ibe303 lecture 5

Lecture 5August 9th 2010

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

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).

8

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

Commodity Capital per employee

Petroleum and coal $617,066

Chemicals $144,029

Paper $118,777

Transportation equipment $92,315

Truck Transportation $30,180

Leather and products $12,573

Clothing $8,954

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.

10

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

Country Capital per workerJapan $49,081France $31,810U.S. $31,657Australia $30,792Canada $24,700Mexico $7,282

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

Mexico U.S.Cars Cars

Textiles TextilesX1

Y1

X6

Y4E e

X2

Y2

X5

Y5

e'

E'

C'

c'

X3

Y3

X4

Y6

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

w/r(w/r)Mex

(PT/PC)Mex

(w/r)US

(PT/PC)US

Both relative commodity and factor prices equalize in trade.

(PT/PC)Int

(w/r)Int8-25

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.

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 CostsU.S. MexicoSText

DText

PT

QT

SText

DText

PT

QT

PIntlPIntl

q1 q2q1

q2

Imp.

Exp.t-costs

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

time

Prodn

, consn

t0 t1

New product phase

Inventing country production

Inventing country consumption

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

time

Prodn

, consn

exports

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

time

Prodn

, consn

exports

imports

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

A B C D E

C D E F G

E F G H J

I

II

III

What products will I and II trade? C, D, and E.

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A B C D E

C D E F G

E F G H J

I

II

III

What products will II and III trade?

E, F, and G.

10-62


A B C D E

C D E F G

E F G H J

I

II

III

What products will I and III trade?

E only.

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 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

P/W

c

P

P

Z

Z

c1

(P/W)1

Point E is the initial equilibrium, with thefirm maximizing itsprofit, and earning zero economic profit.E

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

P/W

c

P

P

Z

Z

c1

(P/W)1

Point E΄ is the newequilibrium; per capita consumption and P/W have both decreased as a result of trade.

E

Z΄

Z΄

E΄

c2

(P/W)2

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)

Country SITC 3-digit

Germany 0.570

U.S. 0.503

Japan 0.398

Brazil 0.373

China 0.305

Indonesia 0.291

Bulgaria 0.287

Morocco 0.150

Russian Fed. 0.146

Saudi Arabia 0.070

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

A II

I

IIIIVY

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


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).


B II

I

IIIIV

Y

X

CPF


•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.


•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



•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.


•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


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

X X

Y

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

Y

X X

YGrowth of factor in which good Y production is intensive.

Growth of factor in which good X production is intensive.

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

Y

X

E1

X1

Y1

X2

Y2E2

(Px/Py)intl

Production of L-intensive good rises; production of K-intensive good falls.

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

Y

X

E0 E1

(Px/Py)0Growth causes a decline in the TOT to (Px/Py)1. Growthincreases welfare, but not as much as in the small country case.

C0

C1

E2

C2

(Px/Py)1

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

Y

X

E0 E1

(Px/Py)0 Growth causes a large enough decline in that welfare is reduced.C0 C1

E2

C2

(Px/Py)1

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.

International Factor Movement

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.

114

U.S. FDI Abroad by Industry, 2007Industry Value ($,

billions)Share

Finance and Insurance $531.9 19.1%

Manufacturing 531.3 19.0%

Wholesale Trade 183.0 6.6%

Mining 147.3 5.3%

Information 119.9 4.0%

Depository Institutions 91.8 3.3%

Other Industries 1,193.8 42.8%

Total 2,791.3 100.0%

115

U.S. FDI Abroad by Region or Country, 2007Region or Country Value ($,

billionsShare

Europe $1,551.2 55.6%

Latin America 472.0 16.9%

Asia/Pacific 454.0 16.3%

Canada 257.1 9.2%

Middle East 29.4 1.1%

Africa 27.8 1.0%

Total 2,791.3 100.0%

116

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

12-116

Company Home Country Revenues

Wal-Mart U.S. $378.8

Exxon Mobil U.S. $372.8

Royal Dutch Shell Netherlands $355.8

BP U.K. $291.4

Toyota Motor Japan $230.2

Chevron U.S. $210.8

ING Group Netherlands $201.5

Total France $187.3

GM U.S. $182.3

Conoco Phillips U.S. $178.6

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

MPPKI

k10

MPPKII

MPPKIMPPKII

0'

Initially, suppose Country I has 0k1 as its capital stock. This means Country II will have 0'k1.

12-118


MPPKI

r1

k10

MPPKII

MPPKIMPPKII

0'

r1'

The price of capital will be r1 in Country I and r1’ in Country II.

12-119


MPPKI

r1

k10

MPPKII

MPPKIMPPKII

0'

r1'

Output in Country I

12-120


MPPKI

r1

k10

MPPKII

MPPKIMPPKII

0'

r1'

Payment to Labor

Payment to Capital

12-121


MPPKI

r1

k10

MPPKII

MPPKIMPPKII

0'

r1'

Output in Country II

12-122


MPPKI

r1

k10

MPPKII

MPPKIMPPKII

0'

r1'

Payment to Labor

Payment to Capital

12-123


K

MPPKI

r1

k10

MPPKII

MPPKIMPPKII

0'

r2

k2

r2'r1'

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 Iand rise in II until r = r2 = r2’ in both countries.

12-124


K

MPPKI

r1

k10

MPPKII

MPPKIMPPKII

0'

r2

k2

r2'r1'

What happens to output in Country I? It rises due to the capital inflow.

Increase in output

12-125


K

MPPKI

r1

k10

MPPKII

MPPKIMPPKII

0'

r2

k2

r2'r1'

What happens to output in Country II? It falls because of the loss of capital.

12-126


K

MPPKI

r1

k10

MPPKII

MPPKIMPPKII

0'

r2

k2

r2'r1'

What happens to output in Country II? It falls because of the loss of capital.

Output after capital outflow

Loss in output

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K

MPPKI

r1

k10

MPPKII

MPPKIMPPKII

0'

r2

k2

r2'r1'

Overall, world output rises.

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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

K

MPPKI

r1

k10

MPPKII

MPPKIMPPKII

0'

r2

k2

r2'r1'

Loss by capitalists in Country I

12-130


K

MPPKI

r1

k10

MPPKII

MPPKIMPPKII

0'

r2

k2

r2'r1'

Gain by laborers in Country I

12-131


K

MPPKI

r1

k10

MPPKII

MPPKIMPPKII

0'

r2

k2

r2'r1'

Net income gain in Country I

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.


K

MPPKI

r1

k10

MPPKII

MPPKIMPPKII

0'

r2

k2

r2'r1'

Income gain by capitalists in Country II

12-134


K

MPPKI

r1

k10

MPPKII

MPPKIMPPKII

0'

r2

k2

r2'r1'

Lost labor income

12-135


K

MPPKI

r1

k10

MPPKII

MPPKIMPPKII

0'

r2

k2

r2'r1'

Overall gain in income in Country II

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

MPPLI

WI

L2

MPPLI

wI MPPLII

MPPLII

WII

0 0'

GDP in Country I is given by the shaded area:

wII wII

wI

Income of capitalists

Income of laborers

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MPPLI

WI

L2

MPPLIwI MPPLII

MPPLII

WII

0 0'

GDP in Country II is given by the shaded area:

wII wII

wI

Income of capitalists

Income of laborers

12-143


MPPLI

WI

L2

MPPLI

wI MPPLII

MPPLII

WII

0 0'

If migration is possible, 0L1 workers will work in Country I and 0'L1 in Country II. The wage will be the same: Weq.

wII wII

wI

L1

weq weq

12-144


MPPLI

WI

L2

MPPLI

wI MPPLII

MPPLII

WII

0 0'

What happens to Country I? GDP falls because of out-migration:

wII wII

wI

L1

weq

weq

Lost GDP

12-145


•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.


MPPLI

WI

L2

MPPLIwI MPPLII

MPPLII

WII

0 0'

What happens to Country II? GDP rises because of in-migration:

wII wII

wI

weq

weq

Increase in GDPII

12-147


•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.


MPPLI

WI

L2

MPPLIwI MPPLII

MPPLII

WII

0 0'

Country I’s loss in GDP is smaller than Country II’s gain, so world GDP rises.

wII wII

wI

weq

weq

Increase in GDPII

12-149


MPPLI

WI

L2

MPPLIwI MPPLII

MPPLII

WII

0 0'


wII wII

wI

weq

weq

Decrease in GDPI

12-150


MPPLI

WI

L2

MPPLIwI MPPLII

MPPLII

WII

0 0'


wII wII

wI

weq

weq

Increase in Total GDP

12-151

International Migration: Other Considerations•Migrants now in Country II may send

remittances back to Country I▫So I’s per capita income rises by even

more, and▫II’s per capita income falls by even more.

•If the migrants are “guest workers” and they can be paid a lower wage, it may be possible for capitalists in Country II to be better off without domestic labor being worse off.

International Migration: Other Considerations•If the immigrants are low-skill workers,

the host country may experience rising social costs.

•If the immigrants are high-skill workers, the host country may benefit, and the migrants’ home countries may suffer. This is called the “brain drain.”

ibe303 lecture 5

Education