Benedikt Heid
Empirische Wirtschaftsforschung, Universität Bayreuth

Gravity with Unemployment

Abstract: The gravity equation ist he workhorse of international trade flow studies and has been the basis for numerous evaluations of the trade and welfare impact of trade liberalizations. However, its theoretical foundations have neglected labor market frictions. We extend a standard structural gravity model by modeling these frictions within a search and matching framework. Our framework allows counterfactual analysis of changes in trade costs and labor market reforms on trade flows, prices, employment, and welfare. We demonstrate that standard gravity models which neglect adjustments on the labor market typically underestimate welfare effects of trade liberalization by deriving a statistic for welfare. We apply our methodology to evaluate the trade effect of endogenous preferential trade agreements (PTA) for a sample of OECD countries and reconsider the border puzzle. On average our estimates imply that welfare effects of PTAs are doubled when taking into account employment effects. However, some countries experience higher unemployment and lower welfare after trade liberalization.