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Beyond BLS

Beyond BLS briefly summarizes articles, reports, working papers, and other works published outside BLS on broad topics of interest to MLR readers.

December 2022

The aftershock of foreign demand shocks

Summary written by: Harry Nitzberg

Exporting allows businesses to reach new overseas customers by accessing foreign markets. Many barriers limit the capability of firms to export. Some barriers include the cost of exporting, lack of know-how in the laws that govern exports, and limited knowledge of foreign importers and markets. One way to overcome these hurdles is by selling to a business that exports goods for you. In their paper “Foreign demand shocks to production networks: firm responses and worker impacts” (National Bureau of Economic Research, Working Paper 30447, September 2022), economists Emmanuel Dhyne, Ayumu Ken Kikkawa, Toshiaki Komatsu, Magne Mogstad, and Felix Tintelnot use data from Belgian exporting firms and their domestic Belgian suppliers to examine the effects of foreign demand shocks on the wages and production levels of these firms.

In firms that sell to domestic exporters, Dhyne and colleagues find that not only the firm size is typically larger but also wages and productivity are higher than those in Belgian firms that do not sell to Belgian exporting firms. The tradeoff is the introduction of a new form of risk. In tying themselves to international markets, firms can expose themselves to unexpected increases (positive) or decreases (negative) in foreign demand for their products, that is, foreign demand shocks.

In their initial analysis, the authors find that immediately following a positive shock, if sales increase by 10 percent, the average wages and employment at these firms immediately increased: 0.9 percent and 0.7 percent, respectively. Moreover, among workers who stayed in the same firm after the shock, if total sales increased by 10 percent in response to a shock, wages increased by 1.1 percent in the short-term.

The authors highlight that the sustained nature of the wage increases contradicts the textbook understanding of labor markets. Theoretically, the economy should have enough firms and workers that wages should not need to continue to rise to attract more workers during a demand shock (what economists call a “perfectly competitive labor market”). As labor demand rises, wages should rise at first, but as more people want to work (increasing the labor supply), wages should come back down. As the author’s data show, however, as more workers were hired, wages still continued to rise.

On the production side of the firms that sell to domestic exporters, the authors find that a 10-percent increase in foreign demand quickly increased total sales 3.1 percent, with a 2.4-percent increase in the 4th year after the shock. The firm’s domestic intermediate input purchases also rose rapidly in response to the shock, rising 7.6 percent immediately and 6 percent over the next 4 years.

Using these results, the authors construct four models to examine the effects of a 5-percent foreign tariff on Belgian exports (a type of negative foreign demand shock). In contrast to a positive shock, in a negative shock, firms may cut wages because the number of people they can afford to lay off is limited (part of “fixed overhead costs”). Each model contains different assumptions of the economy’s true nature:

  • In model 1, firms have fixed overhead costs and the labor market is not perfectly competitive.
  • In model 2, firms have fixed overhead costs and the labor market is perfectly competitive.
  • In model 3, firms have no fixed overhead costs and the labor market is perfectly competitive.
  • In model 4, firms have no fixed overhead costs and the labor market is not perfectly competitive.

On the basis of the first part of their analysis, the authors believe that the first model—Belgian firms have fixed overhead costs and the Belgian labor market is not perfectly competitive—is the closest to reality. The results of the first model show that a negative foreign demand shock greatly reduces wages. Typically, in economic models, small economies that are open to trade (as Belgium is) are assumed to (1) have perfectly competitive labor markets and (2) have firms that do not have fixed overhead costs. The authors’ findings suggest that models with those two assumptions underestimate the effect of negative foreign demand shocks on wages.