Market Thickness, Labour Market Flexibility and Wage Dynamics 

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CHAPTER 3 Factor Market Integration, Unemployment, and Earnings Instability under Invisible Handshake with Heterogeneous Workers

Introduction

\…the structural evolution of the global economy today and its e ects on the US economy mean that, for the rst time, growth and employment in the US are starting to diverge. » [excerpt taken from the article written by Michael Spence in Foreign A airs, on July/August 2011].
We analyse the e ect of increased factor market integration, in the form of cost re-ducing o -shoring and immigration, on earnings instability. In particular, we adapt an implicit contracting model by embedding it into a dynamic general equilibrium model to study the resulting frictional unemployment, long-term unemployment, and how earnings instability arise from the increases in unemployment. The model results, based on di er-ences in factor endowments across countries, suggest that this factor market integration that can be viewed as one manifestation of globalisation can indeed have negative e ects on unemployment and consequently earnings instability.
We conceptualize factor market integration, arising either via the workers’ decision on where to work or the rms decision on where to invest. Thus low barriers on immigration and investment will both work towards the integration of factor markets. While the movement of workers may be formally due to the deregulation of worker movements (as in UK with East European workers), the regulation of intake of workers (as in Germany with Turkish workers), the in ux of refugees (as in Europe recently with Syrian workers), or unauthorized immigrants (as in US with illegal Mexican of the workers), the end result is the same; foreign workers legally or illegally seek employment in countries other than where they reside to improve their welfare. Similarly, employers may choose to (partially or completely) relocate their operations in a foreign country (i.e., o -shoring) if they nd it advantageous to do so.
Just as increased goods market integration (i.e., trade) did before the 1990s, during the last two decades factor market integration is evoking suspicion and insecurity among general public in developed countries. Even if it can be demonstrated that factor market integration will increase the total value of production and that countries involved in those developments will be better o overall, there is not much consensus on subgroups that may be adversely a ected during the transition and afterwards once market conditions stabilize (See Bhagwati and Blinder, 2009 for a debate in the context of services o -shoring). As a result of public ambivalence towards globalisation, an increasingly dominant characteristic of political debate since the new millennium { in the US and other developed countries { is anxiety over factor market integration. The common resentment that is the fuel of those campaigns against globalisation is the expectation of severe deterioration in the economic fortunes of the home country workers. Consistent with high unemployment rates could be seen as primarily a European problem from the 1970s until the recession in late 2007. Katz (2010) implies that the recession from late 2007 ended this dichotomy and merely ,exposed the deferred impact of globalisation1 on unemployment in the US.2 In fact, Daly et al. (2012)’s estimate that the natural rate of unemployment in the US has risen from a pre-recession level of 5 percent to 6 percent and that long-term unemployment has almost tripled since the 1990s is consistent with the jobless recovery argument of Katz. In particular, on both side of the Atlantic Ocean, incidence of long-term unemployment3 has been increasing; in the US from 6.3 percent in 1991 to 18.7 percent in 2015 percent, and in the EU from 43.4 percent in 1991 to 48.3 percent in 2015.
Immigration and o -shoring are widely viewed as the \usual suspects » for the wors-ening of labour market conditions. During the 2004 US election campaign, there were calls to tighten visa restrictions on foreign software engineers to slow down the o -shoring of Information and Communication Technologies (ICT) jobs.4 Trade statistics suggest o -shoring is not limited to the ICT industry and it is an inevitable trend in the whole economy. For example, the index of o -shoring of goods and services production5 rose from 7% to 10% in the US and 12% to 16% in OECD member countries between 1995 and 2005 (OECD, 2010).
Recently, relevant political discourse has mostly focused on immigration. During the 2016 US presidential election, the GOP nominee consistently stated that he wants to build a wall between the US and Mexico to deter illegal immigrants (BallotPedia, 2016).
Also, migration from EU member countries has been a central issue in the UK referendum campaign, famously called BREXIT, over whether to stay in EU. The data also supports the increase in immigration. After the Immigration and Nationality Act of 19656 passed in the US, the number of immigrants entering the country did increase. But the more signi cant increase in the presence of foreign-born workers in the United States occurred during the 1990s and 2000s. For example, the number of people obtaining lawful per-manent resident (LPR) status (those entering with permanent resident visas) annually was 0.178 million between 1925 to 1965, 0.479 million between 1966 to 1988, and 1,012 million between 1989 to 2014 (See O ce of Immigration Statistics, 2016). The stock of LPRs was estimated in 2013 at 13.1 million, with an additional 8.8 million eligible to naturalize, and 63 percent of LPRs obtained that status in 2000 or later (See Baker and Rytina, 2013). An unintended consequence of the Immigration and Nationality Act of 1965 was the increase in unauthorized immigration to the US due to the termination of guest worker program with Mexico, also known as the Bracero Program. As of 2012, the unauthorized immigrant population residing in the US was estimated to be 11.4 million, 42 percent of whom entered in 2000 or later, and 59 percent of whom were from Mexico (See Baker and Rytina, 2014). Recent increases in immigration are not limited to the US. Between 1995 and 2015 in the UK, among working age adults the share of immigrants more than doubled { from 8.2 percent to 16.6 percent (from 3 million to 6.7 million).7
Another observed development accompanying factor market integration is the increase in earnings instability since 1970. Earnings instability is indicative of economic insecurity and risk and measures of transitory variation and volatility of income is used to summarise it. In the previous essays, wage volatility was the the main indicator of earnings instability. In this essay, we will use transitory earnings variation as measure of income risk. Typically, in a given period, income variation can be decomposed into ‘permanent’ and ‘transitory’ variance components. While permanent income variance is a subject of income inequality, transitory component uctuates around the permanent income and thus it is related to earnings instability. Gottschalk and Mo tt (1994) nd that increased transitory variation explains one-third of the expansion in overall cross-sectional earnings inequality in the 1980s. When transitory earnings variance is decomposed according to its source, i.e., wage variation versus employment variation,8 it turns out that 40 percent of the increase in the transitory earnings variance is due to employment variation. Gottshalk and Mo tt (2009), in a follow-up research, note that the transitory earnings variance has risen through the late 1980s and has not fallen back since then.
There are numerous studies that investigate the impact of immigration and o -shoring on unemployment in isolation. For instance, Brucker (2011) studies the e ect of immigra-tion on unemployment in the US and Europe. He nds that unemployment increase by 0.3 percent when immigration increase by 1 percent of the population.9 Crino (2010) focuses on services o -shoring in the US and nds positive employment e ects of o -shoring for relatively skilled home country workers while less skilled home country workers may have to be displaced as expected of Feenstra and Hanson (1996).10
In our view, o -shoring and immigration are closely related, so that studying them separately might potentially underestimate the impact of factor market integration. One study that investigates o -shoring and immigration as a joint phenomena is Ottaviano et al. (2013). In their model, immigrant workers and o shore workers compete with each other, and exhibit stronger substitutability between them than occurs between im-migrant workers and home country workers. Their nding is based on the US data and supports credibility to our model, in which no distinction is made between immigrant workers and o shore workers, but rather developments in immigration and o -shoring since the 1990s are seen as comprising an overall integration of factor markets. Another study that analyses the impact of globalisation using tools from contract theory and in-ternational trade theory is Karabay and McLaren (2010). While their primary concern is to study the impact of globalisation on earnings instability due to wage rate variation, we focus our attention on earnings instability due to employment variation, in particular in-creasing earnings instability due to an increase in frictional unemployment and long-term unemployment.11
For this purpose, we have a stylized open-economy general equilibrium model in which implicit contracts are embedded. In our model, all agents are risk-neutral. There is one sector in which production requires unobservable e ort by a worker and by an employer.

Chapter 1. Market Thickness, Labour Market Flexibility and Wage Dynamics 
1.1. Introduction
1.2. The Model
1.3. Wage-Smoothing Agreement
1.4. Fluctuating-Wage Agreement
1.5. Comparative Static Analysis
1.6. General Equilibrium
1.7. Conclusion
Chapter 2. Joint Design of Unemployment Insurance, Employment Creation and Protection: A Dynamic Model 
2.1. Introduction
2.2. Non-technical Summary
2.3. The Model
2.4. Optimal Contracts
2.5. Comparative Statics Analysis
2.6. Conclusion
Chapter 3. Factor Market Integration, Unemployment, and Earnings Instability under Invisible Handshake with Heterogeneous Workers 
3.1. Introduction
3.2. The Model
3.3. Optimal Contracts
3.4. Comparative Statics Analysis
3.5. Conclusion
Conclusion
References
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Essays on Earnings Instability: The Impact of Search Eectiveness, Labour Market Policy Instruments, and Globalisation

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