1. 1 Welcome to Econ 414 International Economics Study Guide Week Six (Chapter 5)

2. 2 What are the causes of international factor movements? Assume factors of production are mobile between India and the U.S. Assume the U.S. is capital abundant and India is labor abundant. Labor earns a higher wage in the U.S. than in India. Inequality of wages would cause workers from India to migrate to the U.S.

3. 3 What are the effects of international factor movements? Wages would begin to _____ in the U.S. as supply increases. Wages would begin to ______ in India as supply decreases. Migration of labor would stop when wages are equal between countries – no more gains from migration. fall rise

4. 4 What about capital? Capital will migrate from the U.S. to India to earn a higher rate of return. Capital will migrate until the rate of return is the same between the two countries.

5. 5 Fact In general, capital is more mobile than labor; why? –Immigration restrictions –Language/cultural barriers

6. 6 How does the international factor movement compare to international trade? International trade is sometimes –a substitute for factor movements between countries. –a complement for factor movements between countries

7. 7 Example of substitute Ireland is capital abundant and has comparative advantage in production of capital intensive goods and return to capital is low. Two alternatives: 1.Export capital intensive good (machines) & import labor intensive good (shoes), or 2.Capital leaves the nation and labor enters the nation until there is no more comparative advantage or disadvantage; produce machines and shoes domestically. –If factor movements are blocked, trade is pursued.

8. 8 Example of complements Shoes and machines can be traded, but some goods and services can not be traded. Like what? –Haircuts Someone who lives in Ireland will not go to Turkey to get a hair cut But the Turkish hairdresser (labor) can migrate to Ireland

9. 9 Which one is economically preferred? And why? The literature has shown that When possible, factor movements are preferred to trade. –World output will be maximized –Blocking factors from earning the highest rate of return is less efficient.

10. 10 What is foreign direct investment (FDI)? It implies directly investing in the firm’s plant and equipment. (Physical investment as opposed to just sending money.) It takes the form of a domestic corporation opening a foreign subsidiary or buying control of existing foreign firm represents real investments in land, nonresidential investment, and equipment and software.

11. 11 FDI: Facts More than 92% of FDI originated in developed countries. World’s developed countries received nearly 76% of the world’s FDI.

12. 12 FDI in the world Table 5.2

13. 13 Question: what does Africa’s negative outflow of FDI mean? Africa has a negative outflow of FDI which means that Africa has withdrawn its FDI outflow.

14. 14 Sample Question 1 A relatively large amount of intraindustry trade would be associated with: –A) an index of intraindustry trade close to 1.0. –B) an index of intraindustry trade close to zero. –C) an index of intraindustry trade of 0.20. –D) a large amount of imports in a product category with few exports in the same product category.

15. 15 Sample Question 2 According the product cycle model, comparative advantage: –A) may move from one country to another country as the product matures. –B) is based on the income level of the domestic country. –C) will remain in the country where the product is introduced. –D) is based on economies of scale.

16. 16 Sample Question 3 Why is international trade viewed as a "second best" alternative when compared to the movement of the factors of production? –A) Being able to move the factors of production would increase world output. –B) International trade has too many problems associated with it. –C) Factors of production are cheaper and easier to acquire. –D) Resources are best used with international trade.

17. 17 What are the reasons for FDI? Higher rate of return on investment because –the receiving nation is capital scarce and labor abundant Low cost of labor

18. 18 What are the reasons for FDI? Low cost of transportation of output Low cost of transportation of inputs Low cost of paper work (licensing, permits,..etc.) Low taxes High trade barriers in the receiving nation Low cost of natural resources

19. 19 What are the effects of FDI? In the source country The country that sends the capital to another country. –When capital moves out of the source country, the supply of capital ________ which causes an increase in the rate of return to capital. Owners of capital in source country benefit Owners of transferred capital benefit from higher rate of return in foreign country. decreases

20. 20 What are the effects of FDI on the labor in the source country? Reduction in supply of capital means less capital for labor to use. –Capital-to-labor ratio declines –Productivity of labor declines Wages decline –Note: in a competitive market wage = marginal product of labor

21. 21 Question Why when there is less capital the productivity of labor declines? Think of me as a labor, in which scenario will I be more productive in class? 1.Give me a chuck and a blackboard 2.Give me a laptop and projector –Note: by “less capital” we mean lower valued (less technologically advanced) capital

22. 22 What are the effects of FDI on the host country? Host country –The country that receives the factor of production from another country. Supply of capital increases which ________ the rate of return. –Labor productivity _________ because there is more capital per worker. –Return to labor increases. Opening of trade increases wages and decreases returns to capital in the labor- abundant country. decreases Increase

23. 23 Preparation for understanding Figure 5.1 Before we get to the figure let’s prepare ourselves What is a demand curve for oranges? –A curve that shows the highest price we are wiling and able to pay at each level of quantity of oranges The highest price represents the value of oranges to us

24. 24 The same is true for demand curve for capital D P Q2 10 5 7 The value of 2 nd unit of capital is €10 But what determines this value? It depends on how productive capital is We are willing to pay the 2 nd capital €10, because it can produce €10 of output for us. €10 is the value of marginal product of capital

25. 25 The same is true for demand curve for capital D P Q 5 If we end up hiring 5 capital, each unit produces up to the height of the demand curve If we could hire capital continually, the area under the demand curve up to 5 unit of capital = total output

26. 26 Figure 5.1: Output and Welfare Effects of International Capital Mobility Return to Capital, U.S. Capital Stock, U.S. Return to Capital, India Capital Stock, India RUSRUS RIRI D US D INDI A Sk E E’ US is capital abundant India is capital scarce a b a’a’ b’ Total output in the US = a + b Total output in India = a’+ b’ Assumption: Supply of capital is fixed (vertical)

27. 27 Figure 5.1: Output and Welfare Effects of International Capital Mobility Return to Capital, U.S. Capital Stock, U.S. Return to Capital, India Capital Stock, India R US ’ RUSRUS RI’RI’ RIRI D US D INDI A Sk’SkSk’Sk E FE’ F’ a d e c b a’ d’ e’ c’ b’ Capital moves from US to India Out put in US drops by ____________ b+ c Output in India goes up by ________ c’+b’ World out put goes_____ up

28. 28 Figure 5.1: Output and Welfare Effects of International Capital Mobility Return to Capital, U.S. Capital Stock, U.S. Return to Capital, India Capital Stock, India R US ’ RUSRUS RI’RI’ RIRI D US D INDI A Sk’SkSk’Sk E FE’ F’ a d e c b a’ d’ e’ c’ b’ Total return to capital (capital’s share of total output) in the US changes from a + b to ___________ US capital’s share of Indian output is _____. b’ India’s capital’s share of out put declined from a’+d’ to _____. a + d a’

29. 29 Figure 5.1: Output and Welfare Effects of International Capital Mobility Return to Capital, U.S. Capital Stock, U.S. Return to Capital, India Capital Stock, India R US ’ RUSRUS RI’RI’ RIRI D US D INDI A Sk’SkSk’Sk E FE’ F’ a d e c b a’ d’ e’ c’ b’ Us labor’s share of output used to be e+d+c. Now it is ________. India’s labor’s share of out put used to be _________ Now it is _______. a’ e e’ e’+d’+c’

30. 30 Recap 1.World output went up 2.US capital’s share of the world output went up 3.India’s capital share of the world output went down 4.US labor share of out put went down 5.India’s labor share of output went up

31. 31 Governments restrict the free flow of foreign direct investment in several ways. –Industrial Policy A government policy designed to stimulate the development and growth of an industry. –It tends to favor local firms at the expense of foreign firms. The role of Government

32. 32 International Movements of Labor Immigrants –Individuals that permanently change their country of residence to a foreign country. In 1965, 75 million people lived in a country outside their country of birth. In 2000, immigrants residing in a new country was greater than 150 million.

33. 33 Who migrates more? Table 5.3

34. 34 What are the reasons for international movements of labor? Fact: most immigration comes from developing countries. –Push factors- push labor out of these countries low standard of living in developing countries high rates of unemployment. Poverty

35. 35 What are the reasons for international movements of labor? (you asked questions) Pull factors- pull workers into developed nations –Higher incomes –Higher standard of living

36. 36 What are the effects of international movements of labor? Assume that India is labor abundant and the U.S. is capital abundant. –Wages in the U.S. higher than India. –Indian labor would migrate to the U.S.

37. 37 What are the effects of international movements of labor on Indians? Workers in India will benefit from ______ wages with the reduction in supply. India’s capital-to-labor ratio ________. –Increase in India’s labor productivity. –Indian wages will rise. India’s total output will fall. –Returns to owners of capital in India fall because of Higher wages paid Reduced production higher rises

38. 38 What are the effects of international movements of labor on Americans? Increase in labor force lowers the amount of capital each worker has available to work with. –Capital to labor ratio falls in the U.S. which decreases labor productivity. –Wages in U.S. fall. Total output rises.

39. 39 What are the effects of international movements of labor on Americans? Owners of capital in the U.S. gain –Lower wages paid –Produce more output (U.S. labor will oppose open immigration.) (Owners of capital favor open immigration.) The output of the world economy rises since workers can move to countries where they are more productive. Note: I will not go over Figure 5-2 –You are responsible to know it.

40. 40 International Movements of Labor Immigration and Public Policy –To maximize a country’s total output, policy should be completely open immigration. –Output would be maximized but wages may be harmed. –Few countries have open immigration but few have a ban on immigration.

41. 41 International Movements of Labor Government must balance welfare of society and welfare of particular groups that immigration affects. As economic and political factors change over time, so does immigration policy especially in developed countries. Brain drain –The movement of skilled or professional workers from one country to another.

42. 42 International Movements of Labor –Countries have been able to design policies that allow market forces to allocate labor efficiently on a global basis and compatible with public preferences on immigration. For example, the guest worker programs of Europe allow workers from developing countries to work there temporarily rather than to immigrate permanently. –These programs can increase social costs: Unemployment insurance Education Housing Healthcare

43. 43 International Movements of Labor –Offshore assembly provisions Allow U.S. firms to export materials and parts of a good to foreign countries for final assembly; When the assembled goods are returned to the U.S., duties are assessed only on the value added in the foreign country. Final good is imported back to the U.S. with duties assessed only on the value added. US firms can take advantage of lower foreign labor costs without importing labor.

44. 44 International Movements of Labor –Provisions have been used for U.S. firms to set up plants in Northern Mexico called maquiladoras. –Firms have used foreign labor to process paperwork as well as subcontract design and engineering work.

45. 45 The Multinational Corporation A firm that conducts part of its business across national boundaries (MNC) Primary determinant of international movement of capital and FDI Labor shortages in one country cause firms to recruit from another or move workers to another.

46. 46 The Multinational Corporation MNCx exist due to efficiencies from internalizing certain activities instead of contracting them out Profitable to set up business in other countries with horizontal and vertical integration How to control investments in foreign countries affect decisions

47. 47 Table 5.4 The Multinational Corporation

48. 48 The Multinational Corporation Reasons for the Existence of MNCs –Choices for control The firm can export its product to foreign firm and let the foreign firm handle all aspects of selling it in the foreign market. MNC can set up wholly-owned subsidiary to serve the foreign market: –The firm has complete control from the production to the ultimate customer. The firm can establish joint ventures with a firm in a foreign market. –It may need raw materials from foreign market. –It reduces overall production costs by manufacturing sub- components in foreign market.

49. 49 The Multinational Corporation OLI approach –A framework that explains why MNCs engage in foreign direct investment. O is ownership – commonly ownership of an intangible asset –A good or process a firm has developed that other firms find difficult to replicate. –It is a source of comparative advantage.

50. 50 The Multinational Corporation Maintaining control of the asset makes it necessary to set up a subsidiary in a foreign market. Licensing agreement –A domestic firm licenses the right to produce and market a good or to use a technology to a foreign firm in a country. –It increases domestic firm’s profits. –It may allow foreign firm access to technology that may become a competitor

51. 51 The Multinational Corporation L is for locational advantages –It may be in the firm’s global interests to locate outside home country. –For example, location of natural resources –Take advantage of cheaper imports – vertical integration –Horizontal integration to more profitably serve foreign market –Natural and legal barriers to trade

52. 52 The Multinational Corporation I is for internalization –A firms’ propensity to perform functions internally that outside firms could do –Firm derives benefit from internalizing process

53. 53 The Multinational Corporation Table 5.5

54. 54 The Multinational Corporation Public Policy Toward Multinational Corporations –MNC managed from home country but operates in a foreign country –How are MNCs regulated in host countries? –How do home and host countries tax MNCs?

55. 55 The Multinational Corporation Host country could ban activities of MNCs Host country could treat MNCs as a domestic firm – national treatment Most likely regulation falls between the two extremes –Percentage of firm’s output exported –Firm’s ability to repatriate profits

56. 56 The Multinational Corporation Generally MNCs must pay taxes on profits of local subsidiaries in foreign countries. Home country gives tax credit against local tax liability for taxes paid abroad. If taxes differ significantly, incentive to transfer profit to lower taxed country.

57. 57 The Multinational Corporation Transfer pricing- the over or under pricing of goods in intra-firm trade of MNC. –Allows firms to use intra-firm pricing to maximize after-tax profits –Was used to transfer profits out of countries with exchange controls Some transfer pricing will occur until income taxes are uniform across countries.