1. 1 BA 187 – International Trade Krugman & Obstfeld, Chapter 7 International Factor Movements

2. 2 International Capital Flows Foreign Direct Investment (FDI)

3. 3 International Capital Mobility F Two Types of Capital Movements possible F Foreign Direct Investment (FDI): –Movement of capital that involves ownership and control. –Generally involves foreign subsidiary of Multi-National corporation (MNC) –Flow of “real capital” primarily affects nation’s production or income. F Foreign Portfolio Investment: –Capital flows that do not involve ownership or control. –Flow of “financial” capital primarily affects nation’s Balance of payments or exchange rate.

4. 4 FDI Positions By Industry, Dec 31, 1995 U.S. Direct Investment Abroad Foreign Direct Invest. in U.S. By Industry Value $ bill Share Share Manufacturing$257.636.2%$210.337.5% Finance except banking212.129.847.98.6 Wholesale trade71.410.071.712.8 Petroleum69.79.835.66.4 Banking30.44.341.87.5 Services27.83.937.96.8 Other42.76.0114.920.5 Total$711.6100%560.1100% Source: U.S. Dept. of Commerce, Survey of Current Business, 1996

5. 5 FDI Positions By Region, Dec 31, 1995 U.S. Direct Investment Abroad Foreign Direct Invest. in U.S. By Country or Region Value $ bill Share Share Europe$363.551.1%$360.864.4% Asia and Pacific126.017.7124.622.2 Latin & South America122.817.322.74.1 Canada81.411.446.08.2 Middle East8.01.15.10.9 Africa6.50.9 0.2 Int’l Organizations3.50.5 Total$711.6100%560.1100% Source: U.S. Dept. of Commerce, Survey of Current Business, 1996

6. 6 Reasons for International Capital Flows F Considerable international capital mobility today. –Capital should flow to areas where expectation of higher return. F Specific rationales for International Capital Flows –Firms invest as response to large and growing international demand for their products. –Developed country firms invest in countries with similar per-capita incomes, and so similar demands for products. –Firms invest to secure access to mineral or raw material supplies. –Firms invest abroad to access markets with high tariff or non-tariff barriers. EU “Tariff factories” to “get behind the tariff wall”. –Firms invest in countries with low relative wages. –Firms invest abroad as defensive measure to protect market share. –Firms invest abroad as means of risk diversification against economic or exchange rate fluctuations.

7. 7 International Capital Mobility World Capital Market Equilibrium

8. 8 Model of Capital Mobility F Two countries, two factors of production (Capital and Labor), single good sold in perfectly competitive market. –Demand for capital equals its marginal physical product, MPK, in each country ( influenced by amount labor). F Assume total world capital stock fixed. –Distribution of capital initially based on “historical accident”. –Initially return to capital less in Home than Foreign country. F Capital assumed to move to highest rate of return over time. –Capital moves from Home to Foreign, equalizing returns. F Results of Capital Flow from Home to Foreign –Output rises by more in Foreign, than it falls in Home. –World output & resource efficiency increase. –Capital owners in Home gain, Labor in Home loses. Opposite occurs for Foreign factors of production.

9. 9 International Capital Mobility Home MPKForeign MPK* Total World Capital Stock O O* MPK* Initial Foreign Capital MPK Initial Home Capital r0r0 r* 0 Final Home CapitalFinal Foreign Capital Capital Flows from Home to Foreign r eq

10. 10 Potential Benefits of FDI to Host F Increased output. F Increased wages. F Increased employment. F Increased exports. –Assumes foreign capital produces goods with export potential. F Increased tax revenues. F Realization of Scale economies. F Transfer of technical & managerial skills to host nation. –Often scarcest resources in LDC’s, hence large potential benefit. F Potential to weaken existing domestic monopolies.

11. 11 Potential Disadvantages of FDI F Adverse impact of host’s Terms of Trade. –Either through export promotion or transfer pricing effects. F Decreased domestic saving or domestic investment. –If FDI partly financed in host capital market, crowds out domestic investment. If not, allows for less domestic saving (public or private). F Instability in Balance of Payments or Exchange rate. F Loss of control over domestic gov’t policies. F Increased unemployment. –If FDI in capital-intensive industries, then possible fall in employment. F Inadequate attention to development of local skills. –MNC’s may reserve skill positions for home country head office.

12. 12 International Labor Mobility Wages and Migration of Labor

13. 13 Model of Labor Mobility F Two countries, two factors of production (Capital and Labor), single good sold in perfectly competitive market. –Demand for labor equals its marginal physical product, MPL, in each country ( influenced by amount labor). F Assume total world labor force fixed. –Distribution of labor initially based on “historical accident”. –Initially return to capital less in Home than Foreign country. F Labor assumed to move to highest wage over time. –Labor moves from Home to Foreign, equalizing wages. F Results of Immigration from Home to Foreign –Output rises by more in Foreign, than it falls in Home. –World output & resource efficiency increase. –Labor in Home gains, Capital in Home loses. Opposite occurs for Foreign factors of production.

14. 14 International Labor Mobility Home MPLForeign MPL* Total World Labor Force O O* MPL* Initial Foreign Labor MPL Initial Home Labor w0w0 w* 0 Final Home LaborFinal Foreign Labor Migration from Home to Foreign weqweq weqweq

15. 15 Unemployment & Labor Mobility F Same model as before except that Home initially has unemployed workers due to wage above equilibrium. –Might be result of minimum wage, or efficiency wages, or labor market imperfections. –Unemployed often termed “surplus labor” in econ. Development. F Labor again assumed to move to highest wage over time. –Labor moves from Home to Foreign, equalizing wages. F Results of Immigration from Home to Foreign –Output rises by much more in Foreign than it falls in Home. –World output & resource efficiency increase is larger. –Labor in Home gains, Capital in Home loses but by less than previous example. Opposite occurs for Foreign factors.

16. 16 Home Unemployment & Labor Mobility Home MPLForeign MPL* Total Home Labor Force O O* MPL* Initial Foreign Labor MPL Final Home LaborFinal Foreign Labor Migration from Home to Foreign weqweq weqweq w0w0 w* 0 Initial Home EmployedU0HU0H

17. 17 Additional Considerations for Labor F Income Transfers –New immigrants may transfer income back to Home country. –This offsets income loss to Home and income increase to Foreign. F Temporary vs. Permanent Immigration –Temporary (guest) workers may be subject to two-tier wage scheme. –Capital owners in Foreign pay guest workers lower wage, than domestic labor. Note both domestic labor & capital win, guest labor also wins but by less than if not discriminated against. –Less domestic opposition to temporary vs. permanent immigration. F Characteristics of Migrant Labor –If typical migrant labor unskilled, then return to both capital & skilled labor likely to rise with immigration BUT maybe greater social costs. –If typical migrant labor skilled (brain drain) potential for large gains to nation gaining this labor (positive externalities, lower social costs).