Growth and Trade, International Factor Movements

1
Growth and Trade,International Factor Movements

• Appleyard Field ( Cobb) Chapters 1112
• Krugman Obstfeld Chapter 7

2
Growth

• Economic growth may be due to change in
• technology
• amounts of factors of production
• institutions (e.g. allowing international trade)
• Impact of this change
• producers need to decide how to alter production
• consumer need to decide how the change
  consumptions
• world prices may change

3
Growth and PPF
capital saving technological change or increase
of capital
labour saving technological change or increase of
labour force
factor-neutral technological change or capital
and labour increase by the same rate
Paper
Paper
Paper
Clothes
Clothes
Clothes
4
Terminology Production Effects

• Assume a small country (cannot affect world
  prices) exporting clothes
• Let there then be an increase in the production
  possibilities
• Producers select a point from the new PPF, and
  the production effect may be
• neutral production of exports and
  import-competing products grow at the same rate
• protrade production of exports increase
  relatively more
• antitrade production of import-competing
  products increase relatively more

neutral effect
ultra- antitrade effect
antitrade effect
Paper (import)
protrade effect
ultra- protrade effect
Clothes (export)
5
Terminology Consumption Effects

• Similarly consumption effects
• (ultra)protrade consumption of imports increases
  more than consumption of exports larger part of
  income will be spent on imports after growth
• (ultra)anti-trade as above, but the other way
  around
• neutral no change in the relative consumption
  pattern
• The total impact of growth on trade depends on
  the combined production and consumption effects

Note that we are assuming constant prices at this
point
Paper
imports after
imports before
Clothes
exports before
exports after
6
Rybczynski Theorem

• Assumptions constant prices (small-country),
  non-neutral growth in factors
• Growth in one factor leads to an absolute
  expansion in the output of product that uses that
  factor intensively and absolute contraction in
  output of the product that uses the other factor
  intensively
• Why? Relative factor prices cannot change since
  we assume constant product prices ? K/L ratios of
  the industries must remain constant ? capital
  must flow to the labour intensive sector

Growth of labour force ? absolute increase in the
labour- intensive product (clothes) and an
absolute decrease in the production of
capital-intensive product (paper)
Paper
Clothes
7
The Large country case Change in World Prices

• Large country influences world prices
• Assume e.g. that growth in the abundant factor
  (labour) leads to pro-trade production effect and
  neutral consumption effect
• Then, for any given prices, the country produces
  more exports and buys more imports shift of the
  offer curve

OC1
OC0
(PX/PY)1
(PX/PY)2
8
Shift of Offer Curves (2)

• New equilibrium
• More trade
• New terms of trade new relative prices
• (PX/PY)E lt (PX/PY)E

(PX/PY)E TOTE
(PX/PY)E TOTE
Country 2s offer curve
Good Y Imports to country 1 exports from
country 2
Country 1s offer curves
Good X Exports from country 1 Imports to
country 2
9
Terms of Trade Effect

• Part of the gains from trade are lost due to
  reduction in terms of trade
• That is, the price of exports decrease due to
  increased supply of exports
• alternatively price of imports increases due to
  increased demand of imports

Paper
TOT1
TOT0
TOT0
Clothes
10
Immiserizing Growth

• The reduction in terms of trade is so large that
  countrys welfare decreases due to increase of a
  factor of production / improvement in technology

Paper
TOT1
TOT0
Clothes
Jagdish Bhagwati (1958) Immiserizing Growth A
Geometrical Note. Review of Economic Studies 25
11
Foreign Direct Investment (FDI)

• Definition ownership and control of foreign
  capital
• An foreign investment is recorded as FDI if it
  involves buying more than 10 percent of the
  outstanding common stock of a foreign firm
• Otherwise the investment is classified as
  portfolio investment
• The growth of FDI has been dramatically faster
  than the growth in merchandise trade during the
  past few decades
• Here we are studying the impact of increase in
  physical capital due to FDI

12
Reasons for FDI

• Getting close to the final markets
• Access to raw materials
• Low labour cost
• Risk Diversion
• Firm-specific knowledge
• Trade policy (getting behind the tariff wall)
• etc.

13
Analyzing FDI
Note that we keep the amount of labour fixed and
hence the marginal product of capital is
decreasing
MPPK

• Assume two countries, two factors of production
  (labour and capital) and a single homogeneous
  good with free international movement of capital
• Assume that the marginal physical product of
  capital (MPPK) is decreasing (when labour is held
  constant)
• Remember rMPPKXPX

Capital
14
Capital Market Equilibrium Two Countries, Free
Capital Mobility
Country 1
Country 2
15
Capital Market Equilibrium Two Countries, Free
Capital Mobility
Country 2 MPPK, r
Country 1 MPPK, r
Country 1s eqm capital
Country 2s eqm capital

• In autarky, capital is scarce in country 1 and
  hence return of capital is higher than in the
  capital-abundant country 2
• When capital movements are allowed, capital flows
  from 2 to 1 as long as it can get higher return
  in country 1
• In equilibrium, capital returns must be the same
  in both countries, which implies that MPPK1MPPK2

rA1
r
r
rA2
capital flow
Country 1s initial capital
Country 2s initial capital
Total world capital
16
Presenting Output Geometrically
Country 1 MPPK, r

• The amount of production depends on the amount of
  inputs and the marginal productivity of inputs
  YMPPKKMPPLL
• Remember what area means (e.g. area of a square
  is xy)
• Thus, when we hold labour constant, we can study
  the effect of changes in capital on output via
  the area below the MPPK curve

rA1
output
MPPK
Country 1s capital
17
Effect of Capital Flows in the Two Country Model
Country 2 MPPK, r
Country 1 MPPK, r
Country 1s eqm capital
Country 2s eqm capital

• Country 1s output increases more than country
  2s output decreases ? World output increases as
  a result of more efficient use of world resources
• In country 1, capital owners lose (return on
  capital decreases) and labour wins (increased
  capital increases their productivity and hence
  wages)
• In country 2, the opposite occurs
• we discuss this in more detail in the part about
  migration of labour

rA1
increase of world output
r
r
rA2
increase of output in country 1
decrease of output in country 2
Country 1s initial capital
Country 2s initial capital
Total world capital
18
Possible Benefits fromCapital Flows for the Host
Country

• Increased output and wages (as discussed already)
• Increased employment (if excess supply of labour
  exists)
• Increased exports (usually, though not
  necessarily the case)
• Increased tax revenues (if feasible tax policy
  exits)
• Realization of scale economies
• Technical and managerial skill spill-offs
• Weakening a domestic monopoly

See Appleyard and Field (around page 231) for
discussion
19
Possible Disadvantages from Capital Flows for
the Host Country

• Adverse terms-of-trade effect (if the country is
  large enough exporter of the goods FDI flows into
  or due to transfer pricing)
• Decreased domestic saving (government relaxes
  its efforts to generate domestic savings)
• Crowding out domestic investment (domestic
  investors could finance multinationals rather
  than domestic business)
• Instability of exchange rate (when investment
  flows in the currency appreciates when profits
  are sent back, the currency depreciates)
• Loss of control over domestic policy
• Increased unemployment (investment in
  capital-intensive techniques)
• New local monopolies (if multinationals run local
  firms out of business)
• Inadequate attention to local education and skills

Note that many of the possible benefits
disadvantages are things that we are assuming
away in our simple models. Hence we need other
models to analyze these possible effects. Models
suitable for analyzing some of these effects are
introduced later in the course.
20
International Labour Movements
Country 1 MPPL, w
Country 2 MPPL, w

• Assume homogeneous labour, no costs of migration,
  no preferences regarding the country of residence
• Then we can proceed as with capital country 1 is
  labour-abundant, country 2 labour-scarce ? wages
  are higher in country 2 ? there is an incentive
  to move to country 2 until wages are equal

Country 1s eqm employment
Country 2s eqm employment
wA2
w
w
wA1
migration
Country 1s initial employment
Country 2s initial employment
Total world labour force
21
Distribution of income a geometrical
representation
Country 1 MPPL, w

• The amount of production depends on the amount of
  inputs and the marginal productivity of inputs
  YMPPKKMPPLL ? MPPL(Y-MPPKK)/L
• Competitve labour market ? wMPPLXPX
• Labour gets wL, capital owners get the rest

rents
w
wages
MPPL
labour
22
Impact of Migration
Country 1 MPPL, w
Country 2 MPPL, w

• Country 2 (receiving immigrants)
• wages decrease ? transfer of income from labour
  to capital owners
• total output increases more than what is paid to
  the immigrants ? immigration surplus
• However, there is a decrease in per capita output
  (given diminishing marginal productivity)
• Country 1
• wages increase ? transfer of income from capital
  to labour
• total output decreases more than the wage sum of
  those who left ? immigration deficit
• But, there is a increase in per capita output
  (given diminishing marginal productivity)

Country 1s eqm employment
Country 2s eqm employment
wA2
transfer from labour to capital in country 1
immigration surplus
w
w
transfer from capital to labour in country
gain for the immigrants
wA1
Country 1s initial employment
Country 2s employment
Total world labour force
23
Factor Movements, Trade and the World Prices

• Capital and labour flows alter the factor
  endowments of an economy
• This can be analyzed using the methods introduced
  in the beginning of this lecture (growth of
  factor endowments / techonological change)

Country 2
Capital intensive product
Labour intensive product
Country 1
Capital intensive product
Labour intensive product
24
Total Effects of Growth

• The total impact of changed factor endowments
  depends on the combined impact on production and
  consumption and the possible terms-of-trade
  effect
• Note that you can use this framework to analyse a
  change in any factor of production. For example,
  you might assume that there are skilled and
  unskilled labour and all the migrants are
  unskilled. Then, you can put skilled labour to
  the y-axis instead of capital.

Paper
Clothes