4' Trade and factor mobility

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4. Trade and factor mobility

• Globalisation and multinational enterprises

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Outline of the lecture

• motivation
• trade off between factor mobility and trade in
  different theories
• Heckscher-Ohlin-Samuelson
• Factor-proportions model
• Product life-cycle
• Income effects
• Specific factors model
• Economic geography
• empirics

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Motivation

• International factor movements are a pervaisive
  and integral part of the world economy
• Model of international trade tend to disregard
  international factor mobility and vice versa
• As the then President of Mexico Salinas said
  during the NAFTA negotiations We want to export
  goods, not people.

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Motivation

• From a perspective of a firm, it is faced with a
  choice of arms-length trading and multinational
  production
• depending on transport costs and costs of
  establishing a production facility abroad
• depending on the motivation of MNCs they either
  invest and trade in intermediates or trade back
  to the original market or even trade to new
  markets (platform)
• depending on its ability to internalize its
  advantages

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Motivation

• The rapid growth in foreign direct investment
  (FDI) over the last few decades has occurred in
  the context of reductions in barriers to
  investment throughout the world, and the
  empirical evidence shows that investment
  liberalization stimulates FDI
• The effects of FDI can be wide reaching, with
  evidence suggesting that FDI impacts
  significantly on trade, employment and factor
  prices
• According to trade theory, whether foreign direct
  investment (FDI) promotes or substitutes trade
  depends on the motivation for FDI

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Motivation

• if FDI is vertical, where multinational firms
  geographically split stages of production, this
  is likely to stimulate trade.
• if FDI is horizontal, where multinational firms
  produce final goods in multiple locations, this
  is likely to substitute for trade.
• unfortunately, it is not possible to separate the
  data into horizontal and vertical FDI. However,
  theory does provide some guidance by linking the
  type of FDI that is likely to arise to directly
  observable country characteristics.

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Motives for FDI

• Policy framework
• Economic political and social stability
• Rules regarding entry and operation
• Standards of treatment of foreign affiliates
• Policies on functioning and structure of markets
• International agreements on FDI
• Privatisation policy
• Trade policy
• Tax policy

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Motives for FDI

• Economic motives
• Business facilitation
• Investment promotion (image-building,
  investment-generating activities and
  investment-facilitating services)
• Investment incentives
• Hassle costs (corruption, administrative
  inefficiency)
• Social amenities (multilingual schools, quality
  of life)
• After investment services

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Economic motives for FDI

• Market seeking motive
• Market size and per capita income
• Market growth
• Access to regional and global markets
• Country-specific consumer/product preferences
• Structure of markets

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Economic motives for FDI

• Resource/asset seeking motive
• Raw materials
• Low-cost unskilled labor
• Skilled labor
• Technological, innovative and other created
  assets (e.g. brand names) embodies in
  individuals, firms and clusters
• Physical infrastructure (ports, roads,
  telecommunications, power)

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Economic motives for FDI

• Efficiency seeking
• Cost of resources and assets adjusted for
  productivity and labor resources
• Other input costs (transport and communication)
• Membership of a regional agreement conducive to
  the establishment of regional corporate networks

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MOTIVES for FDI
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Two forms of international factor mobility (IFM)

• LABOR worker migration (from low wage countries
  (developing countries) to high wage countries
  (developed countries)),
• CAPITAL capital investment tend to flow from low
  to high return-to-capital countries
• FDI (foreign direct investment) long term
  investment into firms with the aim of permanently
  benefiting the advantages of being present in the
  foreign markets (greenfield, mergers
  acquisitions),
• PI (portfolio investment) short term capital
  investment with the aim of maximizing the
  return-to-capital (financial investments))
• IMF classification
• foreign ownership should exceed 10 of firm's
  equity

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TRADE AND FACTOR MOBILITY IN DIFFERENT TRADE
THEORIES

• NEOCLASSICAL MODEL (HOS MODEL)
• Free trade in goods leads to international
  equalization of product prices, which in turn
  leads to international (absolute and relative)
  factor price equalization.
• Hence, given the FPE theorem (factor price
  equalization) mobility of factors is not needed.
  Similarly, when there is a complete mobility of
  factors, no trade in goods is needed.
• In the HOS model, trade and factor mobility are
  SUBSTITUTES larger trade in goods leads to
  smaller factor mobility and vice versa.

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Two implications of HOS model

• Protectionism volume of FDI and worker
  migrations should be very large (this thesis is
  only partly confirmed by huge migrations in the
  beginning of the 20th century and in the 1960s
  and 1970s,
• Liberalism volume of FDI and worker migrations
  should decline (this thesis does not hold as
  notwithstanding trade liberalization in the
  second half of the 20th century volume of world
  FDI has grown faster than volume of world trade.

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FACTOR-PROPORTIONS MODEL (Brainard 1993)

• HOS model, amended with differentiated goods,
• imperfect competition and intra-industry trade.
• Implications of factor-proportions model (FP
  model)
• If two countries are similar in terms of FP
• There will be no inter-industry trade nor FDI
• Intra-industry trade pattern prevails
• If two countries are very different in terms of
  FP
• FDI flows are likely
• Exports will arise (inter-industry type) from
  host to the home country
• Trade and factor mobility are COMPLEMENTS.

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INCOME EFFECTS LINDER THEORY(Linder 1961)

• Countries similar in factor proportions (and in
  terms of GDPpc) will have similar structure of
  preferences. As a consequence, intra-industry
  trade will arise.
• Implications of Linder theory
• Empirical studies show that the majority of FDI
  and trade that arises due to FDI is within the
  advanced countries group, i.e. between countries
  that are countries of origin as well as countries
  of destination at the same time.
• Similarity in income levels, hence, motivates
  trade as well as FDI at the same time, leading to
  COMPLEMENTARITY of both.

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Motives for foreign direct investment

• Table Geographical breakdown of sales of U.S.
  affiliates in
• Europe, 1966-93 ()

Source World Investment Report, 1998 108.
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• in 1960s, serving the huge local markets in
  Europe seems to dominate (tariff and trade cost
  jumping motive for FDI),
• recently, market access motive seem to be partly
  amended by efficiency motives (sales to other
  markets increase up to 40).
• U.S. affiliates in Europe engage little in
  exports back to U.S. (only 4), indicating
  COMPLEMENTARITY of trade and FDI

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• Table Export orientation of U.S. affiliates,
  1966-93 (v )
• Source World Investment Report, 1998 108.

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Dominant motives of U.S. firms for FDI

• In advanced countries and Latin America dominant
  market-seeking motives for FDI, i.e. access to
  local markets (in 1960s in 1970s export
  orientation of affiliates was below 20 and 10,
  respectively).
• In Asian countries U.S. affiliates serve as
  export platform (export orientation exceeds 65,
  in Malesia, Singapur and Hong Kong it exceeds
  80), indicating clear resource-seeking and
  efficiency-seeking motives for FDI.

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Evolution of world trade and FDI

• Table Total world exports and FDI, 1961-1997

Source Bowen et al., 1998 465, World Investment
Report, 1998 2, average of inward and outward
FDI.
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• After the WW2 and esp. after the Kennedy round
  GATT (1964-1967), world trade has increased
  tremendously.
• In contradiction to HOS implications, after 1975
  FDI flows have increased even faster.

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TEST OF FACTOR-PROPORTIONS MODEL(Brainard 1993a)

• Given the assumption of differences in factor
  proportions, FDI should lead to inter-industry
  flows from affiliates back to the home country.
• There should be no intra-industry trade flows
  neither between parent firm and affiliate nor
  between home and the foreign country.
• The empirical model
• IITij a1DGPLi (or DKLi) a2minBDPi a3maxBDPi
  a4FFij a5Dj.

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Model is estimated in logs at the industry level,
where
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• Two forms of intra-industry trade flows
• MIITij intra-industry trade flows of U.S.
  affiliates abroad and foreign affiliates in the
  U.S. (inter-affiliate trade),
• TIITij total intra-industry trade flows between
  country i and U.S.
• Model is estimated for trade between U.S. and 27
  partner countries using 3-digit BEA (64 product
  groups).

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Table Estimates of characteristics of
inter-affiliate trade (MIIT) and total
intra-industry trade (TIIT) in factor-proportions
model
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• Parameter estimates for affiliate IIT and total
  ITT are similar
• both proxy variables for differences in relative
  factor abundance are significantly negative (in
  line with prediction of the model for total
  trade), while MIIT is more responsive than TIIT,
• minGDP is in line with model predictions, but not
  maxGDP,
• in line with model predictions, transport cost
  negatively affect trade, while MIIT is more
  responsive than TIIT.

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TEST OF PROXIMITY-CONCENTRATION TRADE-OFF
MODEL(Brainard 1993b)

• The model predicts that FDI increases in market
  access
• barriers (transport cost, tariffs) and decreases
  in plant
• economies of scale (horizontal FDI in order to
  serve local
• market).
• There is trade-off between increasing production
  cost
• (less efficient use of economies of scale if
  production is
• divided among many locations) and lower prices
  (trade
• cost are redundant).
• Implications of the model FDI SUBSTITUTES for
  trade
• the higher the trade barriers and the lower the
  plant
• economies of scale.

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• Empirical tests give similar results for both
  forms of IIT, which is
• in line with predictions of factor-proportion
  model for total trade,
• opposite to predictions for inter-affiliate
  trade.
• Moreover, there is surprisingly high correlation
  between both dependent variables, which implies
  that factor-proportions model with differentiated
  goods is not appropriate model for explaining
  motives for FDI, where U.S. serve as target or
  source country.
• In contradiction to the factor-proportions model,
  U.S. FDI seem to be motivated by similarities
  (not differences) in relative factor abundances,
  where transport cost play an important role.

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• Model
• Dependent variables
• Outward side share of affiliates exports in
  total U.S. exports (OUTSH) or export share in
  total U.S. sales in the target country (EXSH).
• Inward side share of foreign affiliates sales in
  U.S. in total U.S. sales of that country (INSH)
  or import share in total U.S. sales of that
  country (IMSH).
• Independent variables
• similarity of preferences (Linder) oz. similarity
  in factor abundance GDPpc in foreign country,
• trade barriers transport cost (FF), foreign
  tariffs (FAT) and U.S. tariffs (USAT), non-trade
  barriers in U.S. (NTB), openness for trade and
  FDI (TOPN, FOPN), corporate tax (TAX), extent of
  depreciation in 1985-89 (EXR),
• economies of scale at the plant level (PSCL).

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• Results indicate
• Linder matters similarity in income
  (preferences) increase affiliate sales and
  decrease regular trade
• Trade barriers matter transport cost, tariffs as
  well as openness for FDI increase U.S. affiliate
  sales abroad and decrease regular exports, while
  trade openness decrease U.S. affiliate sales and
  increase exports
• Economies of scale matter significant plant
  economies of scale decrease affiliate sales and
  increase regular imports

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Specific-factors model

• Neary (1995) develops a two-country model of
  international trade, where capital is specific to
  a given sector and hence immobile in short term
• Goods and factor trade are likely to be
  SUBSTITUTES if internationally mobile capital is
  used in the import competing sector
• On the other hand, if internationally mobile
  capital is used in the exporting sector, they act
  as COMPLEMENTS

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Markusens (1983) model

• Markusen challenged Mudells (1957) finding that
  substitution holds in the Heckscher-Ohlin-Samuelso
  n model
• Under certain conditions, Markusen shows that
  eliminating barriers to factor movement results
  in complementarity

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Markusens (1983) model (source Schiff, 2006)

• He states that the complementarity result in each
  of his models is based on the fact that each
  equilibrium involves a country having the
  relatively high price for the factor used
  intensively in the production of the export good
  (pp. 342-343).
• Thus, factors move to the other countrys sector
  that uses them intensively, resulting in an
  increase in trade. This implies that trade and
  factor movement are complements.

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Markusen with trade policy
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Economic geography

• Economic geography uses concepts of returns to
  scale, transport costs, factor mobility etc. to
  explain the spatial distribution of economic
  activity
• Activity is not equally distributed across space,
  on the other hand, it is very lumpy
• Depending on the structure of the EG models, they
  can imply substitutability between trade and
  factor mobility as well as complementarity

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Economic geography

• Agglomeration forces (scale economies,
  intermediates markets and factor markets)
  generate concentration of economic and
  subsequently trade
• Factor mobility (these chase higher returns) also
  contributes to trade COMPLEMENTARITY
• If factors are not perfectly mobile across
  locations, there will be less trade.