {1, . . . , N},

3

Many factors, indexed by k ∈ {1, . . . , M},

4

Technologies and preferences are identical across countries,

5

FPE prevails under free and frictionless trade.

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HOS

HOV

Technology & Human Capital

Melitz meets Pissarides

Inequality & Unemployment

Empirical Evidence

How does HOV model perform?

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Ricardo

HOS

HOV

Technology & Human Capital

Melitz meets Pissarides

Inequality & Unemployment

Empirical Evidence

**How does HOV model perform?
**

Quoting Davis et al. (NBER 5625). “Empirically... it is a flop.”

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2015

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Ricardo

HOS

HOV

Technology & Human Capital

Melitz meets Pissarides

Inequality & Unemployment

Empirical Evidence

**How does HOV model perform?
**

Quoting Davis et al. (NBER 5625). “Empirically... it is a flop.”

Quoting Davis again “... relaxing the assumption of FPE yields a

dramatic improvement...”

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HOS

HOV

Technology & Human Capital

Melitz meets Pissarides

Inequality & Unemployment

Technology, Human Capital And Unemployment

**In this section we discuss some of the ideas in:
**

Davis (1998) “Technology, unemployment, and relative wages

in a global economy”, European Economic Review, and

Davis et al. (2000) “Human capital, unemployment, and relative wages in a global economy”, Federal Reserve.

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HOS

HOV

Technology & Human Capital

Melitz meets Pissarides

Inequality & Unemployment

**Technology, Human Capital And Unemployment
**

So far, we have always assumed full employment of factors and nonmarket rigidities. However, there are two factor market developments of interest that we would like to understand.

1

**The growing skilled-to-unskilled wage gap in the United
**

States,

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Ricardo

HOS

HOV

Technology & Human Capital

Melitz meets Pissarides

Inequality & Unemployment

**Technology, Human Capital And Unemployment
**

So far, we have always assumed full employment of factors and nonmarket rigidities. However, there are two factor market developments of interest that we would like to understand.

1

**The growing skilled-to-unskilled wage gap in the United
**

States,

2

The rise and persistence of unemployment in Europe.

Jorge Rojas-Vallejos (UW)

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2015

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Index

Ricardo

HOS

HOV

Technology & Human Capital

Melitz meets Pissarides

Inequality & Unemployment

**Technology, Human Capital And Unemployment
**

So far, we have always assumed full employment of factors and nonmarket rigidities. However, there are two factor market developments of interest that we would like to understand.

1

**The growing skilled-to-unskilled wage gap in the United
**

States,

2

The rise and persistence of unemployment in Europe.

**To understand this the usual approach was looking at each region
**

separately, but Davis (1998) had the idea of looking at the problem

in a unified model of a trading world. We are in a global economy

and hence the dynamic system is integrated more than ever before.

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HOS

HOV

Technology & Human Capital

Melitz meets Pissarides

Inequality & Unemployment

Technology and Unemployment

The structure of this economy is the HOS model, except that employment of unskilled labour will be subject to a binding minimum

wage. We (they) assume that skilled labour is fully employed. Thus,

HX + HY = H

(1)

**while the unskilled labour factor market constraint due to the minimum wage regulation is,
**

NX + NY + U = N + U = L

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Technology & Human Capital

Melitz meets Pissarides

Inequality & Unemployment

**Technology and Unemployment
**

Define the relative goods price as P ≡ pX /pY and the relative world

endowment as h ≡ H/L. So,

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Inequality & Unemployment

**Technology and Unemployment
**

For the United States (flexible wage),

US

US

LUS

X + LY = L

(3)

**For Europe (regulation min. wage),
**

NXE + NYE + U = N E + U = LE

(4)

**Figure: Trading equilibrium
**

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Inequality & Unemployment

Neutral technical progress in X at fixed prices

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Inequality & Unemployment

**American labour(unskilled) saving technical
**

progress in X

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Inequality & Unemployment

Human Capital and Unemployment

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Inequality & Unemployment

Human Capital and Unemployment

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Melitz meets Pissarides

Inequality & Unemployment

Melitz meets Pissarides

**“Firm Heterogeneity, search unemployment and trade
**

liberalization”

by Felbermayr, Prat, and Schmerer.

Working paper at The European Trade Study Group (2007).

In this paper, they introduce unemployment a` la Pissarides (2000)

into Melitz (2003).

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Inequality & Unemployment

The Model

Assumptions:

I HH’s utility follows U = ln C + γU 0 ,

I Perfect financial markets,

I r is exogenous,

I Labour only factor of production,

I Labour is inelastically supplied,

I Perfect competition for final consumption good,

I Monopolistic competition, at the intermediate inputs level,

firms produce each a unique variety.

They focus in the long-run, excluding the short-run dynamics.

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Inequality & Unemployment

The Model

Production function:

σ

Z

σ−1

σ−1

− σ1

q(ω) σ dω

,

Y= M

σ>1

(5)

ω∈Ω

**where σ is the elasticity of substitution between any two varieties
**

and Ω is the mass M of intermediate inputs.

The price index dual is:

1

P=

M

Z

−σ

p(ω)

1/(1−σ)

(6)

dω

ω∈Ω

where p(ω) is the price of input ω.

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Inequality & Unemployment

The Model

**Quantities of intermediates inputs are:
**

q(ω) =

Y

p(ω)−σ

M

(7)

**Total production costs are:
**

c(ω) = w(ω)

q(ω)

+f

ϕ(ω)

Jorge Rojas-Vallejos (UW)

Trade, Unemployment & Inequality

(8)

2015

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Technology & Human Capital

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Inequality & Unemployment

The Model

**The labour market is characterized by search frictions. The aggregate matching function exhibits CRS.
**

Firms ⇐⇒ Workers

θ

Some definitions:

θ = v/u: vacancy-unemployment ratio,

c: cost of posting vacancies

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Inequality & Unemployment

Pricing Behaviour

The market value of an intermediate producer with productivity ϕ

is:

1

p(q)q − w(l, ϕ)l − cv + (1 − δ)J(l0 , ϕ)

J(l, ϕ) = Max

v

1+r

subject to

1

Y σ −1

q σ

p(q) =

(9)

M

q = ϕl

l0 = (1 − χ)l + m(θ)v

δ some firms will exit, and χ some worker-firm matches will be destroyed (probabilities).

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Technology & Human Capital

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Inequality & Unemployment

Pricing Behaviour

The market value of an intermediate producer with productivity ϕ

is:

1

p(q)q − w(l, ϕ)l − cv + (1 − δ)J(l0 , ϕ)

J(l, ϕ) = Max

v

1+r

subject to

1

Y σ −1

q σ

p(q) =

← demand

M

q = ϕl

← firm production function

l0 = (1 − χ)l + m(θ)v

← law of motion

δ some firms will exit, and χ some worker-firm matches will be destroyed (probabilities).

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Inequality & Unemployment

Pricing Rule

After some algebra:

σ

∂w(l, ϕ)

c

r+s

1

w(l, ϕ) +

l+

(10)

p(l, ϕ) =

ϕ σ−1

∂l

m(θ) 1 − δ

Second term is the “over-employment” effect, and third term is the

“recruitment” cost.

s ≡ χ + δ + χδ is the rate of job destruction.

Melitz (2003) was:

1

σ

w

p(l, ϕ) =

w(l, ϕ) =

ϕ σ−1

ρϕ

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Technology & Human Capital

Melitz meets Pissarides

Inequality & Unemployment

Wage Bargaining

The bargaining process is summarized in an exogenous parameter β.

However, this could endogenized.

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Technology & Human Capital

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Inequality & Unemployment

Wage Bargaining

The bargaining process is summarized in an exogenous parameter β.

However, this could endogenized. Combining the Nash-bargaining

condition and using the envelope theorem for the pricing problem

leads to:

Jorge Rojas-Vallejos (UW)

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2015

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Ricardo

HOS

HOV

Technology & Human Capital

Melitz meets Pissarides

Inequality & Unemployment

Wage Bargaining

The bargaining process is summarized in an exogenous parameter β.

However, this could endogenized. Combining the Nash-bargaining

condition and using the envelope theorem for the pricing problem

leads to:

Job Creation equation:

σ−1

r+s

c

w(l, ϕ) = ϕp(l, ϕ)

−

σ−β

1 − δ m(θ)

(11)

Wage Curve equation:

β

r+s

c

w(l, ϕ) = rU +

1−β

1 − δ m(θ)

(12)

(12) strikingly shows that wages are constant across firms! Why?

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2015

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Ricardo

HOS

HOV

Technology & Human Capital

Melitz meets Pissarides

Inequality & Unemployment

Wage Bargaining

The bargaining process is summarized in an exogenous parameter β.

However, this could endogenized. Combining the Nash-bargaining

condition and using the envelope theorem for the pricing problem

leads to:

Job Creation equation:

σ−1

r+s

c

w(l, ϕ) = ϕp(l, ϕ)

−

σ−β

1 − δ m(θ)

(11)

Wage Curve equation:

β

r+s

c

w(l, ϕ) = rU +

1−β

1 − δ m(θ)

(12)

**(12) strikingly shows that wages are constant across firms! Why?
**

Firms exploit their monopsony power till workers are paid their outside option.

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2015

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Technology & Human Capital

Melitz meets Pissarides

Inequality & Unemployment

Entry, Exit And Autarky Equilibrium

**As in Melitz (2003), the entry process is in two stages.
**

1

Develop new variety. Sunk cost fE , fixed costs f .

2

Firm learns its productivity and decides {stay, exit}

Similar math to the one in Melitz leads to the next to graphical relations.

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Inequality & Unemployment

Equilibrium Threshold Productivity

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Inequality & Unemployment

Equilibrium Labour Market Tightness

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Inequality & Unemployment

Trade Liberalization

**Next, we study the effects of trade liberalization on productivity
**

and unemployment. They run the following comparative statics:

1

Falling transport costs,

2

Rising number of trade relations,

3

Rising fixed costs for export.

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Inequality & Unemployment

Fall in Transport Costs

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2015

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Inequality & Unemployment

Rise Trade Relations

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2015

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Inequality & Unemployment

Rise Fixed Costs for Export

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Inequality & Unemployment

Inequality: The famous Gini index

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Inequality & Unemployment

A Quick Look at Inequality

**“Since 1947, when the General Agreement on Tariffs and Trade (GATT)
**

was created, the world trading system has benefited from multilateral

trade liberalization” (IMF website)

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Inequality & Unemployment

Gini World Today

Source: World Bank

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Inequality & Unemployment

Poverty $2 a day (PPP) Today

Source: World Bank

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Inequality & Unemployment

Inequality and Unemployment

**In this section we look at the model developed in:
**

Helpman, Elhanan, Oleg Itskhoki, and Stephen Redding. (2010).

“Inequality And Unemployment In A Global Economy”,

Econometrica, 78(4), pp: 1239-1283.

This model introduces search and matching frictions into a Melitz

(2003) framework.

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Inequality & Unemployment

Inequality and Unemployment

**We will study the determinants of wage distributions, namely:
**

1

Within-industry reallocation,

2

Labour market frictions,

3

Differences in workforce composition across firms.

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Inequality & Unemployment

Preview

**I The opening of trade enhances wage inequality, but can either
**

raise or reduce unemployment,

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Inequality & Unemployment

Preview

**I The opening of trade enhances wage inequality, but can either
**

raise or reduce unemployment,

I Wage inequality is higher in a trade equilibrium than in autarky. BUT, gradual trade liberalization first increases and later

decreases inequality.

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Inequality & Unemployment

Preview

A trade friction can either raise or reduce wage inequality depending

upon the initial condition.

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Inequality & Unemployment

What is new here?

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Inequality & Unemployment

What is new here?

In this paper the new key feature is that they allow for an endogenous measure of matched workers for each firm rather than assuming one-to-one matching between firms and workers.

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Technology & Human Capital

Melitz meets Pissarides

Inequality & Unemployment

The Model

Assumptions:

1

Two countries, Home and Foreign (*),

2

Continuous of workers ex-ante identical,

3

**Workers are risk-neutral (later they extend this to risk-averse
**

ones),

4

**Demand within the sector is defined over the consumption of a
**

continuum of horizontally differentiated varieties + CES.

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Inequality & Unemployment

The Model

Real consumption index for the sector is:

Z

Q=

q(j)β dj

1/β

,

β ∈ (0, 1)

(13)

j∈J

**β controls for the elasticity of substitution between varieties.
**

Demand function for a given variety j is,

q(j) = A1/(1−β) p(j)−1/(1−β) ,

A is a demand shifter

(14)

**The equilibrium revenue of a firm is,
**

r(j) = p(j)q(j) = Aq(j)β

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(15)

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Ricardo

HOS

HOV

Firm’s actions

fe > 0

Technology & Human Capital

Melitz meets Pissarides

Inequality & Unemployment

Index

Ricardo

HOS

HOV

Firm’s actions

fe > 0

θ

Technology & Human Capital

Melitz meets Pissarides

Inequality & Unemployment

Index

Ricardo

HOS

HOV

Firm’s actions

fe > 0

θ

ac

Technology & Human Capital

Melitz meets Pissarides

Inequality & Unemployment

Index

Ricardo

HOS

HOV

Technology & Human Capital

Firm’s actions

Exit

fe > 0

θ

ac

Melitz meets Pissarides

Inequality & Unemployment

Index

Ricardo

HOS

HOV

Technology & Human Capital

Firm’s actions

Exit

fe > 0

θ

ac

Domestic

Melitz meets Pissarides

Inequality & Unemployment

Index

Ricardo

HOS

HOV

Technology & Human Capital

Firm’s actions

Exit

fe > 0

θ

Domestic

D&E markets

ac

Melitz meets Pissarides

Inequality & Unemployment

Index

Ricardo

HOS

HOV

Technology & Human Capital

Melitz meets Pissarides

Inequality & Unemployment

Firm’s actions

Exit

fe > 0

θ

Domestic

Bargaining over surplus

D&E markets

ac

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Inequality & Unemployment

Firm’s actions

Where:

fe : fixed entry cost (sunk)

θ is i.d. following a Pareto Distribution

θmin z

, θ ≥ θmin > 0,

Gθ (θ) = 1 −

θ

z>1

ac : screening threshold

**Tractable and a good approximation to observed data.
**

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Inequality & Unemployment

Other costs in the model

1

fd > 0: fixed cost of production,

2

fx > 0: fixed cost of exporting,

3

**τ > 1: “iceberg variable trade cost”, basically, we need to ship τ
**

so the foreign market gets 1 unit of our good.

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Technology & Human Capital

Melitz meets Pissarides

Inequality & Unemployment

Production Technology

¯) ,

y = θ (hγ a

γ ∈ (0, 1)

(16)

where:

y: output of each variety,

θ: firm’s productivity,

h: workers hired,

¯ : average ability of these workers.

a

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Technology & Human Capital

Melitz meets Pissarides

Inequality & Unemployment

Production Technology

¯) ,

y = θ (hγ a

γ ∈ (0, 1)

(16)

where:

y: output of each variety,

θ: firm’s productivity,

h: workers hired,

¯ : average ability of these workers.

a

Also, a ∼ Ga (a) with parameter k > 1. A key feature here is complementarity in worker ability. The productivity of a worker is

increasing in the abilities of other workers employed by the firm.

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Technology & Human Capital

Melitz meets Pissarides

Inequality & Unemployment

Screening Technology

We (they) assume that all firms have the same screening technology. Worker ability cannot be costlessly observed when firms and

workers are matched.

**Screening −→ imprecise signal about a
**

Screening cost is assumed to be:

sc(ac ) = c

aδc

,

δ

c, δ > 0

(17)

Intuitive sense that higher ability higher cost of screening.

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Technology & Human Capital

Melitz meets Pissarides

Inequality & Unemployment

Workers hired

a ≥ ac

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Inequality & Unemployment

Workers hired

a ≥ ac ⇒ h = n

Jorge Rojas-Vallejos (UW)

amin

ac

k

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Technology & Human Capital

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Inequality & Unemployment

Workers hired

a ≥ ac ⇒ h = n

Jorge Rojas-Vallejos (UW)

amin

ac

k

¯=

⇒a

k

ac

k−1

Trade, Unemployment & Inequality

2015

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Technology & Human Capital

Melitz meets Pissarides

Inequality & Unemployment

Workers hired

a ≥ ac ⇒ h = n

amin

ac

k

¯=

⇒a

k

ac

k−1

**This average ability into the production function yields,
**

y = κy θnγ ac1−γk ,

κy =

k

aγk

k−1 c

(18)

The knife-edge condition such that firms screen is γk ∈ (0, 1)

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Technology & Human Capital

Melitz meets Pissarides

Inequality & Unemployment

Firm’s revenues

r(θ) ≡ rd (θ) + rx (θ)

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Inequality & Unemployment

Firm’s revenues

r(θ) ≡ rd (θ) + rx (θ)

r(θ) ≡ Y(θ)1−β Ay(θ)β

where Y(θ) is the firm’s market access.

Y(θ) ≡ 1 + Ix (θ)τ

−β/(1−β)

A∗

A

1/(1−β)

where Ix (θ) is an indicator function for exporting.

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Inequality & Unemployment

Bargaining problem

The outcome is:

I Firm’s fraction is

1

(1 + βγ)

**I Each worker gets
**

1−

1

(1 + βγ)

The firm can perfectly anticipate this while maximizing profits.

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Technology & Human Capital

Melitz meets Pissarides

Inequality & Unemployment

**The Firm’s optimization problem
**

Max π(θ)

s.t.

Production technology

Total Revenue

Firm’s market access

or,

"

∗ 1/(1−β) #1−β

A

1

1 + Ix τ −β/(1−β)

×

π(θ) = Max

A

n,ac ,Ix 1 + βγ

c

A(κy θnγ a1−γk

)β − bn − aδc − fd − Ix fx

c

δ

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Technology & Human Capital

Melitz meets Pissarides

Inequality & Unemployment

Access Market

**The presence of fixed production costs imply a zero-profit cutoff such
**

that:

Y(θ) =

1

Yx

Jorge Rojas-Vallejos (UW)

if

if

θd < θ < θx

θ ≥ θx

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Inequality & Unemployment

FOCs firm

h

h

ac

n

(a) Measure of workers sampled

Jorge Rojas-Vallejos (UW)

(b) Screening a threshold

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2015

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Inequality & Unemployment

**Revenues and Wages
**

The higher the productivity, the larger the revenues and the larger

the size of the firm. This depends on δ > k. We now that the share

of workers is βγ/(1 + βγ). Hence,

w(θ) =

βγ r(θ)

=

1 + βγ h(θ) |{z}

subs.

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HOV

Technology & Human Capital

Melitz meets Pissarides

Inequality & Unemployment

**Revenues and Wages
**

The higher the productivity, the larger the revenues and the larger

the size of the firm. This depends on δ > k. We now that the share

of workers is βγ/(1 + βγ). Hence,

w(θ) =

βγ r(θ)

=

1 + βγ h(θ) |{z}

b

subs.

ac (θ)

amin

k

(19)

**In addition, the expected wage conditional on being sample is the
**

same across all firms, so

w(θ)h(θ)

= b = search cost

n(θ)

(20)

Thus, workers have no incentive to direct their search.

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2015

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Index

Ricardo

HOS

HOV

Technology & Human Capital

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Inequality & Unemployment

Revenues and Wages

**Combining the above with FOCs, we get:
**

ln w(θ) = Constant +

k

ln h(θ)

δ−k

(21)

If δ > k, then there is an employer-size wage premium.

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2015

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Index

Ricardo

HOS

HOV

Technology & Human Capital

Melitz meets Pissarides

Inequality & Unemployment

**Revenues and Productivity
**

Using the FOCs into the revenue function, we get:

h

i1/Γ

r(θ) = κr c−β(1−γk)/δ b−βγ Y(θ)Aθβ

(22)

**From (22) we see that relative revenues of any two firms depend only
**

on:

1

relative productivities,

2

**relative market access.
**

β/Γ

r(θi )

θi

Y(θi ) β/Γ

=

r(θj )

θj

Y(θj )

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2015

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Index

Ricardo

HOS

HOV

Technology & Human Capital

Melitz meets Pissarides

Inequality & Unemployment

**Labour market tightness
**

Search cost is assumed to be increasing in labour market tightness

(x),

b = α 0 x α1 ,

α0 > 1, α1 > 0

**labour market tightness is,
**

x=

N

L

where N is workers sampled and L is workers searching for employment in the sector. Thus, expected income in the sector is,

ω = Expected wage × prob. being sampled = bx

(23)

**(23) uses risk-neutrality of workers.
**

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2015

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Ricardo

HOS

HOV

Technology & Human Capital

Melitz meets Pissarides

Inequality & Unemployment

Wages as a function of firm productivity

**So, more productive firms NOT only have higher revenues, profits
**

and employment, as in the benchmark model of firm heterogeneity

of Melitz (2003), BUT ALSO pay higher wages.

Jorge Rojas-Vallejos (UW)

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2015

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Ricardo

HOS

HOV

Technology & Human Capital

Melitz meets Pissarides

Inequality & Unemployment

**Wage Inequality in the Closed Economy
**

w ∼ Gw (w) = 1 −

Jorge Rojas-Vallejos (UW)

w

min

1+1/µ

w

Trade, Unemployment & Inequality

2015

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Ricardo

HOS

HOV

Technology & Human Capital

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Inequality & Unemployment

**Wage Inequality in the Closed Economy
**

w ∼ Gw (w) = 1 −

w

min

1+1/µ

w

Proposition

In the closed economy, µ is a sufficient statistic for sectoral wage

inequality. In particular,

p

i. the coefficient of variation of wages is µ/ 1 − µ2

ii. the Lorenz curve is represented by sw = 1 − (1 − sh )1/(1+µ) , where

sh is the fraction of workers and sw is the fraction of their wages

when workers are ordered from low-to-high-wage earners,

iii. the Gini coefficient is µ/(2 + µ),

iv. the Theil index is µ − ln(1 + µ).

Jorge Rojas-Vallejos (UW)

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2015

74 / 89

Index

Ricardo

HOS

HOV

Technology & Human Capital

Melitz meets Pissarides

Inequality & Unemployment

Wage Inequality in the Closed Economy

Proposition

In the closed economy, inequality in the sectoral distribution of wages

is increasing in firm productivity dispersion (lower z) and increasing

in worker ability dispersion (lower k) if and only if

z−1 + δ −1 + γ > β −1

Jorge Rojas-Vallejos (UW)

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2015

75 / 89

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Ricardo

HOS

HOV

Technology & Human Capital

Melitz meets Pissarides

Inequality & Unemployment

Open versus Closed Economy

Figure:

Cumulative distribution function of wages

Proposition

i. Sectoral wage inequality in the open economy when some but

not all firms export is strictly greater than in the closed economy,

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2015

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Ricardo

HOS

HOV

Technology & Human Capital

Melitz meets Pissarides

Inequality & Unemployment

Open versus Closed Economy

Proposition

ii. Sectoral wage inequality in the open economy when all firms

export is the same as in the closed economy.

This proposition highlights a new mechanism for wage inequality

due to trade that is not present in HOS...

Jorge Rojas-Vallejos (UW)

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2015

77 / 89

Index

Ricardo

HOS

HOV

Technology & Human Capital

Melitz meets Pissarides

Inequality & Unemployment

Open versus Closed Economy

Proposition

ii. Sectoral wage inequality in the open economy when all firms

export is the same as in the closed economy.

This proposition highlights a new mechanism for wage inequality

due to trade that is not present in HOS...

Participation of some but not all firms in exporting

Jorge Rojas-Vallejos (UW)

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2015

77 / 89

Index

Ricardo

HOS

HOV

Technology & Human Capital

Melitz meets Pissarides

Inequality & Unemployment

**Open versus Closed Economy
**

Corollary

An increase in the fraction of exporting firms,

I raises sectoral wage inequality when the fraction of exporting firms is sufficiently small,

I reduces sectoral wage inequality when the fraction of exporting firms is sufficiently large.

Jorge Rojas-Vallejos (UW)

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2015

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Ricardo

HOS

HOV

Jorge Rojas-Vallejos (UW)

Technology & Human Capital

Melitz meets Pissarides

Trade, Unemployment & Inequality

Inequality & Unemployment

2015

79 / 89

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Ricardo

HOS

HOV

Technology & Human Capital

Melitz meets Pissarides

Inequality & Unemployment

Open versus Closed Economy

Proposition

The opening of the closed economy to trade amplifies differences in

workforce composition across firms.

Jorge Rojas-Vallejos (UW)

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2015

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Index

Ricardo

HOS

HOV

Technology & Human Capital

Melitz meets Pissarides

Inequality & Unemployment

Sectoral Unemployment

Workers may be unemployed mainly for two reasons,

1

They are not matched with a firm,

2

Their match-specific ability draw a < ac

**(1) and (2) are frictional elements since workers cannot immediately
**

achieve another match or another ability level.

Sectoral unemployment rate u is defined as,

u=

H N

L−H

=1−

= 1 − σx

L

N L

|{z}

(24)

σ

**where H is the measure of hired workers, N matched workers, L
**

workers seeking for employment in the sector, and σ is the sectoral

hiring rate.

Jorge Rojas-Vallejos (UW)

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2015

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Index

Ricardo

HOS

HOV

Technology & Human Capital

Melitz meets Pissarides

Inequality & Unemployment

Sectoral Unemployment

**They smartly derived,
**

σ = ϕ(ρ, Yx )σ aut

(25)

**then they analyze the ϕ(·) function,
**

ϕ(0, Yx ) = 1

0 < ϕ(ρ, Yx ) < 1,

∀ρ ∈ (0, 1] since Yx > 1 ∧ δ > k

Thus, they get the next proposition.

Jorge Rojas-Vallejos (UW)

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2015

82 / 89

Index

Ricardo

HOS

HOV

Technology & Human Capital

Melitz meets Pissarides

Inequality & Unemployment

Sectoral Unemployment

Proposition

The opening of the closed economy to trade has an ambiguous

overall effect on the sectoral unemployment rate:

i. The tightness of the labour market can either remain constant

or rise following the opening of trade, which leaves unchanged

or reduces the rate of unemployment,

ii. The hiring rate is strictly lower in the open economy than in the

closed economy, which raises the rate of unemployment.

Jorge Rojas-Vallejos (UW)

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2015

83 / 89

Index

Ricardo

HOS

HOV

Technology & Human Capital

Melitz meets Pissarides

Inequality & Unemployment

**Extensions of this model
**

1

**Heterogenous workers ex-ante
**

The results on within-group wage inequality hold,

Jorge Rojas-Vallejos (UW)

Trade, Unemployment & Inequality

2015

84 / 89

Index

Ricardo

HOS

HOV

Technology & Human Capital

Melitz meets Pissarides

Inequality & Unemployment

**Extensions of this model
**

1

**Heterogenous workers ex-ante
**

The results on within-group wage inequality hold,

Wage inequality between different groups may increase or decrease,

Jorge Rojas-Vallejos (UW)

Trade, Unemployment & Inequality

2015

84 / 89

Index

Ricardo

HOS

HOV

Technology & Human Capital

Melitz meets Pissarides

Inequality & Unemployment

**Extensions of this model
**

1

**Heterogenous workers ex-ante
**

The results on within-group wage inequality hold,

Wage inequality between different groups may increase or decrease,

The rise of within-group inequality dominates, hence trade liberalization raises overall wage inequality.

Jorge Rojas-Vallejos (UW)

Trade, Unemployment & Inequality

2015

84 / 89

Index

Ricardo

HOS

HOV

Technology & Human Capital

Melitz meets Pissarides

Inequality & Unemployment

**Extensions of this model
**

1

**Heterogenous workers ex-ante
**

The results on within-group wage inequality hold,

Wage inequality between different groups may increase or decrease,

The rise of within-group inequality dominates, hence trade liberalization raises overall wage inequality.

2

**Risk-averse workers
**

Predictions for wage inequality are the same as for risk-neutral

workers,

Jorge Rojas-Vallejos (UW)

Trade, Unemployment & Inequality

2015

84 / 89

Index

Ricardo

HOS

HOV

Technology & Human Capital

Melitz meets Pissarides

Inequality & Unemployment

**Extensions of this model
**

1

**Heterogenous workers ex-ante
**

The results on within-group wage inequality hold,

Wage inequality between different groups may increase or decrease,

The rise of within-group inequality dominates, hence trade liberalization raises overall wage inequality.

2

**Risk-averse workers
**

Predictions for wage inequality are the same as for risk-neutral

workers,

The opening of trade has two effects,

increases expected worker income (ω),

Jorge Rojas-Vallejos (UW)

Trade, Unemployment & Inequality

2015

84 / 89

Index

Ricardo

HOS

HOV

Technology & Human Capital

Melitz meets Pissarides

Inequality & Unemployment

**Extensions of this model
**

1

**Heterogenous workers ex-ante
**

The results on within-group wage inequality hold,

Wage inequality between different groups may increase or decrease,

The rise of within-group inequality dominates, hence trade liberalization raises overall wage inequality.

2

**Risk-averse workers
**

Predictions for wage inequality are the same as for risk-neutral

workers,

The opening of trade has two effects,

increases expected worker income (ω),

increases labour market tightness (x) and search costs (b).

Jorge Rojas-Vallejos (UW)

Trade, Unemployment & Inequality

2015

84 / 89

Index

Ricardo

HOS

HOV

Technology & Human Capital

Melitz meets Pissarides

Inequality & Unemployment

THANKS!

Jorge Rojas-Vallejos (UW)

Trade, Unemployment & Inequality

2015

85 / 89

Index

Ricardo

HOS

HOV

Technology & Human Capital

Melitz meets Pissarides

Inequality & Unemployment

Why do we care?

Figure: President Salvador Allende (1971) with Chilean workers

Jorge Rojas-Vallejos (UW)

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2015

86 / 89

Index

Ricardo

HOS

HOV

Technology & Human Capital

Melitz meets Pissarides

Inequality & Unemployment

Why do we care?

**Figure: Coup d’´etat (1973) in Chile. A democratic government was
**

overthrown!

Jorge Rojas-Vallejos (UW)

Trade, Unemployment & Inequality

2015

87 / 89

Index

Ricardo

HOS

HOV

Technology & Human Capital

Melitz meets Pissarides

Inequality & Unemployment

Why do we care?

**Figure: Some of us were lucky. Others still do not know where their
**

relatives are!

Jorge Rojas-Vallejos (UW)

Trade, Unemployment & Inequality

2015

88 / 89

Index

Ricardo

HOS

HOV

Technology & Human Capital

Melitz meets Pissarides

Inequality & Unemployment

Why do we care?

Figure: Some advised the “new” government.

**Without Equality of Opportunity, Freedom is the privileged of a few
**

and Oppression the reality of everyone else.

Jorge Rojas-Vallejos (UW)

Trade, Unemployment & Inequality

2015

89 / 89

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