Efficiency Wages and Unemployment in a Global Economy

This paper considers trade in an asymmetric 2x2x2 world, the two countries being labelled America and Europe. In America, the labor market is perfectly competitive, with flexible wages ensuring full employment. Europe faces unemployment due to efficiency wages. We derive the conditions for there to be factor price equalization (FPE) in this world. It is shown that for every distribution of labor between the two countries, there exists a range of skill allocations leading to FPE. Focusing on the FPE case, we show that labor accumulation in either country decreases wage rates in both countries and increases both the level and the rate of unemployment in Europe. The magnitude of changes in all variables depends on where the labor accumulation occurs. In contrast, skill accumulation in either country benefits labor in both, and the magnitude of the effects is independent from where the skill accumulation occurs. Finally, the entry of newly industrialising countries into the world economy hurts labor in both countries. In all cases, the labor market outcomes in either country are determined by labor market characteristics in both