Rigid Labour Markets and Intra-Industry Trade: The Evidence

This paper develops a simple multi-country model with imperfect labour markets to study the effect of labour market frictions – reflected in the compression of the gap in factor returns of capital versus labour – on bilateral trade flows. We use a framework that allows for goods trade and capital mobility and show that labour market imperfections exert opposite effects in the absence (the short run) and presence of capital mobility (the long run), respectively. While a higher degree of labour market rigidity increases exports in a pure trade environment, the reverse takes place when capital is allowed to cross borders additionally. We derive two hypotheses: an increase in labour market imperfections for the larger one of two countries induces a reduction in the bilateral intra-industry trade share in the short run (Hypothesis 1) but an increase in the long run (Hypothesis 2). Our empirical analysis in a panel of 20 OECD countries and annual data for the period 1982-2001 provides support for either hypothesis.