IBE303 Lecture 5

The Basis for Trade: Factor Endowments and the Heckscher-Ohlin Model

Heckscher-Ohlin In General Heckscher, and his student Ohlin, worked in the early part of the 20th century. Paul Samuelson refined their work after WWII. Closer attention is paid in this model to each country’s resource endowment.

Heckscher-Ohlin Model Assumptions 2 countries 2 commodities 2 factors L - labor K - capital Perfect competition exists in all markets. Each country’s endowment of factors is fixed. Factors are mobile internally, but immobile internationally.

H-O-S Assumptions (cont’d) Each producer has a wide range of options as to how to produce X or Y if K is cheap relative to labor, a relatively capital-intensive method will be adopted. if K is expensive relative to labor, a relatively labor-intensive method will be adopted. Each country has the same constant-return-to-scale (CRTS) technology. Tastes and preferences are the same for both countries.

Concepts and Terminology The capital-labor ratio for good X is simply KX/LX, and for Y is KY/LY. If KX/LX > KY/LY, production of good X is capital intensive relative to production of good Y. For example, the amount of capital per worker in the U.S. petroleum and coal industry is $468,000. The similar figure for apparel products is $8,274. Therefore, petroleum and coal is produced in a relatively capital-intensive manner.

Concepts and Terminology Also, production of Y must be relatively labor intensive (If KX/LX > KY/LY, then LY/KY > LX/KX). That is, clothing is produced in a labor-intensive manner (as compared to petroleum and coal).

Relative Factor Intensities, Selected Canadian Industries (2006), in C$ 8-8

Concepts and Terminology Country A is said to be capital abundant relative to Country B if (K/L)A > (K/L)B. For example, if the U.S. has a capital stock of $4.8 trillion and a labor force of 153 million, then K/L is about $32,000. K/L for Mexico works out to $328 billion/45 million = $7,282. Therefore, the U.S. is K- abundant relative to Mexico; Mexico is relatively L-abundant.

Relative Factor Endowments, Selected Countries (2007), in U.S. $ 8-10

Concepts and Terminology To summarize: goods are produced relatively K or L intensively. countries are relatively K or L abundant.

Concepts and Terminology The factor price of labor (the wage) is “w” The factor price of capital is “r” If labor is relatively expensive, w/r will be a relatively big number. If labor is relatively cheap, w/r will be a relatively small number.

More on Factor Prices What makes labor relatively expensive? If it is relatively scarce. What makes labor relatively cheap? If it is relatively abundant. So: If (K/L)A is a relatively big number (that is, capital is relatively abundant), w/r will be a relatively big number, reflecting the relative scarcity of L and abundance of K.

A Review of Trade in the Neoclassical Model Suppose the U.S. is capital abundant relative to Mexico. This, of course, means that Mexico is relatively labor abundant. These differences affect the shape of each country’s PPF. Suppose that cars are produced rel. K-intensively, and textiles labor intensively.

Autarky in Mexico and the U.S. The relative price of textiles in autarky is greater in the U.S. than in Mexico. That is, the U.S.’s autarky price line is steeper than Mexico’s. In symbols, (PTextile/PCar)US > (PTextile/PCar)Mex This means that Mexico has the comparative advantage in textiles.

Autarky in Mexico and the U.S. This also means that the relative price of cars in autarky is lower in the U.S. than in Mexico. That is, (PCar/PTextile)US > (PCar/PTextile)Mex This means that the U.S. has the comparative advantage in cars.

Trade in the H-O Model U.S. Mexico Cars Cars e' Y5 C' Y3 E e Y1 Y4 c' Y6 E' Y2 X1 X2 Textiles Textiles X5 X6 X3 X4

The Result The relatively capital abundant country (U.S.) exports the relatively capital intensive good (cars). The relatively labor abundant country (Mexico) exports the relatively labor intensive good (textiles).

The Heckscher-Ohlin Theorem A country will export the commodity that uses relatively intensively the factor that country has in relative abundance. A country will import the commodity that uses relatively intensively the factor that is relatively scarce in that country.

The Source of Comparative Advantage So it is a country’s relative factor endowment that determines its comparative advantage. This is why the H-O-S model is also called the factor proportions theory.

Changes in Relative Commodity Prices : Review As we learned before, (PTextile/PCar)US falls as the U.S. moves to trade. That is, the international relative textile price is lower than the U.S.’s autarky price. (PTextile/PCar)Mex rises as Mexico moves to trade. That is, the international relative textile price is higher than Mexico’s autarky price.

Changes in Factor Prices In autarky, the K-intensive product (cars) is less expensive to produce in the U.S. as compared to Mexico. This is because K is relatively abundant in the U.S., which makes the price of capital relatively low. As trade commences, r will rise since demand for capital will rise.

Changes in Factor Prices In autarky, the L-intensive product (textiles) is more expensive to produce in the U.S. as compared to Mexico. This is because L is relatively scarce in the U.S., which makes the price of labor relatively high. As trade commences, w will fall since demand for labor will fall.

Commodity and Factor Prices In Trade: A Summary In our example, (PTextile/PCar)US falls as trade commences. (w/r)US also falls. In Mexico, the opposite is happening: (PTextile/PCar)Mex rises. (w/r)Mex also rises. Therefore relative commodity and factor prices move together as trade commences.

The Relative Cost Curve PT/PC (PT/PC)US (PT/PC)Int Both relative commodity and factor prices equalize in trade. (PT/PC)Mex (w/r)Mex (w/r)US w/r (w/r)Int 8-25

The Factor Price Equalization Theorem (FPE) In equilibrium, with both countries facing the same relative product prices, relative costs will be equalized. This can only happen if relative factor prices are equalized between countries.

H-O and the Distribution of Income The H-O theorem, together with the FPE theorem, also tell us about how the incomes of different groups within a country change as trade starts. This provides insight into the politics of free trade.

The Stolper-Samuelson Theorem (S-S) As trade commences, the owners of the relatively abundant factor will find their real incomes rising; the owners of the relatively scarce factor will find their real incomes falling.

H-O and the Distribution of Income According to the S-S theorem, if the U.S. is a relatively K-abundant country, who in America should favor free trade? Who in America should favor protectionism?

Theoretical Qualifications to H-O Suppose we relax some of the many assumptions. Will the implications of the H-O-S model still be the same?

Qualification #1: Demand Reversal Suppose we let demand conditions differ. Suppose domestic demand for the good that uses relatively intensively the relatively abundant factor is very strong in each country. That is, suppose demand for cars is very strong in the U.S., and that demand for textiles is very strong in Mexico.

Qualification #1: Demand Reversal Such strong demand makes the autarky car price in the U.S. higher, and the textile price in Mexico higher. In the extreme, demand reversal could occur: (PCar/PTextile)US > (PCar/PTextile)Mex (PTextile/PCar) US < (PTextile/PCar)Mex

Bottom Line on Demand Reversals If demand reversals occur, the H-O theorem no longer holds: the K-abundant country is exporting the L-intensive good, and the L-abundant country is exporting the K-intensive good.

Qualification #2: Factor Intensity Reversal Implicitly, we’ve assumed that if good X is K-intensive relative to good Y at one factor price ratio, it will be K-intensive at all factor prices. A FIR is when a good is relatively K-intensive at one set of factor prices, but relatively labor intensive at another.

Qualification #2: Factor Intensity Reversal FIRs occur when capital and labor can be substituted more easily in the production of one good than another.

Factor Intensity Reversal: Implications for Trade Suppose France is K-abundant relative to Germany (that is (K/L)France > (K/L)Germany). This means that (w/r) France > (w/r) Germany. Suppose further that there is a FIR: in France, at (w/r ) France apples are produced relatively K-intensively but in Germany at (w/r ) Germany apples are produced in a relatively L-intensive way.

Factor Intensity Reversal: Implications for Trade If trade begins, according to the H-O theorem the relatively K-abundant country (France) will export the rel. K-intensive good (apples) and the rel. L-abundant country will export the rel. L-intensive good (also apples). H-O theorem breaks down.

Qualification #3: Transportation Costs In the real world, it is costly to transport goods internationally. How do the implications of our model change if we allow for transportation costs? Consider the supply and demand curves for textiles in Mexico and the U.S.

Adding Transportation Costs Unless Mexico is the only seller in the world, transportation costs will be borne by both the consumer (the U.S.) and the seller (Mexico). How does this look on the graph?

Adding Transportation Costs U.S. Mexico SText PT PT SText Exp. PIntl PIntl t-costs Imp. DText DText q1 q2 q1 q2 QT QT 8-40

Adding Transportation Costs: the Bottom Line In general, the H-O theorem will still hold. The FPE theorem breaks down, since factor prices only equalize if the commodity prices do. Therefore, in the presence of transportation costs, factor prices have a tendency to move towards each other, but we should not expect equalization.

Relaxing Other Assumptions One can relax many other assumptions and examine how the implications of the model change: perfect competition CRTS identical production technologies lack of policy obstacles factors being perfectly transferable

Post–Heckscher-Ohlin Theories of Trade and Intra-Industry Trade

Posner’s Imitation Lag Hypothesis In Posner’s model, there may be a delay in the diffusion of technology between countries. If a new product is invented in country I, there are two sorts of lags that delay the production the good in country II: imitation lag, and demand lag. During these lags the inventing country will export.

The Product Cycle Model How might comparative advantage change over time? H-O is a static model, and therefore offers little info on this. The Product Cycle model (Vernon, 1966) follows a product from its invention through its “old age.” How does it work?

The Product Cycle Model: The New Product Phase A new product is invented in the developed world. Typically, the new product will be capital-intensive and labor-saving. aimed at high-income consumers. All demand is located in the inventing country.

The Product Cycle Model: The New Product Phase Production is located in the inventing country. Technological uncertainties make mass production unfeasible. No trade occurs during this phase.

The Product Cycle Prodn, consn Inventing country consumption Inventing country production time t0 t1 New product phase

The Product Cycle Model: The Maturing Product Phase The product is increasingly standardized. Consumers are increasingly aware of the product. Mass production becomes possible, and economies of scale are realized. Price steadily drops. Demand in other developed countries picks up, so inventing country producers export more and more.

The Product Cycle Model: The Maturing Product Phase Later in the maturing product phase, other developed countries begin to produce the product. Lower transportation costs may give these new entrants an edge in the emerging markets. Increasingly, output in the inventing country is displaced.

The Product Cycle Prodn, consn Inventing country consumption exports Inventing country production time t0 t1 t2 New product phase Maturing product phase

The Product Cycle Model: The Standardized Product Phase Global demand has grown. Production techniques are well-known and standard. Competition becomes ever fiercer. As a result, production shifts mainly to developing countries. Product differentiation may occur, with the inventing country left producing only fancier versions. The inventing country becomes a net importer.

The Product Cycle Prodn, consn Inventing country consumption imports exports Inventing country production time t0 t1 t2 New product phase Maturing product phase Standardized product phase 10-53

The Product Cycle Theory Vernon’s Product Cycle theory tells us that comparative advantage is fleeting: we need to perpetually invent new products.

Vertical Specialization Different stages of production process may occur in different countries. If different parts of the production process vary in terms of capital or labor intensity, the production process may be spread over multiple countries.

Firm-Focused Theories Stage theory: owners and managers learn over time; this implies exporting firms tend to be larger and run by more experienced managers. Resource-exchange theory: firms internationalize because they cannot generate all resources domestically. Network theory: networking can compensate for any lack of experience or expertise.

The Linder Theory In the H-O model, the pattern of trade is determined by relative resource endowments. A model by Linder (1961) focuses mainly on the demand side. Basic idea is that a country produces stuff to satisfy domestic demand; these goods will be likely exports (and imports, too).

The Linder Theory: An Example Suppose Country I’s income pattern is such that it produces goods A, B, C, D and E. Let Country I have a relatively low per capita income level. Suppose these goods are in ascending order of sophistication: A and B are fairly simple. C, D, and E are slightly more sophisticated.

The Linder Theory: An Example Suppose Country II has a higher level of per capita income. It therefore produces goods C, D, and E (just like Country I), but also F and G. F and G are even more sophisticated.

The Linder Theory: An Example Suppose Country III has an even higher level of per capita income. It therefore produces good E (just like Country I), F and G (just like country II), but also H and J. H and J are even more sophisticated. Let’s look at a diagram of these countries:

The Linder Theory: An Example What products will I and II trade? I A B C D E C, D, and E. II G C D E F III G E F H J 10-61

The Linder Theory: An Example What products will II and III trade? I A B C D E E, F, and G. II G C D E F III G E F H J 10-62

The Linder Theory: An Example What products will I and III trade? I A B C D E E only. II G C D E F III G E F H J 10-63

The Linder Theory So trade will involve goods for which there is overlapping demand. Implication: trade should be most intense between countries with similar levels of per capita income.

The Linder Theory This theory would explain two things that H-O cannot: why most trade is between the industrialized countries, which all have (presumably) very similar resource endowments. why a country might import and export the same product (intra-industry trade).

The Linder Theory The theory has been subjected to a barrage of tests. Sailors, et al. (1973), Thursby and Thursby (1987), and McPherson, Redfearn and Tieslau (2000) and others found evidence to support the Linder theory. Hoftyzer (1984), Kennedy and McHugh (1983) and others found evidence against the theory.

The Krugman Model Incorporates economies of scale and monopolistic competition. Consider a graph: The price of the good relative to the wage (P/W) is on the vertical axis. Per capita consumption (c) is on the horizontal axis.

The Krugman Model Two functions are on the graph: The PP curve slopes upward, since P/W increases as c increases. The ZZ curve has a negative slope: as c increases, average cost decreases (due to economies of scale). To maintain the zero-profit condition in monopolistically competitive firms, price must be reduced.

The Krugman Model Point E is the initial equilibrium, with the firm maximizing its profit, and earning zero economic profit. P/W P Z E (P/W)1 Z P c1 c

The Krugman Model Suppose this firm exists in country 1. Let country 2 be identical to country 1 on both the demand and the supply sides of the economy. Traditional trade theory posits that these countries would not trade. However, because trade effectively increases the market size in each country, economies of scale are realized in the Krugman model. Trade effectively shifts the ZZ curve to the left.

The Krugman Model Point E΄ is the new equilibrium; per capita consumption and P/W have both decreased as a result of trade. P/W P Z Z΄ E (P/W)1 E΄ (P/W)2 Z P Z΄ c1 c2 c

The Krugman Model: The Bottom Line Although trade causes per capita consumption (c) to fall, total consumption of the firm’s output has risen. P/W has decreased because of trade; this also means that its reciprocal (W/P) rises. This suggests that trade causes the real wage of workers to rise. Even owners of the relatively scarce factor see a rise in real wages, suggesting that the negative income distribution effects of trade may not occur.

Other Trade Models Reciprocal dumping model (Brander and Krugman, 1983) Because of imperfect competition, intra-industry trade occurs in this model. Welfare may increase due to increased competition, but may decrease due to waste involved with transporting identical products internationally; the overall welfare effect is unclear. The gravity model The focus is on explaining trade volume. These models illuminate the underlying causes of trade.

Intra-Industry Trade Examples: Japan imports and exports computers. The Netherlands imports and exports beer. The U.S. imports and exports broccoli. H-O-S is useless in explaining this - there’s no way a country could export and import the same good.

Intra-Industry Trade: Possible Explanations Product differentiation Transportation costs Dynamic economies of scale Degree of product aggegation Differing national income distributions Differing factor endowments and product variety

How Common is Intra-Industry Trade? A recent study by Brülhart attempts to measure IIT in several countries, using an index: an index value of 0 implies no IIT is taking place. an index value of 1 implies that a country’s exports in one product category exactly equal its imports.

Intra-Industry Trade: Evidence from Brülhart (2009)

Economic Growth and International Trade

Introduction How does economic growth in China affect other countries? Has China’s growth come at the expense of other countries?

The Trade Effects of Growth As real income rises, producers are affected: how should they alter production in response? consumers are also affected: how should they spend the additional income?

Trade Effects of Production Growth If a country experiences growth its PPF will shift outwards. The producers in that country will now have the chance to select a production point on the new PPF. Suppose a country exports good X and imports good Y.

Trade Effects of Production Growth Y III IV I II A X

Trade Effects of Production Growth New production points in region II of the new PPF involve production of more of the export good (Y) and less of the import good (X). This is ultra-protrade production growth. This means the growth has a strong positive effect on the country’s desire to trade.

Trade Effects of Production Growth New production points in region I of the new PPF involve production of more of the both goods, but proportionately more of the export good (X). This is protrade production growth. This growth will have a positive effect on the country’s desire to trade.

Trade Effects of Production Growth New production points in region IV of the new PPF involve production of more of the import good (Y) and less of the export good (X). This is ultra-antitrade production growth. This means the growth has a strong negative effect on the country’s desire to trade.

Trade Effects of Production Growth New production points in region III of the new PPF involve production of more of the both goods, but proportionately more of the import good (Y). This is antitrade production growth. This growth will have a negative effect on the country’s desire to trade.

Trade Effects of Consumption Growth If a country experiences growth, the consumers in that country will now have the chance to select a new consumption point. Let us continue to suppose a country exports good X and imports good Y. To focus on consumption, we’ll look only at the consumption possibilities frontier (CPF).

Trade Effects of Consumption Growth III IV Y I II B CPF X

Trade Effects of Consumption Growth New consumption points in region II of the new CPF involve consumption of more of the export good (Y) and less of the import good (X). This is ultra-antitrade consumption effect. This means the growth has a strong negative effect on the country’s desire to trade.

Trade Effects of Consumption Growth New consumption points in region I of the new CPF involve consumption of more of the both goods, but proportionately more of the export good (X). This is antitrade consumption effect. This growth will have a negative effect on the country’s desire to trade.

Trade Effects of Consumption Growth New consumption points in region IV of the new CPF involve consumption of more of the import good (Y) and less of the export good (X). This is ultra-protrade consumption effect. This means the growth has a strong positive effect on the country’s desire to trade.

Trade Effects of Consumption Growth New consumption points in region III of the new PPF involve consumption of more of the both goods, but proportionately more of the import good (Y). This is a protrade consumption effect. This growth will have a positive effect on the country’s desire to trade.

Production and Consumption Effects Combined To summarize the combined production and consumption effects of growth, we look at the income elasticity of demand for imports (YEM). YEM is the percentage change in imports divided by the percentage change in national income.

Production and Consumption Effects Combined YEM = 1: neutral effect 0 < YEM < 1: antitrade effect YEM < 0: ultra-antitrade effect YEM > 1: protrade or ultra-protrade effect

Sources of Growth Technological change Factor-neutral: results in same relative amounts of K and L are used. Labor-saving: results in increases in relative amount of capital used. Capital-saving: results in increases in relative amount of labor used.

Technological Change: Commodity-neutral Y X

Technological Change: Commodity-specific Y Y X X 11-97

Sources of Growth Factor Growth Factor-neutral: K and L grow at the same rate. Growth in K Growth in L

Factor Growth: Factor-neutral Y X

Factor Growth: Factor-specific Growth of factor in which good Y production is intensive. Growth of factor in which good X production is intensive. Y Y X X 11-100

Factor Growth and Trade: Small Country Case Suppose good X is relatively labor-intensive, and Y is capital intensive. Economic growth shifts the PPF disproportionately along the X-axis. Since country is small international prices don’t change.

Factor Growth and Trade (Px/Py)intl Y Production of L-intensive good rises; production of K-intensive good falls. Y1 E1 E2 Y2 X X1 X2

Factor Growth and Trade: the Rybczynski Theorem Growth in one factor of production leads to an absolute expansion of output of the product using that factor intensively and an absolute contraction of output of the product using the other factor intensively.

Factor Growth and Trade: the Rybczynski Theorem If the abundant factor grows, there will be an ultra-protrade production effect. If the scarce factor grows, there will be an ultra-antitrade production effect. If the consumption effect is protrade, growth in abundant factor will increase trade overall; growth in scarce factor causes the opposite.

Growth and Trade: Welfare Effects Growth in K or technological improvements will generally increase welfare, since both increase real per capita income and allow a country to reach a higher indifference curve. Growth in L may or may not increase welfare.

Factor Growth and Trade: Large Country Case Suppose a large country experiences growth in its abundant factor. There will be an ulra-protrade production effect. Assuming a neutral consumption effect, the growth will cause an increase in demand for imports and an increase in the supply of exports. The increased willingness to trade leads to a deterioration in the country’s terms of trade.

Large Country Case (Px/Py)0 Y Growth causes a decline in the TOT to (Px/Py)1. Growth increases welfare, but not as much as in the small country case. C1 C2 C0 E2 E0 E1 (Px/Py)1 X

Growth and Trade: Immiserizing Growth It is possible that the deterioration in the terms of trade will be large enough that a country with growth finds itself on a lower indifference curve. This phenomenon was dubbed “immiserizing growth” by Jagdish Bhagwati.

Immiserizing Growth (Px/Py)0 Growth causes a large enough decline in that welfare is reduced. Y C0 C1 C2 E2 (Px/Py)1 E0 E1 X

Growth and the Terms of Trade: Developing Countries Developing countries may experience declining terms of trade as they grow; this suggests a strategy of export product diversification. Income elasticities of demand for minerals and food products tend to be low; those for manufactured goods tend to be higher. Prices of non-petroleum primary products have generally declined over time.

Factors of Production: Capital Types of capital foreign investment Foreign Direct Investment (FDI) Foreign Portfolio Investment (FPI) FDI: Can involve individuals but the bulk is done by firms. known as: Multinational corporations (MNCs) Multinational Enterprise (MNE) Transnational Corporation (TNC) Transnational Enterprise (TNE)

Global FDI Flows In 2007, the accumulated stock of global FDI was over $15 trillion. This stock grows rapidly each year – 22% in 2007 alone.

U.S. FDI Abroad by Industry, 2007

U.S. FDI Abroad by Region or Country, 2007

World’s Largest Corporations, 2008 (billions of $) 12-116

Reasons for International Movement of Capital To access growing markets. To secure access to raw materials. To avoid tariffs and NTBs. To take advantage of low wages. Defensive purposes to prevent loss of market share. Risk diversification. MNC efficiency over local suppliers.

Capital Market Equilibrium MPPKII MPPKI Initially, suppose Country I has 0k1 as its capital stock. This means Country II will have 0'k1. MPPKII MPPKI 0 k1 0' 12-118

Capital Market Equilibrium MPPKII MPPKI The price of capital will be r1 in Country I and r1’ in Country II. r1 r1' MPPKII MPPKI 0 k1 0' 12-119

Capital Market Equilibrium MPPKII MPPKI Output in Country I r1 r1' MPPKII MPPKI 0 k1 0' 12-120

Capital Market Equilibrium MPPKII MPPKI Payment to Labor Payment to Capital r1 r1' MPPKII MPPKI 0 k1 0' 12-121

Capital Market Equilibrium MPPKII MPPKI Output in Country II r1 r1' MPPKII MPPKI 0 k1 0' 12-122

Capital Market Equilibrium MPPKII MPPKI Payment to Labor Payment to Capital r1 r1' MPPKII MPPKI 0 k1 0' 12-123

Capital Market Equilibrium If capital can flow freely across international borders, k2k1 units of capital will flow from II to I because r1 > r1’. Eventually, r will fall in I and rise in II until r = r2 = r2’ in both countries. MPPKII MPPKI r1 r2' r2 r1' MPPKII MPPKI 0 k2 K k1 0' 12-124

Capital Market Equilibrium MPPKII MPPKI What happens to output in Country I? It rises due to the capital inflow. Increase in output r1 r2' r2 r1' MPPKII MPPKI 0 k2 K k1 0' 12-125

Capital Market Equilibrium MPPKII MPPKI What happens to output in Country II? It falls because of the loss of capital. r1 r2' r2 r1' MPPKII MPPKI 0 k2 K k1 0' 12-126

Capital Market Equilibrium MPPKII MPPKI What happens to output in Country II? It falls because of the loss of capital. Output after capital outflow Loss in output r1 r2' r2 r1' MPPKII MPPKI 0 k2 K k1 0' 12-127

Capital Market Equilibrium MPPKII MPPKI Overall, world output rises. r1 r2' r2 r1' MPPKII MPPKI 0 k2 K k1 0' 12-128

Economic Effects of International Capital Flows On Incomes Output rises in country I (the country to which the capital flows), BUT: Returns fall for capitalists, since their rate of return decreases. Returns rise for laborers. Capitalists are hurt; labor benefits. Therefore, per capita income rises in Country I.

Economic Effects of Int’l Capital Flows On Incomes MPPKII MPPKI Loss by capitalists in Country I r1 r2' r2 r1' MPPKII MPPKI 0 k2 K k1 0' 12-130

Economic Effects of Int’l Capital Flows On Incomes MPPKII MPPKI Gain by laborers in Country I r1 r2' r2 r1' MPPKII MPPKI 0 k2 K k1 0' 12-131

Economic Effects of Int’l Capital Flows On Incomes MPPKII MPPKI Net income gain in Country I r1 r2' r2 r1' MPPKII MPPKI 0 k2 K k1 0' 12-132

Economic Effects of Int’l Capital Flows On Incomes Output falls in country II (the country from which the capital flows), BUT: Returns rise for capitalists, since their rate of return increases. Returns for laborers fall. Capitalists are better off; labor is worse off. Because overall incomes rise, per capita income rises.

Economic Effects of Int’l Capital Flows On Incomes MPPKII MPPKI Income gain by capitalists in Country II r1 r2' r2 r1' MPPKII MPPKI 0 k2 K k1 0' 12-134

Economic Effects of Int’l Capital Flows On Incomes MPPKII MPPKI Lost labor income r1 r2' r2 r1' MPPKII MPPKI 0 k2 K k1 0' 12-135

Economic Effects of Int’l Capital Flows On Incomes MPPKII MPPKI Overall gain in income in Country II r1 r2' r2 r1' MPPKII MPPKI 0 k2 K k1 0' 12-136

International Capital Flows: A Summary Both countries’ incomes rise as a result of capital flows. World output rises. Capitalists in inflow country (Country I) and Laborers in outflow country (Country II). Capitalists in outflow country (Country II) and Laborers in inflow country (Country I) are better off.

Potential Benefits of FDI to Host Country Increased output Increased wages Increased employment Increased exports Increased tax revenues Realization of economies of scale Import of technical and managerial skills Weakening power of domestic monopoly

Potential Costs of FDI to Host Country Adverse impact in the country’s commodity terms of trade Transfer pricing Decrease in domestic savings Decrease in domestic investment Instability in the balance of payments Loss of control over domestic policy

Potential Costs of FDI to Host Country (cont’d) Increase in Unemployment Establishment of Local Monopoly Inadequate attention to the development of local education and skills Loss of natural resources

Why Migrate? Simply put, migration occurs when the expected costs of migrating are less than the expected benefits.

Economic Effects of Labor Migration GDP in Country I is given by the shaded area: MPPLII WII MPPLI WI Income of capitalists Income of laborers wII wII wI wI MPPLII MPPLI 0' L2 0 12-142

Economic Effects of Labor Migration GDP in Country II is given by the shaded area: MPPLII WII MPPLI WI Income of capitalists Income of laborers wII wII wI wI MPPLI MPPLII 0' L2 0 12-143

Economic Effects of Labor Migration If migration is possible, 0L1 workers will work in Country I and 0'L1 in Country II. The wage will be the same: Weq. MPPLII WII MPPLI WI wII wII weq weq wI wI MPPLII MPPLI 0' L2 0 L1 12-144

Economic Effects of Labor Migration What happens to Country I? GDP falls because of out-migration: MPPLII WII MPPLI WI Lost GDP wII wII weq weq wI wI MPPLII MPPLI 0' L2 0 L1 12-145

Economic Effects of Labor Migration GDP falls in country I (the country from which the migrants come), BUT: Wages rise for remaining workers. It can be shown that the decrease in the Country I labor force is greater than the decrease in GDP, so per capita income rises. Capitalists are hurt; labor benefits.

Economic Effects of Labor Migration What happens to Country II? GDP rises because of in-migration: MPPLII WII MPPLI WI Increase in GDPII wII wII weq weq wI wI MPPLI MPPLII 0' L2 0 12-147

Economic Effects of Labor Migration GDP rises in country II (the country to which migrants go), BUT: Wages fall. It can be shown that the increase in the Country II labor force is greater than the increase in GDP, so per capita income falls. Labor is worse off; capitalists are better off.

Economic Effects of Labor Migration Country I’s loss in GDP is smaller than Country II’s gain, so world GDP rises. MPPLII WII MPPLI WI Increase in GDPII wII wII weq weq wI wI MPPLI MPPLII 0' L2 0 12-149

Economic Effects of Labor Migration Country I’s loss in GDP is smaller than Country II’s gain, so world GDP rises. MPPLII WII MPPLI WI Decrease in GDPI wII wII weq weq wI wI MPPLI MPPLII 0' L2 0 12-150

IBE303 Lecture 5

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IBE303 Lecture 5