Over the last decade, quantifying the welfare effects from tariff changes has become one of the main challenges among international trade economists. There are a number of quantitative trade models with micro-foundations which emphasize demand-side (Anderson and Van Wincoop 2003), supply-side (Eaton and Kortum 2002), Bertrand competition (Bernard et al. 2003), extensive and intensive margin (Chaney 2008), etc, and conclude that trade liberalization with tariff reductions leads an economy to reach a higher level of welfare compared to pre-liberalization (Costinot and Rodriguez-Clare 2014). While elegant, these models inducing gravity equations share the common assumption, a perfect labor market. Quantitative trade models with full-employment developed so far have not taken account of labor market frictions when evaluating the welfare effects from tariff changes. This paper aims to fill the gap in the trade literature by explicitly considering labor market frictions.
  I employ search-and-matching to a multi-country and multi-sector Ricardian model with input-output linkages, trade in intermediate goods, and sectoral heterogeneity, in order to quantify the welfare effects from tariff changes. The paper shows that labor market frictions can be a source of comparative advantage in the sense that better labor market conditions contribute to lower cost in production. Labor market frictions play a critical role in determining the probability of exporting goods to trading partners, and interact with bilateral trade share, price, expenditures, etc. Unemployment and changes in unemployment rates due to tariff reductions contribute welfare changes across countries, implying that welfare effects based on quantitative trade models with full-employment are likely to be biased. I confirm the biased welfare effects by revisiting Caliendo and Parro (2015), who conduct an analysis of the welfare effects from the NAFTA from 1993 to 2005. I show that the welfare gap between theirs and mine has a positive correlation with changes in observed unemployment rates across countries. With the constructed model, I further conduct counterfactual exercises by asking what would happen if China’s tariffs remain unchanged from 2006 to 2015. It turns out that there are mild welfare effects to trading partners in the world trading system.

Keywords: Quantitative Trade Model, Unemployment, Welfare
JEL Classification: F10, F17, F60 

Executive Summary

1. Introduction

2. The Model
2-1. Consumer
2-2. Firm
2-3. Labor market and production
2-4. International trade

3. Equilibrium
3-1. On the equilibrium
3-2. Changes in equilibrium
3-3. Solution algorithm

4. Counterfactual Analysis Based on the Model
4-1. A revisit to Caliendo and Parro (2015)
4-2. The welfare effect of China’s tariff reductions

5. Conclusion

References

Appendix