1. Growth and Trade, International Factor Movements Appleyard & Field (& Cobb): Chapters 11–12 Krugman & Obstfeld: Chapter 7

2. 2 Growth Economic growth may be due to change in o technology o amounts of factors of production o institutions (e.g. allowing international trade) Impact of this change o producers need to decide how to alter production o consumer need to decide how the change consumptions o world prices may change

3. 3 Growth and PPF Clothes Paper Clothes capital saving technological change or increase of capital labour saving technological change or increase of labour force factor-neutral technological change or capital and labour increase by the same rate

4. 4 Terminology: Production Effects Assume a small country (=cannot affect world prices) exporting clothes Let there then be an increase in the production possibilities Producers select a point from the new PPF, and the production effect may be o neutral: production of exports and import-competing products grow at the same rate o protrade: production of exports increase relatively more o antitrade: production of import- competing products increase relatively more Clothes (export) Paper (import) “ultra- protrade effect” protrade effect antitrade effect “ultra- antitrade” effect neutral effect

5. 5 exports before Terminology: Consumption Effects Similarly consumption effects o (ultra)protrade: consumption of imports increases more than consumption of exports = larger part of income will be spent on imports after growth o (ultra)anti-trade: as above, but the other way around o neutral: no change in the relative consumption pattern The total impact of growth on trade depends on the combined production and consumption effects Clothes Paper imports before export s after Note that we are assuming constant prices at this point imports after

6. 6 Rybczynski Theorem Assumptions: constant prices (small-country), non-neutral growth in factors Growth in one factor leads to an absolute expansion in the output of product that uses that factor intensively and absolute contraction in output of the product that uses the other factor intensively Why? Relative factor prices cannot change since we assume constant product prices → K/L ratios of the industries must remain constant → capital must flow to the labour intensive sector Clothes Paper Growth of labour force → absolute increase in the labour- intensive product (clothes) and an absolute decrease in the production of capital-intensive product (paper)

7. 7 The Large country case: Change in World Prices Large country = influences world prices Assume e.g. that growth in the abundant factor (labour) leads to pro-trade production effect and neutral consumption effect Then, for any given prices, the country produces more exports and buys more imports = shift of the offer curve Exports of good X Imports of good Y ( P X /P Y ) 2 (P X /P Y ) 1 OC 0 OC 1

8. 8 Shift of Offer Curves (2) New equilibrium: More trade New terms of trade = new relative prices (P X /P Y ) E’ < (P X /P Y ) E Good X: Exports from country 1 Imports to country 2 Good Y: Imports to country 1 exports from country 2 (P X /P Y ) E = TOT E Country 1’s offer curves Country 2’s offer curve (P X /P Y ) E’ = TOT E’

9. 9 Terms of Trade Effect Part of the gains from trade are lost due to reduction in terms of trade That is, the price of exports decrease due to increased supply of exports o alternatively price of imports increases due to increased demand of imports Clothes Paper TOT 0 TOT 1

10. 10 Immiserizing Growth The reduction in terms of trade is so large that country’s welfare decreases due to increase of a factor of production / improvement in technology Clothes Paper TOT 0 TOT 1 Jagdish Bhagwati (1958): Immiserizing Growth: A Geometrical Note. Review of Economic Studies 25

11. 11 Foreign Direct Investment (FDI) Definition: ownership and control of foreign capital o An foreign investment is recorded as FDI if it involves buying more than 10 percent of the outstanding common stock of a foreign firm o Otherwise the investment is classified as portfolio investment The growth of FDI has been dramatically faster than the growth in merchandise trade during the past few decades Here we are studying the impact of increase in physical capital due to FDI

12. 12 Reasons for FDI 1. Getting close to the final markets 2. Access to raw materials 3. Low labour cost 4. Risk Diversion 5. Firm-specific knowledge 6. Trade policy (“getting behind the tariff wall”) etc.

13. 13 Analyzing FDI Assume two countries, two factors of production (labour and capital) and a single homogeneous good with free international movement of capital Assume that the marginal physical product of capital (MPP K ) is decreasing (when labour is held constant) Remember: r=MPP K X *P X MPP K Capital Note that we keep the amount of labour fixed and hence the marginal product of capital is decreasing

14. 14 Capital Market Equilibrium: Two Countries, Free Capital Mobility Country 1 Country 2 MPP K CapitalK1K1 r1r1 K2K2 MPP K r2r2 K2K2 r2r2

15. 15 Capital Market Equilibrium: Two Countries, Free Capital Mobility Total world capital rA1rA1 Country 1’s initial capital Country 2’s initial capital rA2rA2 In autarky, capital is scarce in country 1 and hence return of capital is higher than in the capital- abundant country 2  When capital movements are allowed, capital flows from 2 to 1 as long as it can get higher return in country 1  In equilibrium, capital returns must be the same in both countries, which implies that MPP K 1 =MPP K 2 capital flow Country 1: MPP K, r Country 2: MPP K, r r*r* r*r* Country 1’s eq’m capital Country 2’s eq’m capital

16. 16 Presenting Output Geometrically rA1rA1 Country 1’s capital Country 1: MPP K, r The amount of production depends on the amount of inputs and the marginal productivity of inputs: Y=MPP K *K+MPP L *L Remember what area means (e.g. area of a square is x*y) Thus, when we hold labour constant, we can study the effect of changes in capital on output via the area below the MPP K curve MPP K output

17. 17 Effect of Capital Flows in the Two Country Model Total world capital rA1rA1 Country 1’s initial capital Country 2’s initial capital rA2rA2 Country 1’s output increases more than country 2’s output decreases → World output increases as a result of more efficient use of world resources In country 1, capital owners lose (return on capital decreases) and labour wins (increased capital increases their productivity and hence wages) In country 2, the opposite occurs o we discuss this in more detail in the part about migration of labour Country 1: MPP K, r Country 2: MPP K, r r*r* r*r* Country 1’s eq’m capital Country 2’s eq’m capital increase of output in country 1 decrease of output in country 2 increase of world output

18. 18 Possible Benefits from Capital Flows for the Host Country 1. Increased output and wages (as discussed already) 2. Increased employment (if excess supply of labour exists) 3. Increased exports (usually, though not necessarily the case) 4. Increased tax revenues (if feasible tax policy exits) 5. Realization of scale economies 6. Technical and managerial skill spill-offs 7. Weakening a domestic monopoly See Appleyard and Field (around page 231) for discussion

19. 19 Possible Disadvantages from Capital Flows for the Host Country 1. Adverse terms-of-trade effect (if the country is large enough exporter of the goods FDI flows into or due to transfer pricing) 2. Decreased domestic saving (“government relaxes its efforts to generate domestic savings”) 3. Crowding out domestic investment (domestic investors could finance multinationals rather than domestic business) 4. Instability of exchange rate (when investment flows in the currency appreciates; when profits are sent back, the currency depreciates) 5. Loss of control over domestic policy 6. Increased unemployment (investment in capital-intensive techniques) 7. New local monopolies (if multinationals run local firms out of business) 8. Inadequate attention to local education and skills Note that many of the possible benefits & disadvantages are things that we are assuming away in our simple models. Hence we need other models to analyze these possible effects. Models suitable for analyzing some of these effects are introduced later in the course.

20. 20 International Labour Movements Total world labour force wA1wA1 Country 1’s initial employment Country 2’s initial employment wA2wA2 Assume homogeneous labour, no costs of migration, no preferences regarding the country of residence Then we can proceed as with capital: country 1 is labour- abundant, country 2 labour- scarce → wages are higher in country 2 → there is an incentive to move to country 2 until wages are equal migration Country 1: MPP L, w Country 2: MPP L, w w*w* w*w* Country 1’s eq’m employment Country 2’s eq’m employment

21. 21 Distribution of income: a geometrical representation w Country 1: MPP L, w The amount of production depends on the amount of inputs and the marginal productivity of inputs: Y=MPP K *K+MPP L *L  MPP L =(Y-MPP K *K)/L Competitve labour market → w=MPP L X *P X Labour gets w*L, capital owners get the rest MPP L wages rents labour

22. 22 Impact of Migration Total world labour force wA1wA1 Country 1’s initial employment Country 2’s employment wA2wA2 Country 2: (receiving immigrants) wages decrease → transfer of income from labour to capital owners total output increases more than what is paid to the immigrants → immigration surplus However, there is a decrease in per capita output (given diminishing marginal productivity) Country 1: wages increase → transfer of income from capital to labour total output decreases more than the wage sum of those who left → immigration deficit But, there is a increase in per capita output (given diminishing marginal productivity) Country 1: MPP L, w Country 2: MPP L, w w*w* w*w* Country 1’s eq’m employment Country 2’s eq’m employment transfer from capital to labour in country transfer from labour to capital in country 1 gain for the immigrants immigration surplus

23. 23 Factor Movements, Trade and the World Prices Capital and labour flows alter the factor endowments of an economy This can be analyzed using the methods introduced in the beginning of this lecture (growth of factor endowments / techonological change) Capital intensive product Labour intensive product Country 2 Country 1 Capital intensive product Labour intensive product

24. 24 Total Effects of Growth The total impact of changed factor endowments depends on the combined impact on production and consumption and the possible terms-of-trade effect Note that you can use this framework to analyse a change in any factor of production. For example, you might assume that there are skilled and unskilled labour and all the migrants are unskilled. Then, you can put skilled labour to the y-axis instead of capital. Clothes Paper