growth and trade, international factor movements appleyard & field (& cobb): chapters...

Growth and Trade,International Factor Movements

Appleyard & Field (& Cobb): Chapters 11–12

Krugman & Obstfeld: Chapter 7

2

Growth• Economic growth may be due to change in

o technologyo amounts of factors of productiono institutions (e.g. allowing international trade)

• Impact of this changeo producers need to decide how to alter

productiono consumer need to decide how the change

consumptionso world prices may change

3

Growth and PPF

Clothes

Pap

er

Pap

er

Pap

er

Clothes 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

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 beo 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)

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er

(im

port

)“ultra-protradeeffect”

protradeeffect

antitradeeffect

“ultra-antitrade”effect

neutral effect

5

exportsbefore

Terminology: Consumption Effects

• Similarly consumption effectso (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

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er

importsbefore

exports

after

Note that we are assuming constant prices at this point

importsafter

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

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er

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

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

Imp

ort

s o

f g

oo

d Y

(PX/PY)2

(PX/PY)1OC0

OC1

8

Shift of Offer Curves (2)

New equilibrium:

• More trade• New terms

of trade = new relative prices

• (PX/PY)E’ < (PX/PY)E

Good X: Exports from country 1

Imports to country 2

Go

od

Y:

Imp

ort

s to

co

un

try

1 ex

po

rts

fro

m c

ou

ntr

y 2

(PX/PY)E = TOTE

Country 1’s offer curves

Country 2’s offer curve

(PX/PY)E’ = TOTE’

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 exportso alternatively price of

imports increases due to increased demand of imports Clothes

Paper

TOT0 TOT0

TOT1

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

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TOT0TOT1

Jagdish Bhagwati (1958): Immiserizing Growth: A Geometrical Note. Review of Economic Studies 25

11

Foreign Direct Investment (FDI)

• Definition: ownership and control of foreign capitalo 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

Reasons for FDI

1. Getting close to the final markets2. Access to raw materials3. Low labour cost4. Risk Diversion5. Firm-specific knowledge6. Trade policy (“getting behind the tariff

wall”)etc.

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 (MPPK) is decreasing (when labour is held constant)

• Remember: r=MPPKX*PX

MPPK

Capital

Note that we keep the amount of labour fixed and hence the marginal product of capital is decreasing

14

Capital Market Equilibrium: Two Countries, Free Capital Mobility

Country 1 Country 2

MP

PK

CapitalK1

r1

K2

MP

PK

r2

K2

MP

PK

r2

15

Capital Market Equilibrium: Two Countries, Free Capital Mobility

Total world capital

rA1

Country 1’s initial capital


rA2

• 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 MPPK

1=MPPK2

capitalflow

Country 1:MPPK, r

Country 2:MPPK, r

r*r*

Country 1’s eq’m capital


16

Presenting Output Geometrically

rA1

Country 1’s capital

Country 1:MPPK, r

• The amount of production depends on the amount of inputs and the marginal productivity of inputs: Y=MPPK*K+MPPL*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 MPPK curve

MPPK

output

17

Effect of Capital Flows in the Two Country Model

Total world capital

rA1



rA2

• 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:MPPK, r

Country 2:MPPK, r

r*r*



increase of outputin country 1

decrease of output

in country 2

increaseof worldoutput

18

Possible Benefits fromCapital 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 economies6. Technical and managerial skill spill-

offs 7. Weakening a domestic monopoly

See Appleyard and Field (around page 231) for discussion

19

Possible Disadvantages from Capital Flows for the Host Country1. 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 policy6. 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

International Labour Movements

Total world labour force

wA1

Country 1’s initial employment


wA2

• 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:MPPL, w

Country 2:MPPL, w

w*w*

Country 1’s eq’m employment


21

Distribution of income: a geometrical representation

w

Country 1:MPPL, w

• The amount of production depends on the amount of inputs and the marginal productivity of inputs: Y=MPPK*K+MPPL*L MPPL=(Y-MPPK*K)/L

• Competitve labour market → w=MPPL

X*PX

• Labour gets w*L, capital owners get the rest

MPPL

wages

rents

labour

22

Impact of Migration

Total world labour force

wA1


Country 2’s employment

wA2

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:MPPL, w

Country 2:MPPL, w

w*w*



transfer from capitalto labour in country

transfer from labour to capital in country 1

gain for the immigrants

imm

igrat

ion

surp

lus

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)

Capit

al in

ten

sive

pro

duct

Labour intensive product

Country 2

Country 1

Capit

al in

ten

sive

pro

duct

Labour intensive product

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

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