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Index

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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Ricardo

HOS

HOV

Technology & Human Capital

Melitz meets Pissarides

Inequality & Unemployment

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Ricardo

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HOS

HOV

Technology & Human Capital

Melitz meets Pissarides

Inequality & Unemployment

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Ricardo

HOS

HOV

Technology & Human Capital

Melitz meets Pissarides

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Ricardo

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HOV

Technology & Human Capital

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Ricardo
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HOS

HOV

Melitz meets Pissarides

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Ricardo

HOS

HOV

Technology & Human Capital

Melitz meets Pissarides

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Ricardo
Technology

HOS

HOV
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Ricardo

HOS

HOV

Technology & Human Capital

Melitz meets Pissarides

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Ricardo
Technology

HOS

Melitz meets Pissarides

HOV
Human Capital

Index

Ricardo

HOS

HOV

Technology & Human Capital

Melitz meets Pissarides

Inequality & Unemployment

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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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Ricardo

HOS

HOV

Technology & Human Capital

Melitz meets Pissarides

Inequality & Unemployment

Trade

International Trade −→
1

Allocation of resources across economic activities,

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Ricardo

HOS

HOV

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.

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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),

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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,

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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,

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2015

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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,

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2015

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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).

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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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2015

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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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Index

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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Index

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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Index

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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Ricardo

HOS

HOV

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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Ricardo

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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Ricardo

HOS

HOV

Technology & Human Capital

Melitz meets Pissarides

Inequality & Unemployment

DFS model
Putting everything together gives:

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Index

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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2015

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Ricardo

HOS

HOV

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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2015

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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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Index

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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2015

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Ricardo

HOS

HOV

Technology & Human Capital

Melitz meets Pissarides

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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Ricardo

HOS

HOV

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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Ricardo

HOS

HOV

Technology & Human Capital

Melitz meets Pissarides

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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Ricardo

HOS

HOV

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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2015

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Index

Ricardo

HOS

HOV

Technology & Human Capital

Melitz meets Pissarides

Inequality & Unemployment

PPF in HOS
QT

QC
Why the PPF is not a straight-line?

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Ricardo

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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2015

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Index

Ricardo

HOS

HOV

Technology & Human Capital

Melitz meets Pissarides

Inequality & Unemployment

Open to trade

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Index

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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2015

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Index

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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2015

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Index

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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Index

Ricardo

HOS

HOV

Technology & Human Capital

Melitz meets Pissarides

Inequality & Unemployment

Empirical Evidence

How does HOV model perform?

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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.”

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2015

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Index

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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Ricardo

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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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,

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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.

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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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Ricardo

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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(2)

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Ricardo

HOS

HOV

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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Ricardo

HOS

HOV

Technology & Human Capital

Melitz meets Pissarides

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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Ricardo

HOS

HOV

Technology & Human Capital

Melitz meets Pissarides

Inequality & Unemployment

Neutral technical progress in X at fixed prices

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Ricardo

HOS

HOV

Technology & Human Capital

Melitz meets Pissarides

Inequality & Unemployment

American labour(unskilled) saving technical
progress in X

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2015

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Ricardo

HOS

HOV

Technology & Human Capital

Melitz meets Pissarides

Inequality & Unemployment

Human Capital and Unemployment

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2015

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Index

Ricardo

HOS

HOV

Technology & Human Capital

Melitz meets Pissarides

Inequality & Unemployment

Human Capital and Unemployment

Jorge Rojas-Vallejos (UW)

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2015

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Ricardo

HOS

HOV

Technology & Human Capital

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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Ricardo

HOS

HOV

Technology & Human Capital

Melitz meets Pissarides

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)

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)

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(8)

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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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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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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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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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Inequality & Unemployment

Wage Bargaining
The bargaining process is summarized in an exogenous parameter β.
However, this could endogenized.

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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:

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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:
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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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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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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Equilibrium Labour Market Tightness

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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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Fall in Transport Costs

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Rise Trade Relations

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Rise Fixed Costs for Export

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Inequality & Unemployment

Inequality: The famous Gini index

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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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Gini World Today

Source: World Bank

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Poverty $2 a day (PPP) Today

Source: World Bank

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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 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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Preview

I The opening of trade enhances wage inequality, but can either
raise or reduce unemployment,

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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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Preview
A trade friction can either raise or reduce wage inequality depending
upon the initial condition.

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What is new here?

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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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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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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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Firm’s actions

fe > 0

Technology & Human Capital

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Index

Ricardo

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Firm’s actions

fe > 0

θ

Technology & Human Capital

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Index

Ricardo

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HOV

Firm’s actions

fe > 0

θ

ac

Technology & Human Capital

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Inequality & Unemployment

Index

Ricardo

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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

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Technology & Human Capital

Firm’s actions

Exit
fe > 0

θ

Domestic
D&E markets

ac

Melitz meets Pissarides

Inequality & Unemployment

Index

Ricardo

HOS

HOV

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Inequality & Unemployment

Firm’s actions

Exit
fe > 0

θ

Domestic

Bargaining over surplus

D&E markets
ac

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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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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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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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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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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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Workers hired

a ≥ ac

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Workers hired 

a ≥ ac ⇒ h = n

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amin
ac 

k

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Workers hired 

a ≥ ac ⇒ h = n

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amin
ac 

k
¯=
⇒a

k
ac
k−1

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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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Firm’s revenues

r(θ) ≡ rd (θ) + rx (θ)

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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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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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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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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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FOCs firm

h

h

ac

n
(a) Measure of workers sampled

Jorge Rojas-Vallejos (UW)

(b) Screening a threshold

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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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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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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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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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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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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.
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Inequality & Unemployment

Wage Inequality in the Closed Economy
w ∼ Gw (w) = 1 −

Jorge Rojas-Vallejos (UW) 

w

min 

1+1/µ

w

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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).
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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

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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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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...

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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

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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.

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Open versus Closed Economy

Proposition
The opening of the closed economy to trade amplifies differences in
workforce composition across firms.

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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.
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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.

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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.

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Extensions of this model
1

Heterogenous workers ex-ante 
The results on within-group wage inequality hold,

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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,

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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.

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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,

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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)

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Ricardo

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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).

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THANKS!

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Why do we care?

Figure: President Salvador Allende (1971) with Chilean workers

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Why do we care?

Figure: Coup d’´etat (1973) in Chile. A democratic government was
overthrown!
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Why do we care?

Figure: Some of us were lucky. Others still do not know where their
relatives are!

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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.

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