Endogenous labor market institutions in an open economy

The paper sets up a two-country asymmetric trade model with heterogeneous firms, search frictions and endogenous labor market institutions. Countries are linked by trade in goods and non-cooperatively set unemployment benefits to maximize national welfare. We show that more open and smaller economies have more generous unemployment benefit replacement rates as a larger fraction of the costs is borne by foreign trading partners. These results are in line with empirical stylized facts. Additionally, we find that the optimal level of unemployment benefits is independent from the level of unemployment benefits abroad and that non-cooperatively set unemployment rates are inefficiently high. (C) 2011 Elsevier Inc. All rights reserved.