Chapter Ten

1. Chapter Ten Growth, Immigration, and Multinationals

2. Introduction Economic Growth I: More Inputs Economic Growth II: More Productivity What if Factors Can Move? Chapter Ten Outline

3. Introduction • Basic trade model will be extended to consider issues related to economic growth and factor mobility. • Factor flows between countries represent another way in which countries can use economic interaction to benefit from their differences. • Study of economic growth has become a growth industry within economics. • Economic growth defined as any shift outward in a country’s production possibilities frontier.

4. Introduction • Major sources of economic growth: • Increases in quantities of inputs or resources available to the country; and • Technical progress, or improvements in available production technology. • Empirical evidence suggests that increases in resources have accounted for a little less than half of economic growth in the modern era…technical progress accounted for the remainder. • Endogenous growth theory • New approaches to growth recognize knowledge and ideas as inputs.

5. Introduction • Growth rates among countries differ dramatically. • Assumption that factors of production move more freely within than among countries seems realistic. • Inter-country factor movement remains small relative to intra-country movement because: • Most governments maintain some restrictions on flows of both capital and labor across their national boundaries. • Differences in costs would produce a differential rate of movement.

6. Economic Growth I: More Inputs • More labor and capital • Country’s balanced growth: proportional increase in country's endowments of both capital and labor. • Figure 10.2 depicts the effects of balanced growth • Increases production and consumption of each good, imports, exports, and volume of trade in same proportion as the factor endowments. • Subscript p refers to production, c to consumption, 0 to pre-growth, and 1 to post-growth.

7. Figure 10.2: What Are the Effects of Balanced Growth? tt Y Slope = – (P /P ) X Y 1 Y c U 0 Y 1 c U 0 1 Y p 0 Y p 0 1 0 1 0 X X X X X c c p p

8. Economic Growth I: More Inputs • More labor and capital (cont.) • Two components of growth’s effect on welfare: • Income effect of growth: growth’s effect on per capita consumption at unchanged terms of trade. • Terms-of-trade effect: Captures the effect of changes in relative output prices. • Equals the price of its exports relative to the price of its imports. • Figure 10.3 illustrates the effects of a deterioration in a country’s terms of trade.

9. Figure 10.3: What Are the Effects of Deterioration in a Country’s Terms of Trade? Y U 1 U 2 tt Slope = – (P /P ) X Y 1 U 0 tt Slope = – (P /P ) X Y 0 0 X

10. Economic Growth I: More Inputs • More labor and capital (cont.) • Net effect of balanced growth on per capita income in a large country depends on: • Source of growth in labor endowment (population vs. labor-force participation); and • Relative magnitudes of income and terms-of-trade effects.

11. Economic Growth I: More Inputs • Just more labor • Increase in labor endowment with a constant capital endowment shifts production possibilities frontier asymmetrically. • Figure 10.4: Good X is labor-intensive. Out put of X rises more than proportionally with the labor endowment and output of the capital-intensive good falls. • Provides example of Rybczynski theorem. • When terms of trade are constant, an increase in endowment of one factor with the other factor endowment held constant increases production of the good intensive in the increased factor, and decreases production of the good intensive in the constant factor.

12. Figure 10.4: What Are the Effects of Labor Endowment Growth? Y tt Slope = – (P /P ) X Y Y II I 0 Y 1 0 X X X 0 1

13. Economic Growth I: More Inputs • Just more capital • Overall effects are ambiguous (as in the case of labor-based growth). • Major change is a positive income effect: • Total consumption rises – because the population does not change, a rise in per capita consumption follows. • Small country: growth has no effect on its trading partners. • Large country: if growth is import replacing, the terms of trade improve and effect on welfare is positive; if growth is export expanding, terms of trade deteriorate and welfare effect is not clear (see Table 10.3).

14. Economic Growth I: More Inputs • Extreme Case: Immiserizing Growth • In some cases, increased production may lower welfare through its deteriorating effect on the terms of trade. • Implication that growth may lower per capita consumption even if population remains constant. • Fig. 10.5 shows that with unrestricted trade, growth at unchanged terms of trade shifts out the production possibilities curve, allowing the country to reach U1, rather than the pre-growth U0. • If increased volume of trade significantly worsened the terms of trade, the country could end up on U2, which lies below U0.

15. Figure 10.5: Immiserizing Growth Y tt Slope = – (P /P ) X Y 1 tt Slope = – (P /P ) X Y 0 U 1 U 0 U 2 0 X

16. Economic Growth II: More Productivity • Increase in productivity is Technical Progress. • Types of technical progress: • Neutral technical progress leaves firms’ chosen capital-labor ratio unchanged. • Fig. 10.6 represents neutral technical progress in production of good X. • Shifts the isoquant that represents production level X0 in toward the origin – firms’ capital-labor ratio is unchanged at the old relative factor prices.

17. Figure 10.6: Neutral Technical Progress in the X Industry K X before after (K/L) = (K/L) X X Slope = – (w/r) X (before technical progress) 0 X (after technical progress) 0 0 L X

18. Economic Growth II: More Productivity • Capital-saving technical progress raises the marginal productivity of labor relative to that of capital. • Fig. 10.7 indicates that at unchanged factor prices, firms use a lower capital-labor ratio. • Along any ray from the origin (for any given K/L), the new isoquant is steeper than the old one.

19. Figure 10.7: Capital-Saving Technical Progress K X before (K/L) X after (K/L) X Slope = – (w/r) X (before technical progress) 0 X (after technical progress) 0 0 L X

20. Economic Growth II: More Productivity • Labor-saving technical progress involves an increase in the marginal product of capital relative to that of labor. • The cost-minimizing capital-labor ratio rises. • How does increased productivity affect welfare? • Small country: income effect constitutes only component of welfare effect, and overall impact is favorable. • Large country: Depends on relative strength of positive income effect and the negative terms-of-trade effect, identical to that in the case of balanced growth.

21. Economic Growth II: More Productivity • Figure 10.8 illustrates the effects of neutral technical progress in the X industry in a small country: • The country reduces production of good Y and increases production of good X.

22. Figure 10.8: What Are the Effects of Neutral Technical Progress in the X Industry? Y tt Slope = – (P /P ) X Y Y 0 Y 1 0 X X X 0 1

23. What if Factors Can Move? • Welfare analysis of factor movements involves four questions: • How does factor movement affect total world output? • How does factor movement affect the division of welfare between the two countries? • How does factor movement affect the distribution of income within each country? • How does the movement affect the factors that move? • assuming factor movements occur voluntarily, owners of the factors must expect to be better off, or they would not move

24. What if Factors Can Move? • Inter-country labor mobility • Labor generally flows less easily than capital across national boundaries. • Incentives for labor migration: • Economic: desire to better themselves and to improve conditions for their children. • Text focuses on these motivations and assumes that an individual moves when the reward paid to labor is higher in the destination country. • Noneconomic: desire for religious and political freedom.

25. What if Factors Can Move? • Inter-country labor mobility (cont.) • Fig. 10.9 provides a convenient guide for analyzing labor mobility’s effects. • Labor’s ability to move from country B to country A in response to a wage differential raises total world output by an amount represented by area of triangle EGJ. • Country A gains, and country B loses. • In A, capital owners gain relative to labor; and • In B, workers gain relative to capital owners.

26. Figure 10.9: What Are the Effects of Labor Mobility? A w B w E A w 0 G F B w A w 1 1 B w 0 J H B VMP L A VMP L A B 0 L L 0 0 1 Native labor in A Migration from B to A

27. What if Factors Can Move? • Inter-country labor mobility (cont.) • Labor migration’s effects: Gains are not divided equally among all countries. • Country A as a whole gains from immigration. • Net gain is sum of gains by capital owners in A, losses by native country-A workers, and gains by the immigrants themselves. • Country B as a whole loses from its emigration. • But workers in B gain relative to owners of capital.

28. What if Factors Can Move? • Inter-country labor mobility (cont.) • Opposition to immigration policies: • Open immigration can lower wagesof domestic workers (including earlier immigrants) who compete with new immigrants in labor markets. • Many countries have adopted strong social laws guaranteeing residents minimal levels of food, housing, medical care, education, and income; they fear influx of immigrants who will not work and produce. • Fear of aBrain Drain: tendency of most highly skilled, trained, and educated individuals from developing countries to migrate to industrialized countries.

29. What if Factors Can Move? • Inter-country labor mobility (cont.) • Theory, evidence, and politics: an important caveat… • Assume that country produces at least two goods, a labor-intensive one and a capital-intensive one, and that these goods can be traded internationally. • An inflow of labor makes a country more labor abundant and causes it to shift toward more labor-intensive goods and away from capital-intensive ones. • Result is an increase in the demand for labor to match the increased supply.

30. What if Factors Can Move? • Inter-country labor mobility (cont.) • Labor mobility without immigration? • Recently firms have begun to use several arrangements that amount to labor mobility without immigration: • Outsourcing: offshore assembly in which a firm performs each step in a manufacturing process in a country with a comparative advantage in that particular stage. • Use of electronic means to allow work like software programming to be outsourced to places like India and Russia – finished work retransmitted back to U.S. • No brain drain and earnings remain in developing country.

31. What if Factors Can Move? • Inter-country capital mobility • Two major classes of capital mobility: • International portfolio investment: flow across national boundaries of funds for financing investments in which the lender does not gain operating control over the borrower. • U.S. firm issues bonds (borrows) and sells some to German resident (makes loan to U.S. firm). • From German perspective: equals capital outflow (international purchase of assets). • From U.S. perspective: equals capital inflow (international sale of assets): • Direct investment: gives the lender operating ownership of and control over the borrower.

32. What if Factors Can Move? See Figures 10.10 and 10.11 • Inter-country capital mobility (cont.) • Recent patterns of international capital mobility. • Two main trends: • Rapid and erratic growth. • Diversification of source and host countries. • Figure 10.10 illustrates the top 20 host countries for cumulative foreign direct investment during the 1985-95 period. • Figure 10.11 indicates the regional allocation of U.S. outward and inward direct foreign investment for 1996.

33. Figure 10.10: Top Source and Host Countries for Foreign Direct Investment, 1999

34. Figure 10.11a, b: Destination and Sources of U.S. Outward and Inward FDI, 1999 (% of Total)

35. What if Factors Can Move? • Inter-country capital mobility (cont.) • Incentives for international capital movements: • Opportunity to earn higher rate of return or reward. • Desire to diversify assets to reduce risk. • Diversification refers to holding a variety of assets, chosen such that when some perform poorly, others are likely to perform well. • Mobility is a way of trading goods across time, called intemporal trade. • Intemporal exchange in assets can be mutually beneficial in much the same way as ordinary trade in goods and services.

36. What if Factors Can Move? • Inter-country capital mobility (cont.) • Capital mobility’s effects: • Analysis of the effects of capital mobility is very similar to that for labor mobility. • Fig. 10.12 points out that beginning at point E, capital flows, in response to the higher rate of return in country A, improve efficiency and increase output by EGJ. • Both countries gain because ownership of the migrant capital remains with country B. • In A, workers gain relative to capital owners, and in B capital owners gain relative to workers.

37. Figure 10.12: What Are the Effects of Capital Mobility? A B r r E A r G 0 F A B r r 1 1 J B r 0 H A VMP B VMP K K A B 0 K K 0 0 1

38. What if Factors Can Move? • Taxation and factor mobility • Rates of taxation vary widely from country to country. • Hong Kong corporate rate: 16%; Germany: 56%. • Factor mobility increases world efficiency by drawing resources to those locations where they can be most productive. • This conclusion does not apply to mobility motivated solely by countries’ differing tax rates and rules. • Such mobility clearly benefits migrant labor or capital, but does not increase efficiency of the world economy.

39. What if Factors Can Move? • Taxation and factor mobility (cont.) • Taxation of wages and capital income have similar effects. • Figure 10.13 examines the effects of wage taxation by Country A: • Beginning with an efficient allocation of labor between A and B, taxation of wages by A reduces total output by EGJ. • Workers between L1 and L0 migrate to B in response to a differential in wages net of taxes. Immigration harms workers in B. Workers in A are better off than they would be in the presence of the tax and with no labor mobility.

40. Figure 10.13: What Are the Effects of Wage Taxation by Country A? A B w w E A w G 1 A B w w 0 0 A A B w (1 – t ) w H 1 1 J A A w (1 – t ) 0 M A VMP L A A VMP (1 – t ) B VMP L L B L L 0 A 0 1 0

41. What if Factors Can Move? • Taxation and factor mobility (cont.) • Double taxation, or taxation on the same income by two governments, creates a strong disincentive for factor mobility. • Most governments agree, through tax treaties, to reduce, if not eliminate, double taxation by granting either tax credits or tax reduction for taxes paid to foreign governments.

42. Multinational Enterprises and the World Economy • One of the major economic trends of the postwar period has been the growth of firms across national boundaries. • Definition of Multinational Enterprises (MNEs): • Firms that manage facilities in at least 2 countries. • Classified into three groups: • Horizontally integrated MNEs: Produce basically the same or identical goods in several countries. • Vertically integrated MNEs: Produce inputs in one country that they use to produce another good in another country. • Diversified or Conglomerate MNEs: Production of different goods in various countries.

43. Multinational Enterprises and the World Economy • Why go multinational? • Capital arbitrage theory of multinationals: perspective of analysts who view MNEs as vehicles for spreading capital from one country to another. • Capital arbitrage view appears inconsistent with at least 3 aspects of observed MNE behavior: • MNE capital does not necessarily flow from capital-abundant to capital-scarce countries. • In many countries, inflows and outflows of MNE capital occur simultaneously. • Although MNEs often do move capital form one country to another, such movements are not necessary because MNEs can borrow funds locally for their subsidiaries.

44. Multinational Enterprises and the World Economy • Why go multinational? • Studies have confirmed that trade barriers encourage MNE development. • Tactic by host country involves imposing import restrictions high enough to force foreign firms that want to sell in the market to establish local production facilities. • Called tariff-jumping foreign direct investment. • Foreign direct investment can also defuse political sentiment in the host country. • Called quid pro quo investment.

45. Multinational Enterprises and the World Economy • Why go multinational? • Deliberate use of high trade barriers to attract inward FDI can work, but has some negative consequences: • Investment attracted tends to be simply production units to service the domestic market – not technology transfer or export-oriented production. • High trade barriers can make the domestic MNE affiliate less competitive by raising the cost of imported inputs.

46. Multinational Enterprises and the World Economy • Why go multinational? (cont.) • Due to lack of adequate intellectual property protection in developing countries, firms in technologically innovative or R&D-intensive industries tend to choose multinationalism over licensing. • By forming an MNE, the firm can maintain control over its technology while using it to serve foreign markets. • Fig. 10.14 reveals that U.S. FDI tends to be higher in industries that involve high levels of R&D.

47. Figure 10.14: U.S. FDI and R&D, 1994 ($ Billions) Foreign direct investment 60 Chemicals 50 Other manufactures 40 30 Transportation Food Industrial machinery Services Electronic 20 equipment Primary and 10 fabricated R&D expenditures metals 0 5 10 15 20 25 30

48. MNEs’ Effects • As MNEs help move production to least-cost locations and contribute to the spread of technological improvements, total world output increases. • Makes possible increases in total world welfare. • MNEs facilitate achievement of economies of scale by handling some functions centrally while continuing to adapt to local conditions in relevant areas of operation.

49. MNEs’ Effects • Claims by labor that shifting production to other countries constitutes the export of jobs that rightfully belong to U.S. • Once short-term adjustment and relocation costs are overcome, movement of production maximizes total world output and income. • Often, firm faces a choice between moving abroad or stopping production completely. • If foreign production makes inputs cheaper for U.S. producers, their competitive positions improve. • More foreign production raises foreign incomes, demand for U.S. exports increase, and employment in export-oriented industries increases.

50. MNEs’ Effects • MNEs tend to spread the technology developed in parent countries to the rest of the world. • Developing countries sometimes charge that the sheer size and economic strength of MNEs allow them to exploit their host countries. • Bargaining with host government for excessive tax concessions; • Paying unfairly low prices for raw materials removed from the host country. • Issuing deceptive financial statements to repatriate all the benefits from the operation to the parent country. • MNE’s general domination of host’s economy and culture – causes loss of indigenous values and damage to local companies.