Inequality and Unemployment in a Global Economy


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Inequality and Unemployment in a Global Economy∗ Elhanan Helpman Harvard University and CIFAR Oleg Itskhoki Princeton University Stephen Redding London School of Economics February 9, 2010 Abstract This paper develops a new framework for examining the determinants of wage distribu- tions that emphasizes within-industry reallocation, labor market frictions, and differences in workforce composition across firms. More productive firms pay higher wages and exporting increases the wage paid by a firm with a given productivity. The opening of trade enhances wage inequality and can either raise or reduce unemployment. While wage inequality is higher in a trade equilibrium than in autarky, gradual trade liberalization first increases and later decreases inequality. Key words: Wage Inequality, International Trade, Risk, Unemployment JEL classification: F12, F16, E24 ∗This paper is a combined version of Helpman, Itskhoki and Redding (2008a, 2008b). Work on these papers started when Redding was a Visiting Professor at Harvard University. We thank the National Science Foundation for financial support. Redding thanks the Centre for Economic Performance at the London School of Economics and the Yale School of Management for financial support. We are grateful to Daron Acemoglu, four anonymous referees, Pol Antràs, Matilde Bombardini, Arnaud Costinot, Gilles Duranton, Gene Grossman, James Harrigan, Larry Katz, Marc Melitz, Guy Michaels, Steve Pischke, Esteban Rossi-Hansberg, Peter Schott, Dan Trefler and conference and seminar participants at AEA, Berkeley, CEPR, Chicago, Columbia, Harvard, LSE, NBER, NYU, Northwestern, Penn State, Princeton, Stanford, Stockholm, Tel Aviv, UCLA and Yale for helpful comments. The usual disclaimer applies. 1 Introduction Two core issues in international trade are the allocation of resources across economic activities and the distribution of incomes across factors of production. In this paper, we develop a new framework for examining the determinants of resource allocation and income distribution, in which both wage inequality and unemployment respond to trade. Our framework encompasses a number of important features of product and labor markets, as a result of which it generates predictions that match features of the data. This framework is rich, flexible and tractable, as we demonstrate by deriving a number of interesting results on trade, inequality and unemployment. And we show how this framework can be extended in various ways and how it can accommodate different general equilibrium structures. Moreover, our framework fits squarely into the new view of foreign trade that emphasizes firm heterogeneity in differentiated product sectors. We introduce standard Diamond-Mortensen-Pissarides search and matching frictions into a Melitz (2003) model, but unlike previous work in this area, such as Helpman and Itskhoki (2009a), we also introduce ex post match-specific heterogeneity in a worker’s ability. Because a worker’s ability is not directly observable by his employer, firms screen workers in order to improve the composition of their employees. Complementarities between workers’ abilities and firm productivity imply that firms have an incentive to screen workers to exclude those with lower abilities. As larger firms have higher returns to screening and the screening technology is the same for all firms, more productive firms screen more intensively and have workforces ...

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