Inefficiencies in Globalized Economies with Labor Market Frictions

In an open-economy model with labor market search frictions and both the intensive and extensive margins, we identify two interrelated inefficiencies in the decentralized allocation. First, a trade externality arises because domestic agents do not internalize their market power on external demand, leading to excessively high import prices. Second, labor market matching frictions create suboptimal employment levels. These inefficiencies create a policy dilemma. While protectionism can address the trade externality, it comes at the cost of lower employment. Conversely, hiring subsidies can boost employment, but at the expense of higher import prices. Interestingly, and unlike the conventional view, our analysis suggests that increasing the labor tax wedge can be optimal, even in the presence of labor market frictions. This is the case in economies with large trade externality.