Labor and Capital Mobility ch. 15

Introduction to factor mobility Where we’ve been Where we’re going Goods are mobile across countries, factors (labor and capital) are not. But: labor and capital are really very mobile Labor migrates (legally and illegally) Capital flow are a major element of international finance Labor and capital mobility – factors freely move across international boarders. Why? HO assumes countries differ in factor abundance. Factor Price Equalization Countries differ in factor endowments  Countries differ in factor prices  Differences in relative prices of goods  Factor price equalization Note: These theories require free trade…we know it is not.

Introduction to factor mobility Question: Would countries trade goods/services or trade factors of production? US is K abundant rus < rm: Abundant K in US would move to Mexico since (rm) is higher Mexico is L abundant wus > wm : Abundant L in Mexico would move to US (oops… but it can’t freely move under NAFTA) Factor mobility could equalize relative factor endowments and prices  eliminating the basis for HO HO and factor mobility can be thought of as substitutes since result from differences in endowments This Photo by Unknown Author is licensed under CC BY-SA

Introduction to factor mobility Concerns about factor mobility: Owners of scarce factors: support trade protection and limits on factor movement (US: AFL-CIO) Owners of abundant factors: support free trade and more factor mobility. Multinational Enterprises (movement of capital): Do their global activities conflict with the well-being of individual countries? Do they have the power to circumvent national sovereignty? LDC’s: worry that foreign firms will invest in them ⇒fear of being exploited LDC’s: worry that foreign firms will not invest in them ⇒fear of limited access to foreign capital, technology, marketing and management skill needed to grow To better understand let’s think about: What is the impact of foreign direct investment (capital mobility) on exports/imports?

Capital Mobility - definitions foreign direct investment (FDI) Def 1: international capital flows in which a firm in one country creates or expands a subsidiary into another country Def 2: flow of funding provided by an investor or lender (usually a firm) to establish or acquire a foreign company or expand finance to an existing foreign company that the investor owns and controls key distinction is the degree to which an investor can control or influence the management of the company a rule of thumb (intl standard) : if someone owns at least 10% of a firm, they can have the ability to influence management Thus: Def 3: FDI is any flow of lending to, or purchase of ownership in, a foreign firm in which the investor (usually a firm) has (or gains) ownership of 10% or more of the foreign firm.

Capital Mobility - definitions FDI: involves the transfer of capital resources and the acquisition of control FDI is usually discussed in the context of the multinational corporation (MNC) Foreign subsidiary If US company purchases more than 50% of the shares outstanding in a French company -- US company has controlling interests Branch plant If US builds a plant in France -- there is ownership and control over this facility

Capital Mobility - definitions Multinational corporation (MNC) or Multinational enterprise (MNE) a firm that owns and controls operations in more than one country is an MNE Ex: production takes place in plants located in 2+ countries, but under the supervision and general direction of the headquarters located in one country. parent firm in the MNE is the headquarters or base firm located in the "home" country foreign affiliates (subsidiary or branch) parent firm has one or more located in the "host" country

Capital Mobility - definitions MNE characteristics MNE operates in 2+ countries via branches or subsidiaries over which it has effective control 10%+ ownership in stock is deemed to be sufficient for direct control of business operations. International borrowing and lending sometimes occurs between a parent company and its subsidiary. MNE uses flows of FDI to establish/finance foreign affiliates Note: foreign affiliates may only receive part of total financing from FDI; rest comes from outside lenders or borrowing in host country. Why? Avoid risk (exchange rate risk, political risk)

Capital Mobility - definitions MNE characteristics MNEs transfer other "things" to foreign affiliates: intangible assets Proprietary technology Brand names marketing capabilities Management practices Trade secrets

Fortune 500’s list of world’s largest corporations in 2016 Company Country Revenue ( billions) Wal-Mart Stores U.S. 482.1 State Grid China 329.6 China National Petroleum 299.2 Sinopec Group 294.3 Royal Dutch Shell Netherlands 272.1 Exxon Mobil 246.2 Volkswagen Germany 236.6 Toyota Motor Japan 236.5 Apple 233.7 BP United Kingdom 225.9 Source: http://beta.fortune.com/global500/

Capital Mobility - definitions MNEs diversify their operations Vertical integration: a parent MNE establishes foreign subsidiaries to produce intermediate goods or inputs used to produce a final . 2. Horizontal integration: parent MNE produces commodity in the source country sets up a subsidiary to produce the identical product in the host country Coca-Cola Forward integration: in the direction of the final consumer market. Toyota has foreign subsidiaries to market the finished good of the parent company in the US Backward integration: includes the extraction and processing of raw materials. Exxon-Mobil: oil production is located in Middle East, but refining/marketing are located in North America 3. Conglomerate integration: firms that have diversified in non-related markets Berkshire Hathaway: a conglomerate that includes planes to real estate, owns majority stake in 50+ companies & minority holdings in Wal-Mart to car manufacturers.

FDI – how much does it occur? To measure the importance of MNEs across countries and over time, look at data Flows of FDI: measure new equity investments and loans within the MNE during a period of time Stock of FDI: measures the total amount of direct investment that exists at a point in time. Stocks are sums of past flows of FDI

FDI – how much does it occur?

Capital Mobility –Why do MNEs Exist? 4 Issues about MNEs Inherent disadvantages of MNE lack of knowledge of local laws, customs, procedures, practices and relationships extra cost of initially managing from a distance lack of initial connection to political leaders - could face some hostility

Capital Mobility –Why do MNEs Exist? Firm-specific advantages of MNE ownership of intangible assets A MNE has expertise it hopes to exploit in larger markets 2 question(s) are: Export or FDI: Should a firm sell to foreign buyers by exporting from "home" country? Or Should a firm set up local production in the foreign country to produce and sell locally? License or FDI: Should a firm license products to local firms in foreign country (foreign firms use their local operations to produce/sell)? Or Should the firm set up foreign production operations that it owns and controls?

Capital Mobility –Why to MNEs Exist? Locational Factors: advantages or disadvantages of producing in home or producing in multiple countries key to answering question of "export or FDI“? locational factors: Comparative advantage: the effect of resource availability Mining occurs where minerals are located, labor intensive production occurs where there exist labor pools, service industries (KFC) locate near customers Scale economies Ex: High plant-specific costs but low transportation cost or low barriers to trade  encourage exports. Ex: High plant-specific costs but high transportation cost or high barriers to trade  encourage FDI. Host country gov. polices: trade barriers or domestic taxes/subsidies (local tax rates are a big motivator) Existence of a PTA Transportation costs

Capital Mobility – Why to MNEs Exist? Internalization advantages: The advantages of using an asset within the firm rather than finding other firms to buy, rent or license the asset key to answering question of "license or FDI“? license: an agreement for one firm to use another firm's assets, with restrictions on how the asset can be used, and with payments for the right to use the asset. Advantages of licenses: Avoid the inherent disadvantages of establishing and managing its own foreign operations.

Capital Mobility – Why to MNEs Exist? Internalization advantages: What are benefits of internalization, using an asset within the firm rather than finding other firms to buy, rent or license the asset? More profitable to conduct transactions and production within a single organization than in separate organizations. Why: Avoid the transaction costs and risk of licensing to an independent firm License negotiations may be costly and difficult License may leak secret technology or may produce poor quality products under a brand name Technology transfers May be easier within a single firm than through a market transaction May be weak property right laws across countries Vertical integration Vertical integration involves consolidation of different stages of production, which may be easier if operated by one firm

Capital Mobility – MNE and Trade Does MNE ↑ or ↓ International Trade case 1: vertical integration FDI and trade are complements low transportation costs and low trade barriers → FDI can reduce total cost by locating different stages of production in different countries. FDI thus leads to more trade case 2: horizontal integration FDI and trade are substitutes Need to find a balance between: centralizing production in one (few) locations and exporting to achieve scale economies spreading production to many host countries to reduce transportation costs and avoid trade barriers. If scale economies are less important (transport/trade barriers high)  FDI will substitute for trade

Model of Capital Mobility Question 1: Should home country should restrict FDI outflows? Think about: What is the effect on workers and others who provide inputs into production in home country? What is the effect on owners of MNE based in this home country? What is the effect on the home country gov. budget (gov. tax revenue)? Are there any external benefit/cost with FDI outflows?

Model of Capital Mobility 1st: FDI outflows shift capital stock out of home country (France) less capital stock is available at home with less capital stock (French) workers at home may be harmed Less production by MNE at home  Demand for labor has decreased in home country  some workers will have unemployment  real wages of workers may decline broadly Who cares? Organized labor in home country cares. Ex. Organized labor in US/Canada fought hard against freedom for US/Canadian MNE to set up foreign production affiliates in Mexico. They thought of it as exporting jobs.

Model of Capital Mobility 2nd FDI outflows result in a loss of home country government tax revenue Home government receives less/no taxes from the part of the MNE’s profits that become profits of the foreign affiliate 3rd FDI outflows may carry external technological benefits out with it to the host country Host country gains: worker training and ability to imitate (copy) home technology These can be viewed as external benefits lost to home country. Question: Do gains to MNE owners exceed loss to home workers, home government and home loss of external benefits?

Model of Capital Mobility 4th FDI outflows gain from increased returns on their equity investments as the returns to MNE assets increases Home (French) owners of capital gain at home. Question: Do gains to MNE owners exceed loss to home workers, home government and home loss of external benefits?

Model of Capital Mobility Question 2: Should host country (England) restrict FDI inflows? 1st: FDI inflows to host country offers gains to workers in host country because there is an increase in demand for their services. Other suppliers of inputs to affiliates also gain. 2nd: FDI inflows provide increased tax revenue to government of host country 3rd: FDI inflows compete with host country producers, thus host producers may loose. But additional considerations: The foreign MNE may exercise market power to raise prices once they have eliminated/reduced competition from host country producers. The host country receives positive externalities (new technology, marketing capability, worker training) Thus local host country firms still in the mkt may still benefit from these externalities.