Harvard University

We study a two-country two-sector model of international trade in which one sector produces homogeneous products while the other produces di¤erentiated products. The di¤erentiated-product industry has \u85rm heterogeneity, monopolistic competition, search and matching in its labor market, and wage bargaining. Some of the workers searching for jobs end up being unemployed. Countries are similar except for frictions in their labor markets. We study the interaction of labor market rigidities and trade impediments in shaping welfare, trade ows, productivity, price levels and unemployment rates. We show that both countries gain from trade but that the exible country which has lower labor market frictions gains proportionately more. A exible labor market confers comparative advantage; the exible country exports di¤erentiated products on net. A country bene\u85ts by lowering frictions in its labor market, but this harms the countrys trade partner. And the simultaneous proportional lowering of labor market frictions in both countries bene\u85ts both of them. The model generates rich patterns of unemployment. Speci\u85cally, trade integration which bene\u85ts both countries may raise their rates of unemployment. Moreover, di¤erences in rates of unemployment do not necessarily reect di¤erences in labor market rigidities; the rate of unemployment can be higher or lower in the exible country. Finally, we show that the exible country has both higher total factor productivity and a lower price level, which operates against the standard Balassa-Samuelson e¤ect