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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
Inventing country production
Inventing country consumption
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
Inventing country production
Inventing country consumption
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.
10-61
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 II and III trade?
E, F, and G.
10-62
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 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
the country’s desire to trade.
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).
Trade Effects of Consumption Growth
B II
I
IIIIV
Y
X
CPF
Trade Effects of Consumption Growth
•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.
Trade Effects of Consumption Growth
•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
the country’s desire to trade.
Trade Effects of Consumption Growth
•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.
Trade Effects of Consumption Growth
•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
the country’s desire to trade.
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
Capital Market Equilibrium
MPPKI
r1
k10
MPPKII
MPPKIMPPKII
0'
r1'
The price of capital will be r1 in Country I and r1’ in Country II.
12-119
Capital Market Equilibrium
MPPKI
r1
k10
MPPKII
MPPKIMPPKII
0'
r1'
Output in Country I
12-120
Capital Market Equilibrium
MPPKI
r1
k10
MPPKII
MPPKIMPPKII
0'
r1'
Payment to Labor
Payment to Capital
12-121
Capital Market Equilibrium
MPPKI
r1
k10
MPPKII
MPPKIMPPKII
0'
r1'
Output in Country II
12-122
Capital Market Equilibrium
MPPKI
r1
k10
MPPKII
MPPKIMPPKII
0'
r1'
Payment to Labor
Payment to Capital
12-123
Capital Market Equilibrium
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
Capital Market Equilibrium
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
Capital Market Equilibrium
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
Capital Market Equilibrium
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
12-127
Capital Market Equilibrium
K
MPPKI
r1
k10
MPPKII
MPPKIMPPKII
0'
r2
k2
r2'r1'
Overall, world output rises.
12-128
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
Economic Effects of Int’l Capital Flows On Incomes
K
MPPKI
r1
k10
MPPKII
MPPKIMPPKII
0'
r2
k2
r2'r1'
Gain by laborers in Country I
12-131
Economic Effects of Int’l Capital Flows On Incomes
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.
Economic Effects of Int’l Capital Flows On Incomes
K
MPPKI
r1
k10
MPPKII
MPPKIMPPKII
0'
r2
k2
r2'r1'
Income gain by capitalists in Country II
12-134
Economic Effects of Int’l Capital Flows On Incomes
K
MPPKI
r1
k10
MPPKII
MPPKIMPPKII
0'
r2
k2
r2'r1'
Lost labor income
12-135
Economic Effects of Int’l Capital Flows On Incomes
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
12-142
Economic Effects of Labor Migration
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
Economic Effects of Labor Migration
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
Economic Effects of Labor Migration
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
Economic Effects of Labor Migration
•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.
Economic Effects of Labor Migration
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
Economic Effects of Labor Migration
•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.
Economic Effects of Labor Migration
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
Economic Effects of Labor Migration
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
Decrease in GDPI
12-150
Economic Effects of Labor Migration
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 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.”