Trade and labour market institutions: A tale of two liberalizations

In this paper I study how labour market institutions at the time of a trade reform determine the dynamic response of unemployment. I first document that for a large group of developing countries (1) unemployment increases on average following a trade reform, (2) there are significant cross-country differences in unemployment response, and (3) cross-country variation in the labour market institutions in place at the time of the reform can account for the observed unemployment changes. I interpret this evidence through the lens of a model of international trade, featuring heterogeneous firms, endogenous industry dynamics and search and matching frictions and a dual labour market. I estimate the model to match the pre-liberalization firm dynamic in Colombia and Mexico, two countries that differed by the labour regulations in place at the time of trade liberalization, and I characterize numerically the full transition path towards the new steady state. I show that the dynamic response of unemployment to a reduction in trade costs is non-linear across different combinations of labour market institutions in place at the time of the reform. Consistent with the cross-country evidence, the response is stronger and more persistent when the firing costs are lower and the statutory minimum wage and unemployment benefits are larger. Those three institutions account for up to 46 percent of the average unemployment response in the case of Mexico, and up to 41 percent in the case of Columbia.