Optimal Trade Policy, Equilibrium Unemployment and Labor Market Inefficiency

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, we incorporate a Diamond-Mortensen-Pissarides frictional labor market into the standard Heckscher-Ohlin model of international trade. The model offers various findings. First, when the relative price of the labor (capital)-intensive good increases, equilibrium unemployment decreases (increases). Second, the 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 an extra welfare gain from international trade that is not present in traditional models without equilibrium unemployment. Finally, when the la- bor 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 sup- ported by patterns of tariffs in WTO member countries.