International trade, risk taking and welfare

This paper shows that the gains from opening up to international trade are smaller when firms do not fully internalize downward risk. I develop a general equilibrium model with two key assumptions. First, when faced with adverse productivity shocks, employers can lay off workers without fully paying the social costs of their layoff decisions, a common feature of many institutions. Second, when opening to international trade, the elasticity of demand perceived by an industry increases. In this setup, I show that international trade induces firms to take more risk and (i) raises the equilibrium unemployment rate, (ii) increases the volatility of sectoral sales and (iii) increases welfare proportionately less than in the absence of the externality. Inducing firms to internalize the costs of layoff (Blanchard and Tirole, 2003) therefore appears even more important in a globalized world.