Growth and Trade,
International Factor Movements
Appleyard & Field (& Cobb): Chapters 11–12
Krugman & Obstfeld: Chapter 7
Growth
• Economic growth may be due to change in
o
o
o
technology
amounts of factors of production
institutions (e.g. allowing international trade)
• Impact of this change
o
o
o
producers need to decide how to alter production
consumer need to decide how the change consumptions
world prices may change
2
Growth and PPF
Clothes
factor-neutral technological
change or capital and labour
increase by the same rate
Paper
labour saving technological
change or increase of
labour force
Paper
Paper
capital saving technological
change or increase of
capital
Clothes
Clothes
3
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 be
o 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 importcompeting products increase
relatively more
neutral effect
Paper (import)
•
“ultraantitrade”
effect
antitrade
effect
protrade
effect
“ultraprotrade
effect”
Clothes (export)
4
Terminology: Consumption Effects
Paper
• Similarly consumption effects
o (ultra)protrade: consumption
of imports increases more than
consumption of exports =
larger part of income will be
spent on imports after growth imports
o (ultra)anti-trade: as above, but after
imports
the other way around
before
o neutral: no change in the
relative consumption pattern
• The total impact of growth on
trade depends on the
combined production and
consumption effects
Note that we are
assuming constant
prices at this point
exports export
before
s
after
Clothes
5
•
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
Paper
Rybczynski Theorem
Growth of labour force →
absolute increase in the labourintensive product (clothes) and an
absolute decrease in the production
of capital-intensive product (paper)
Clothes
6
The Large country case:
Change in World Prices
• Large country = influences
•
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,
Imports of good Y
world prices
OC1
OC0
(PX/PY)1
(PX/PY)2
the country produces more
exports and buys more
imports =
shift of the
offer curve
Exports of good X
7
New equilibrium:
• More trade
• New terms of
trade = new
relative prices
• (PX/PY)E’ <
(PX/PY)E
Good Y:
Imports to country 1
exports from country 2
Shift of Offer Curves (2)
(PX/PY)E
= TOTE
(PX/PY)E’
= TOTE’
Country 2’s offer curve
Country 1’s offer curves
Good X:
Exports from country 1
Imports to country 2
8
Terms of Trade Effect
are lost due to reduction in
terms of trade
• That is, the price of exports
decrease due to increased
supply of exports
o
Paper
• Part of the gains from trade
alternatively price of
imports increases due to
increased demand of
imports
TOT1
TOT0
TOT0
Clothes
9
Immiserizing Growth
of trade is so large
that country’s welfare
decreases due to
increase of a factor of
production /
improvement in
technology
Paper
• The reduction in terms
TOT1
TOT0
Clothes
10
Jagdish Bhagwati (1958): Immiserizing Growth: A Geometrical Note. Review of Economic Studies 25
Foreign Direct Investment (FDI)
• Definition: ownership and control of foreign capital
o 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
11
Reasons for FDI
1. Getting close to the final markets
2. Access to raw materials
3. Low labour cost
4. Risk Diversion
5. Firm-specific knowledge
6. Trade policy (“getting behind the tariff wall”)
etc.
12
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
Note that we keep the amount of
MPPK labour fixed and hence the marginal
product of capital is decreasing
Capital
13
Capital Market Equilibrium: Two
Countries, Free Capital Mobility
Country 1
MPPK
MPPK
MPPK
Country 2
r1
r2
K1
Capital
r2
K2
K2
14
Capital Market Equilibrium: Two
Countries, Free Capital Mobility
In autarky, capital is scarce in
country 1 and hence return of
capital is higher than in the capitalabundant 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 MPPK1=MPPK2
Country 1:
MPPK, r
•
Country 1’s
eq’m capital
Country 2:
Country 2’s
MPPK, r
eq’m capital
rA 1
r*
r*
rA 2
capital
flow
Country 1’s
initial capital
Country 2’s
initial capital
Total world capital
15
Presenting Output Geometrically
• The amount of production
Country 1:
MPPK, r
depends on the amount of
inputs and the marginal
productivity of inputs:
Y=MPPK*K+MPPL*L
• Remember what area means (e.g.
rA 1
output
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
Country 1’s
capital
16
Effect of Capital Flows in the Two
Country Model
•
•
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
Country 1:
MPPK, r
Country 1’s
eq’m capital
Country 2:
Country 2’s
MPPK, r
eq’m capital
rA 1
r*
increase
of world
output
r*
productivity and hence wages)
•
In country 2, the opposite occurs
o
rA 2
increase
decrease
of
ofoutput
output
in
in
country 1
2
we discuss this in more detail in the part
about migration of labour
Country 1’s
initial capital
Country 2’s
initial capital
Total world capital
17
Possible Benefits from
Capital Flows for the Host Country
1.
2.
3.
4.
5.
6.
7.
Increased output and wages (as discussed already)
Increased employment (if excess supply of labour exists)
Increased exports (usually, though not necessarily the case)
Increased tax revenues (if feasible tax policy exits)
Realization of scale economies
Technical and managerial skill spill-offs
Weakening a domestic monopoly
18
See Appleyard and Field (around page 231) for discussion
Possible Disadvantages
from Capital Flows for the Host Country
1.
Adverse terms-of-trade effect (if the country is large enough exporter of
2.
Decreased domestic saving (“government relaxes its efforts to generate
3.
Crowding out domestic investment (domestic investors could finance
4.
Instability of exchange rate (when investment flows in the currency
5.
6.
7.
8.
Loss of control over domestic policy
Increased unemployment (investment in capital-intensive techniques)
New local monopolies (if multinationals run local firms out of business)
Inadequate attention to local education and skills
the goods FDI flows into or due to transfer pricing)
domestic savings”)
multinationals rather than domestic business)
appreciates; when profits are sent back, the currency depreciates)
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. Models19
suitable for analyzing some of these effects are introduced later in the course.
International Labour Movements
• Assume homogeneous labour,
no costs of migration, no
preferences regarding the
country of residence
• Then we can proceed as with
capital: country 1 is labourabundant, country 2 labourscarce → wages are higher in
country 2 → there is an
incentive to move to country 2
until wages are equal
Country 1:
MPPL, w
Country 1’s
eq’m employment
Country 2:
Country 2’s MPPL, w
eq’m employment
wA2
w*
w*
wA1
migration
Country 1’s
initial employment
Country 2’s
initial employment
Total world labour force
20
Distribution of income:
a geometrical representation
• 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=MPPLX*PX
• Labour gets w*L, capital
owners get the rest
Country 1:
MPPL, w
rents
w
wages
MPPL
labour
21
Impact of Migration
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 1’s
eq’m employment
Country 2:
Country 2’s MPPL, w
eq’m employment
wA2
transfer from labour
to capital in country 1
w*
transfer from capital
to labour in country
w*
gain for the
immigrants
wA1
Country 1’s
initial employment
Country 2’s
employment
Total world labour force
22
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)
Country 2
Labour intensive product
Capital intensive
product
• Capital and labour flows
Capital intensive
product
Factor Movements, Trade and the
World Prices
Country 1
Labour intensive product
23
Total Effects of Growth
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.
Paper
• The total impact of changed
Clothes
24