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BA 187 – International Trade. Krugman & Obstfeld, Chapter 7 International Factor Movements. International Capital Flows. Foreign Direct Investment (FDI). International Capital Mobility. Two Types of Capital Movements possible Foreign Direct Investment (FDI):

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BA 187 – International Trade

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BA 187 – International Trade

Krugman & Obstfeld, Chapter 7

International Factor Movements


International Capital Flows

Foreign Direct Investment (FDI)


International Capital Mobility

  • Two Types of Capital Movements possible

  • 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.

  • 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.


FDI Positions By Industry, Dec 31, 1995

Source: U.S. Dept. of Commerce, Survey of Current Business, 1996


FDI Positions By Region, Dec 31, 1995

Source: U.S. Dept. of Commerce, Survey of Current Business, 1996


Reasons for International Capital Flows

  • Considerable international capital mobility today.

    • Capital should flow to areas where expectation of higher return.

  • 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.


International Capital Mobility

World Capital Market Equilibrium


Model of Capital Mobility

  • 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).

  • Assume total world capital stock fixed.

    • Distribution of capital initially based on “historical accident”.

    • Initially return to capital less in Home than Foreign country.

  • Capital assumed to move to highest rate of return over time.

    • Capital moves from Home to Foreign, equalizing returns.

  • 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.


MPK*

MPK

Capital Flows from

Home to Foreign

r*0

req

req

r0

Final Home Capital

Final Foreign Capital

Initial Home Capital

Initial Foreign Capital

International Capital Mobility

Home MPK

Foreign MPK*

O*

O

Total World Capital Stock


Potential Benefits of FDI to Host

  • Increased output.

  • Increased wages.

  • Increased employment.

  • Increased exports.

    • Assumes foreign capital produces goods with export potential.

  • Increased tax revenues.

  • Realization of Scale economies.

  • Transfer of technical & managerial skills to host nation.

    • Often scarcest resources in LDC’s, hence large potential benefit.

  • Potential to weaken existing domestic monopolies.


Potential Disadvantages of FDI

  • Adverse impact of host’s Terms of Trade.

    • Either through export promotion or transfer pricing effects.

  • 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).

  • Instability in Balance of Payments or Exchange rate.

  • Loss of control over domestic gov’t policies.

  • Increased unemployment.

    • If FDI in capital-intensive industries, then possible fall in employment.

  • Inadequate attention to development of local skills.

    • MNC’s may reserve skill positions for home country head office.


International Labor Mobility

Wages and Migration of Labor


Model of Labor Mobility

  • 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).

  • Assume total world labor force fixed.

    • Distribution of labor initially based on “historical accident”.

    • Initially return to capital less in Home than Foreign country.

  • Labor assumed to move to highest wage over time.

    • Labor moves from Home to Foreign, equalizing wages.

  • 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.


MPL*

MPL

Migration from

Home to Foreign

w*0

weq

weq

w0

Final Home Labor

Final Foreign Labor

Initial Home Labor

Initial Foreign Labor

International Labor Mobility

Home MPL

Foreign MPL*

O*

O

Total World Labor Force


Unemployment & Labor Mobility

  • 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.

  • Labor again assumed to move to highest wage over time.

    • Labor moves from Home to Foreign, equalizing wages.

  • 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.


Migration from

Home to Foreign

w*0

weq

weq

w0

Final Home Labor

Final Foreign Labor

Initial Home Employed

U0H

Home Unemployment & Labor Mobility

Home MPL

Foreign MPL*

MPL*

MPL

O*

O

Initial Foreign Labor

Total Home Labor Force


Additional Considerations for Labor

  • Income Transfers

    • New immigrants may transfer income back to Home country.

    • This offsets income loss to Home and income increase to Foreign.

  • 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.

  • 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).


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