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Optimal Trade Policy, Equilibrium Unemployment and Labor Market Inefficiency

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  • Wisarut Suwanprasert

Abstract

Why do politicians advocate trade protections to save domestic jobs when neoclassical trade models suggest that small open economies should implement free trade? The novel insight of this paper is that trade protections can be rationalized as a second-best policy that improves the domestic welfare when the equilibrium unemployment is different from the constrain-efficient unemployment. To understand the puzzle, I incorporate a Diamond-Mortensen-Pissarides frictional labor market into the standard Heckscher-Ohlin model of international trade. The model offers four main findings. First, when the relative price of the labor (capital)-intensive good increases, equilibrium unemployment decreases (increases). Second, a labor market in a competitive equilibrium is constrained-efficient when the Hosios condition is satisfied. Third, a capital-abundant country with inefficiently high unemployment may experience welfare losses from trade. Conditional on having the same observed trade share, a labor-abundant country with inefficiently high unemployment have extra welfare gains from international trade. Finally and importantly, when the labor market in a small open economy generates inefficiently high equilibrium unemployment, the optimal trade policy is to raise the domestic price of its labor-intensive goods (an import tariff in a capital-abundant country and an export subsidy in a labor-abundant country). Free trade is optimal only when a labor market is initially efficient. The model predictions are supported by patterns of tariffs in WTO member countries.

Suggested Citation

  • Wisarut Suwanprasert, 2016. "Optimal Trade Policy, Equilibrium Unemployment and Labor Market Inefficiency," 2016 Papers psu467, Job Market Papers.
  • Handle: RePEc:jmp:jm2016:psu467
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    References listed on IDEAS

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    1. Optimal Trade Policy, Equilibrium Unemployment and Labor Market Inefficiency
      by Christian Zimmermann in NEP-DGE blog on 2016-05-13 18:00:31

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    Cited by:

    1. Tanapong Potipiti & Wisarut Suwanprasert, 2019. "Why Does the WTO Prohibit Export Subsidies But Not Import Tariffs?," PIER Discussion Papers 119, Puey Ungphakorn Institute for Economic Research.

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    More about this item

    JEL classification:

    • F11 - International Economics - - Trade - - - Neoclassical Models of Trade
    • F13 - International Economics - - Trade - - - Trade Policy; International Trade Organizations
    • F16 - International Economics - - Trade - - - Trade and Labor Market Interactions
    • F66 - International Economics - - Economic Impacts of Globalization - - - Labor

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