International Factor Movements and FDI Study Guide

1. Welcome to Econ 414 International Economics Study Guide Week Six (Chapter 5)

2. What are the causes of international factor movements? • Assume factors of production are mobilebetween India and the U.S. • Assume the U.S. is capital abundant and India is labor abundant. • Labor earns a higher wage in the U.S. than in India. • Inequality of wages would cause workers from India to migrate to the U.S.

3. What are the effects of international factor movements? • Wages would begin to _____ in the U.S. as supply increases. • Wages would begin to ______ in India as supply decreases. • Migration of labor would stop when wages are equal between countries • – no more gains from migration. fall rise

4. What about capital? • Capital will migrate from the U.S. to India to earn a higher rate of return. • Capital will migrate until the rate of return is the same between the two countries.

5. Fact • In general, capital is more mobile than labor; why? • Immigration restrictions • Language/cultural barriers

6. How does the international factor movement compare to international trade? • International trade is sometimes • a substitute for factor movements between countries. • a complement for factor movements between countries

7. Example of substitute • Ireland is capital abundant and has comparative advantage in production of capital intensive goods and return to capital is low. • Two alternatives: • Export capital intensive good (machines) & import labor intensive good (shoes), or • Capital leaves the nation and labor enters the nation until there is no more comparative advantage or disadvantage; produce machines and shoes domestically. • If factor movements are blocked, trade is pursued.

8. Example of complements • Shoes and machines can be traded, but some goods and services can not be traded. Like what? • Haircuts • Someone who lives in Ireland will not go to Turkey to get a hair cut • But the Turkish hairdresser (labor) can migrate to Ireland

9. Which one is economically preferred? And why? • The literature has shown that • When possible, factor movements are preferred to trade. • World output will be maximized • Blocking factors from earning the highest rate of return is less efficient.

10. What is foreign direct investment (FDI)? • It implies directly investing in the firm’s plant and equipment. (Physical investment as opposed to just sending money.) • It takes the form of a domestic corporation opening a foreign subsidiary or buying control of existing foreign firm represents real investments in land, nonresidential investment, and equipment and software.

11. FDI: Facts • More than 92% of FDI originated in developed countries. • World’s developed countries received nearly 76% of the world’s FDI.

12. FDI in the world Table 5.2

13. Question: what does Africa’s negative outflow of FDI mean? • Africa has a negative outflow of FDI which means that Africa has withdrawn its FDI outflow.

14. Sample Question 1 • A relatively large amount of intraindustry trade would be associated with: • A) an index of intraindustry trade close to 1.0. • B) an index of intraindustry trade close to zero. • C) an index of intraindustry trade of 0.20. • D) a large amount of imports in a product category with few exports in the same product category.

15. Sample Question 2 • According the product cycle model, comparative advantage: • A) may move from one country to another country as the product matures. • B) is based on the income level of the domestic country. • C) will remain in the country where the product is introduced. • D) is based on economies of scale.

16. Sample Question 3 • Why is international trade viewed as a "second best" alternative when compared to the movement of the factors of production? • A) Being able to move the factors of production would increase world output. • B) International trade has too many problems associated with it. • C) Factors of production are cheaper and easier to acquire. • D) Resources are best used with international trade.

17. What are the reasons for FDI? • Higher rate of return on investment because • the receiving nation is capital scarce and labor abundant • Low cost of labor

18. What are the reasons for FDI? • Low cost of transportation of output • Low cost of transportation of inputs • Low cost of paper work (licensing, permits ,..etc.) • Low taxes • High trade barriers in the receiving nation • Low cost of natural resources

19. What are the effects of FDI? • In the source country • The country that sends the capital to another country. • When capital moves out of the source country, the supply of capital ________ which causes an increase in the rate of return to capital. • Owners of capital in source country benefit • Owners of transferred capital benefit from higher rate of return in foreign country. decreases

20. What are the effects of FDI on the labor in the source country? • Reduction in supply of capital means less capital for labor to use. • Capital-to-labor ratio declines • Productivity of labor declines • Wages decline • Note: in a competitive market wage = marginal product of labor

21. Question • Why when there is less capital the productivity of labor declines? • Think of me as a labor, in which scenario will I be more productive in class? • Give me a chuck and a blackboard • Give me a laptop and projector • Note: by “less capital” we mean lower valued (less technologically advanced) capital

22. What are the effects of FDI on the host country? • Host country • The country that receives the factor of production from another country. • Supply of capital increases which ________ the rate of return. • Labor productivity _________ because there is more capital per worker. • Return to labor increases. • Opening of trade increases wages and decreases returns to capital in the labor-abundant country. decreases Increase

23. Preparation for understanding Figure 5.1 • Before we get to the figure let’s prepare ourselves • What is a demand curve for oranges? • A curve that shows the highest price we are wiling and able to pay at each level of quantity of oranges • The highest price represents the value of oranges to us

24. The same is true for demand curve for capital The value of 2nd unit of capital is €10 But what determines this value? It depends on how productive capital is We are willing to pay the 2nd capital €10, because it can produce €10 of output for us. €10 is the value of marginal product of capital P 10 7 D 5 2 Q

25. The same is true for demand curve for capital If we end up hiring 5 capital, each unit produces up to the height of the demand curve If we could hire capital continually, the area under the demand curve up to 5 unit of capital = total output P D 5 Q

26. Return to Capital, U.S. Return to Capital, India Sk Sk RI RUS DUS DINDIA Capital Stock, U.S. Capital Stock, India Figure 5.1: Output and Welfare Effects of International Capital Mobility US is capital abundant India is capital scarce Total output in the US = a + b Total output in India = a’+ b’ a’ E’ a E b’ b Assumption: Supply of capital is fixed (vertical)

27. Return to Capital, U.S. Return to Capital, India Sk’ Sk Sk Sk’ e’ RI e d’ c’ RUS’ RI’ d c RUS DUS a’ b’ DINDIA a b Capital Stock, U.S. Capital Stock, India Figure 5.1: Output and Welfare Effects of International Capital Mobility Out put in US drops by ____________ b+ c Capital moves from US to India Output in India goes up by ________ c’+b’ F’ World out put goes_____ F E’ up E

28. Return to Capital, U.S. Return to Capital, India Sk’ Sk Sk Sk’ e’ RI e d’ c’ RUS’ RI’ d c RUS DUS a’ b’ DINDIA a b Capital Stock, U.S. Capital Stock, India Figure 5.1: Output and Welfare Effects of International Capital Mobility US capital’s share of Indian output is _____. Total return to capital (capital’s share of total output) in the US changes from a + b to ___________ b’ a + d India’s capital’s share of out put declined from a’+d’ to _____. F’ a’ F E’ E

29. Return to Capital, U.S. Return to Capital, India Sk’ Sk Sk Sk’ e’ RI e d’ c’ RUS’ RI’ d c RUS DUS a’ b’ DINDIA a b Capital Stock, U.S. Capital Stock, India Figure 5.1: Output and Welfare Effects of International Capital Mobility India’s labor’s share of out put used to be _________ Now it is _______. Us labor’s share of output used to be e+d+c. Now it is ________. e e’ e’+d’+c’ F’ a’ F E’ E

30. Recap • World output went up • US capital’s share of the world output went up • India’s capital share of the world output went down • US labor share of out put went down • India’s labor share of output went up

31. The role of Government • Governments restrict the free flow of foreign direct investment in several ways. • Industrial Policy • A government policy designed to stimulate the development and growth of an industry. • It tends to favor local firms at the expense of foreign firms.

32. International Movements of Labor • Immigrants • Individuals that permanently change their country of residence to a foreign country. • In 1965, 75 million people lived in a country outside their country of birth. • In 2000, immigrants residing in a new country was greater than 150 million.

33. Who migrates more? Table 5.3

34. What are the reasons for international movements of labor? • Fact: most immigration comes from developing countries. • Push factors- push labor out of these countries • low standard of living in developing countries • high rates of unemployment. • Poverty

35. What are the reasons for international movements of labor? (you asked questions) • Pull factors- pull workers into developed nations • Higher incomes • Higher standard of living

36. What are the effects of international movements of labor? • Assume that India is labor abundant and the U.S. is capital abundant. • Wages in the U.S. higher than India. • Indian labor would migrate to the U.S.

37. What are the effects of international movements of labor on Indians? • Workers in India will benefit from ______ wages with the reduction in supply. • India’s capital-to-labor ratio ________. • Increase in India’s labor productivity. • Indian wages will rise. • India’s total output will fall. • Returns to owners of capital in India fall because of • Higher wages paid • Reduced production higher rises

38. What are the effects of international movements of labor on Americans? • Increase in labor force lowers the amount of capital each worker has available to work with. • Capital to labor ratio falls in the U.S. which decreases labor productivity. • Wages in U.S. fall. • Total output rises.

39. What are the effects of international movements of labor on Americans? • Owners of capital in the U.S. gain • Lower wages paid • Produce more output • (U.S. labor will oppose open immigration.) • (Owners of capital favor open immigration.) • The output of the world economy rises since workers can move to countries where they are more productive. • Note: I will not go over Figure 5-2 • You are responsible to know it.

40. International Movements of Labor • Immigration and Public Policy • To maximize a country’s total output, policy should be completely open immigration. • Output would be maximized but wages may be harmed. • Few countries have open immigration but few have a ban on immigration.

41. International Movements of Labor • Government must balance welfare of society and welfare of particular groups that immigration affects. • As economic and political factors change over time, so does immigration policy especially in developed countries. • Brain drain • The movement of skilled or professional workers from one country to another.

42. International Movements of Labor • Countries have been able to design policies that allow market forces to allocate labor efficiently on a global basis and compatible with public preferences on immigration. • For example, the guest worker programs of Europe allow workers from developing countries to work there temporarily rather than to immigrate permanently. • These programs can increase social costs: • Unemployment insurance • Education • Housing • Healthcare

43. International Movements of Labor • Offshore assembly provisions • Allow U.S. firms to export materials and parts of a good to foreign countries for final assembly; • When the assembled goods are returned to the U.S., duties are assessed only on the value added in the foreign country. • Final good is imported back to the U.S. with duties assessed only on the value added. • US firms can take advantage of lower foreign labor costs without importing labor.

44. International Movements of Labor • Provisions have been used for U.S. firms to set up plants in Northern Mexico called maquiladoras. • Firms have used foreign labor to process paperwork as well as subcontract design and engineering work.

45. The Multinational Corporation • A firm that conducts part of its business across national boundaries (MNC) • Primary determinant of international movement of capital and FDI • Labor shortages in one country cause firms to recruit from another or move workers to another.

46. The Multinational Corporation • MNCx exist due to efficiencies from internalizing certain activities instead of contracting them out • Profitable to set up business in other countries with horizontal and vertical integration • How to control investments in foreign countries affect decisions

47. The Multinational Corporation Table 5.4

48. The Multinational Corporation • Reasons for the Existence of MNCs • Choices for control • The firm can export its product to foreign firm and let the foreign firm handle all aspects of selling it in the foreign market. • MNC can set up wholly-owned subsidiary to serve the foreign market: • The firm has complete control from the production to the ultimate customer. • The firm can establish joint ventures with a firm in a foreign market. • It may need raw materials from foreign market. • It reduces overall production costs by manufacturing sub-components in foreign market.

49. The Multinational Corporation • OLI approach • A framework that explains why MNCs engage in foreign direct investment. • O is ownership – commonly ownership of an intangible asset • A good or process a firm has developed that other firms find difficult to replicate. • It is a source of comparative advantage.

50. The Multinational Corporation • Maintaining control of the asset makes it necessary to set up a subsidiary in a foreign market. • Licensing agreement • A domestic firm licenses the right to produce and market a good or to use a technology to a foreign firm in a country. • It increases domestic firm’s profits. • It may allow foreign firm access to technology that may become a competitor