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3. Trade and factor mobility. Globalisation and multinational enterprises. Outline of the lecture. motivation trade off between factor mobility and trade in different theories Heckscher-Ohlin-Samuelson Factor-proportions model Product life-cycle Income effects Specific factors model

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3 trade and factor mobility l.jpg

3. Trade and factor mobility

Globalisation and multinational enterprises

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Outline of the lecture

  • motivation

  • trade off between factor mobility and trade in different theories

    • Heckscher-Ohlin-Samuelson

    • Factor-proportions model

    • Product life-cycle

    • Income effects

    • Specific factors model

    • Economic geography

  • empirics

Motivation l.jpg

  • International factor movements are a pervaisive and integral part of the world economy;

  • Model of international trade tend to disregard international factor mobility and vice versa;

  • As the then President ofMexico Salinas said during the NAFTA negotiations: “We want to export goods, not people.”

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  • From a perspective of a firm, it is faced with a choice of arms-length trading and multinational production

    • depending on transport costs and costs of establishing a production facility abroad;

    • depending on the motivation of MNCs they either invest and trade in intermediates or trade back to the original market or even trade to new markets (platform)

    • depending on its ability to internalize its advantages

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  • The rapid growth in foreign direct investment (FDI) over the last few decadeshas occurred in the context ofreductions in barriers to investment throughout the world, and the empiricalevidence shows that investment liberalization stimulates FDI;

  • The effects of FDIcan be wide reaching, with evidence suggesting that FDI impacts significantly ontrade, employment and factor prices;

  • According to trade theory, whether foreign direct investment (FDI) promotes or substitutes trade depends on the motivation for FDI;

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  • if FDI is vertical, where multinational firms geographicallysplit stages of production, this is likely to stimulate trade.

  • if FDI ishorizontal, where multinational firms produce final goods in multiple locations,this is likely to substitute for trade.

  • unfortunately, it is not possible to separate thedata into horizontal and vertical FDI. However, theory does provide someguidance by linking the type of FDI that is likely to arise to directly observablecountry characteristics.

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Motives for FDI

  • Policy framework

    • Economic, political and social stability

    • Rules regarding entry and operation

    • Standards of treatment of foreign affiliates

    • Policies on functioning and structure of markets

    • International agreements on FDI

    • Privatisation policy

    • Trade policy

    • Tax policy

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Motives for FDI

  • Economic motives

  • Business facilitation

    • Investment promotion (image-building, investment-generating activities and investment-facilitating services)

    • Investment incentives

    • Hassle costs (corruption, administrative inefficiency)

    • Social amenities (multilingual schools, quality of life)

    • After investment services

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Economic motives for FDI

  • Market seeking motive

    • Market size and per capita income

    • Market growth

    • Access to regional and global markets

    • Country-specific consumer/product preferences

    • Structure of markets

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Economic motives for FDI

  • Resource/asset seeking motive

    • Raw materials

    • Low-cost unskilled labor

    • Skilled labor

    • Technological, innovative and other created assets (e.g. brand names) embodies in individuals, firms and clusters

    • Physical infrastructure (ports, roads, telecommunications, power)

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Economic motives for FDI

  • Efficiency seeking

    • Cost of resources and assets adjusted for productivity and labor resources

    • Other input costs (transport and communication)

    • Membership of a regional agreement conducive to the establishment of regional corporate networks

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Two forms of international factor mobility (IFM):

  • LABOR: worker migration (from low wage countries (developing countries) to high wage countries (developed countries)),

  • CAPITAL: capital investment tend to flow from low to high return-to-capital countries:

    • FDI (foreign direct investment) – long term investment into firms with the aim of permanently benefiting the advantages of being present in the foreign markets (greenfield, mergers & acquisitions),

    • PI (portfolio investment) – short term capital investment with the aim of maximizing the return-to-capital (financial investments))

  • IMF classification:

    foreign ownership should exceed 10% of firm's equity

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  • Free trade in goods leads to international equalization of product prices, which in turn leads to international (absolute and relative) factor price equalization.

  • Hence, given the FPE theorem (factor price equalization) mobility of factors is not needed. Similarly, when there is a complete mobility of factors, no trade in goods is needed.

  • In the HOS model, trade and factor mobility are SUBSTITUTES: larger trade in goods leads to smaller factor mobility and vice versa.

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Two implications of HOS model:

  • Protectionism: volume of FDI and worker migrations should be very large (this thesis is only partly confirmed by huge migrations in the beginning of the 20th century and in the 1960s and 1970s,

  • Liberalism: volume of FDI and worker migrations should decline (this thesis does not hold as notwithstanding trade liberalization in the second half of the 20th century volume of world FDI has grown faster than volume of world trade.

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HOS model, amended with differentiated goods,

imperfect competition and intra-industry trade.

Implications of factor-proportions model (FP model):

  • If two countries are similar in terms of FP:

    • There will be no inter-industry trade nor FDI

    • Intra-industry trade pattern prevails

  • If two countries are very different in terms of FP:

    • FDI flows are likely

    • Exports will arise (inter-industry type) from host to the home country

  • Trade and factor mobility are COMPLEMENTS.

Income effects linder theory linder 1961 l.jpg

Countries similar in factor proportions (and in terms ofGDPpc) will have similar structure of preferences. As aconsequence, intra-industrytrade will arise.

Implications of Linder theory:

  • Empirical studies show that the majority of FDI and trade that arises due to FDI is within the advanced countries group, i.e. between countries that are countries of origin as well as countries of destination at the same time.

  • Similarity in income levels, hence, motivates trade as well as FDI at the same time, leading to COMPLEMENTARITY of both.

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Motives for foreign direct investment

Table: Geographical breakdown of sales of U.S. affiliates in

Europe, 1966-93 (%)

Source: World Investment Report, 1998: 108.

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  • in 1960s, serving the huge local markets in Europe seems to dominate (tariff and trade cost jumping motive for FDI),

  • recently, market access motive seem to be partly amended by efficiency motives (sales to other markets increase up to 40%).

  • U.S. affiliates in Europe engage little in exports back to U.S. (only 4%), indicating COMPLEMENTARITY of trade and FDI

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Table: dominate (tariff and trade cost jumping motive for FDI), Export orientation of U.S. affiliates, 1966-93 (in %)

Source: World Investment Report, 1998: 108.

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Dominant motives of U.S. firms for FDI: dominate (tariff and trade cost jumping motive for FDI),

  • In advanced countries and Latin America: dominant market-seeking motives for FDI, i.e. access to local markets (in 1960s in 1970s export orientation of affiliates was below 20% and 10%, respectively).

  • In Asian countries U.S. affiliates serve as export platform (export orientation exceeds 65%, in Malesia, Singapur and Hong Kong it exceeds 80%), indicating clear resource-seekingandefficiency-seeking motives for FDI.

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Evolution of world trade and FDI congressional committees 2006

Table: Total world exports and FDI, 1961-1997

Source: Bowen et al., 1998: 465, World Investment Report, 1998, 2009: 2,

* stock of world FDI.

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Global labour migration (1964-1967), world trade has increased tremendously.

  • Stock of foreign-born population

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Global labour migration (1964-1967), world trade has increased tremendously.

  • Stock of foreign-born population

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Global labour migration (1964-1967), world trade has increased tremendously. (cont. 2)

  • Flow of foreign-born population (total vs. employed)

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Global labour migration (1964-1967), world trade has increased tremendously. (cont. 3)

  • Flow of foreign-born population (total vs. employed)

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TEST OF FACTOR-PROPORTIONS MODEL (1964-1967), world trade has increased tremendously. (Brainard 1993a)

  • Given the assumption of differences in factor proportions, FDI should lead to inter-industry flows from affiliates back to the home country.

  • There should be no intra-industry trade flows neither between parent firm and affiliate, nor between home and foreign country.

    The empirical model:

    IITij = α1DGPLi (or DKLi) + α2minBDPi + α3maxBDPi + α4FFij + α5Dj.

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Model is estimated in logs at the industry level, where: (1964-1967), world trade has increased tremendously.

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  • Two forms of intra-industry trade flows are explored: (1964-1967), world trade has increased tremendously.

    • MIITij: intra-industry trade flows of U.S. affiliates abroad and foreign affiliates in the U.S. (inter-affiliate trade),

    • TIITij: total intra-industry trade flows between country i and U.S.

  • Model is estimated for trade between U.S. and 27 partner countries using 3-digit BEA (64 product groups).

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Table: Estimates of characteristics of inter-affiliate trade (MIIT) and total intra-industry trade (TIIT) infactor-proportions model

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Parameter estimates for affiliate IIT and total ITT are similar:

  • both proxy variables for differences in relative factor abundance are significantly negative (in line with prediction of the model for total trade), while MIIT is more responsive than TIIT,

  • minGDP is in line with model predictions, but not maxGDP,

  • in line with model predictions, transport cost negatively affect trade, while MIIT is more responsive than TIIT.

Test of proximity concentration trade off model brainard 1993b l.jpg

The model predicts that FDI increases in market access

barriers (transport cost, tariffs) and decreases in plant

economies of scale (horizontal FDI in order to serve local


There is trade-off between increasing production cost

(less efficient use of economies of scale if production is

divided among many locations) and lower prices (trade

cost are redundant).

Implications of the model: FDI SUBSTITUTES for trade

the higher the trade barriers and the lower the plant

economies of scale.

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Empirical tests give similar results for both forms of IIT, which is:

  • in line with predictions of factor-proportion model for total trade,

  • opposite to predictions for inter-affiliate trade.

    Moreover, there is surprisingly high correlation between both dependent variables, which implies that factor-proportions model with differentiated goods is not appropriate model for explaining motives for FDI, where U.S. serve as target or source country.

    In contradiction to the factor-proportions model, U.S. FDI seem to be motivated by similarities (not differences) in relative factor abundances, where transport cost play an important role.

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Model: which is:

Dependent variables:

  • Outward side: share of affiliates exports in total U.S. exports (OUTSH) or export share in total U.S. sales in the target country (EXSH).

  • Inward side: share of foreign affiliates sales in U.S. in total U.S. sales of that country (INSH) or import share in total U.S. sales of that country (IMSH).

    Independent variables:

  • similarity of preferences (Linder) oz. similarity in factor abundance: GDPpc in foreign country,

  • trade barriers: transport cost (FF), foreign tariffs (FAT) and U.S. tariffs (USAT), non-trade barriers in U.S. (NTB), openness for trade and FDI (TOPN, FOPN), corporate tax (TAX), extent of $ depreciation in 1985-89 (EXR),

  • economies of scale at the plant level (PSCL).

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Results indicate: which is:

  • Linder matters: similarity in income (preferences) increase affiliate sales and decrease regular trade

  • Trade barriers matter: transport cost, tariffs as well as openness for FDI increase U.S. affiliate sales abroad and decrease regular exports, while trade openness decrease U.S. affiliate sales and increase exports

  • Economies of scale matter: significant plant economies of scale decrease affiliate sales and increase regular imports

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Specific-factors model which is:

  • Neary (1995) develops a two-country model of international trade, where capital is specific to a given sector and hence immobile in short term

  • Goods and factor trade are likely to be SUBSTITUTES if internationally mobile capital is used in the import competing sector

  • On the other hand, if internationally mobile capital is used in the exporting sector, they act as COMPLEMENTS

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Markusen’s (1983) model which is:

  • Markusen challenged Mudell’s (1957) finding that substitution holds in the Heckscher-Ohlin-Samuelson model;

  • Under certain conditions, Markusen shows that eliminating barriers to factor movement results in complementarity;

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Markusen’s (1983) model which is:(source: Schiff, 2006)

  • He states that the complementarity result in each of his models isbased on the fact that “… each equilibrium involves a country having the relatively highprice for the factor used intensively in the production of the export good” (pp. 342-343).

  • Thus, factors move to the other country’s sector that uses them intensively, resulting in anincrease in trade. This implies that trade and factor movement are complements.

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Economic geography which is:

  • Economic geography uses concepts of returns to scale, transport costs, factor mobility etc. to explain the spatial distribution of economic activity

  • Activity is not equally distributed across space, on the other hand, it is very “lumpy”

  • Depending on the structure of the EG models, they can imply substitutability between trade and factor mobility as well as complementarity

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Economic geography which is:

  • Agglomeration forces (scale economies, intermediates markets and factor markets) generate concentration of economic and subsequently trade

  • Factor mobility (these chase higher returns) also contributes to trade – COMPLEMENTARITY

  • If factors are not perfectly mobile across locations, there will be less trade.

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Further reading which is:

  • L. Brainard (1993): A Simple Theory of Multinational Corporations and Trade with a Trade-Off Between Proximity and Concentration, NBER, No. 4269.

  • W.J.Ethier (1986): The multinational firm. Quarterly Journal of Economics, 14, 277-88

  • J.R. Markusen (1983): Factor movements and commodity trade as complements. Journal of International Economics, 19(2), 341-56.

  • J.P. Neary (1995): Factor Mobility and International Trade. The Canadian Journal of Economics, 28(1), pp.4-23

  • V.D. Norman and A.J.Venables (1995): International Trade, Factor Mobility and Trade Costs. The Economic Journal, 105 (433), 1488-1504.

  • K. Wong (1986): Are International Trade and Factor Mobility substitutes? Journal of International Economics, 21, 25-44.