Week 16

(Lecture 1)
Chapter 7
International Factor Movement

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 Movements in Factors of Production

• Ch 3, 4, 5 and 6 : covered the discussion on

trade in goods and services.
• International integration or trade can also be
on account of international movement of
factors.
• International factor movement is movement of
labor, capital or other FOP between the
countries.

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 Movements in Factors of Production

• Movements in factors of production include

 labor migration,
 the transfer of financial capital through
international borrowing and lending,
 transactions of multinational corporations involving
direct ownership of foreign firms

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 Movements in
Factors of Production (cont.)
• Movements of factors of production are
politically sensitive and are often more
restricted than movement of goods and
services.
 Restrictions on immigration
 Restrictions on financial capital flows (less
common today in Europe and US)
 Restrictions on the activities of multinational
corporations

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 International Labor Mobility

• International labor mobility is an important

feature of international economy.
• However, it’s politically a contentious subject
when considering the illegal movement of
people across borders.
• Nevertheless, the traditional international
theory maintains that reduction in barriers to
labor mobility leads to equalization of wages
across the countries.
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 A One-Good Model Without Factor
Mobility
• To show the effects of labor migration (mobility),
let’s build a simple model with only one good
(output) and 2 countries (Home and Foreign).
• Suppose that there are only two important
factors of production: land and labor.
• On a fixed parcel of land, each worker often
becomes less productive or efficient as more
workers are added to that fixed parcel of land.
 The marginal product of labor often decreases.

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 A One-Good Model Without Factor
Mobility (cont.)

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 A One-Good Model Without Factor
Mobility (cont.)
• Q(T,L) which is the output , shows how output
changes due to change in labor , holding land
constant.
• Slope of output function = MPL= dQ/dL
• (MPL decrease as more labor is used with fixed
amount of land). This can be graphed in Fig 7.2 to
show “ how real wages and total wages are
determined in this economy”.
• For any given level of employment, real wages paid to
the workers will be equal to the MPL of labor.

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 A One-Good Model Without Factor
Mobility (cont.)
• Total Wages= real wage * no. of employees
• $100 = $10 * 10
• (The total wages paid are shown in blue rectangle in Fig 7.2, while rest of the
area under the MPL curve shows the rent paid to the land-owners).
• Note: (An important point about MPL curve is that area under the entire curve
show the value of output, out of which blue shaded area represent wages paid
to workers while rest of the area represents the rent paid to land-owners. The
detailed analysis with graph is shown in Appendix 1 of this chapter).

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•
 A One-Good Model Without Factor
Mobility (cont.)

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 A One-Good Model Without Factor
Mobility (cont.)
• If the domestic country is the labor abundant
country and the foreign country is the land
abundant country, then wage rate will be low
in domestic country while it will be high in
foreign country.
• There is an incentive for domestic workers to
move to the foreign country.

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 International Labor Movement
• If we allow the factor mobility, then workers
from domestic country will migrate to foreign
country, resulting in an increase in real wage
in domestic country.
• Contrary to this , an inflow of workers in
foreign country will increase labor supply and
will result in a decrease in wages in foreign
country.
• This transfer of labor will continue until wage
rate is equalized in both countries.

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 International Labor Movement (cont.)

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 International Labor Movement (cont.)
• In Fig 7.3, initially, OL1 = labor employed at home
• O*L1 = Labor employed in Foreign
• Real wage in Home < Real wage in Foreign
• (point C) < (point B)
• Labor migrate from home to foreign country, until real
wage is equalized in both the countries at point A.
• At point A, OL2 = labor employed in home
• O*L2 = labor employed in Foreign

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 International Labor Movement (cont.)
• This redistribution of world labor force leads to
following three important conclusions.
• 1. Convergence of real wages (Real wages in Home
increase, while decrease in Foreign )
• 2. World Output as a whole increases.
 Foreign output rises by the area under its MPL*
curve from O*L1 to O*L2
 Domestic output falls by the area under its MPL
curve from OL1 to OL2
 Since foreign gain > Home loss by area ABC ,
which implies world output as a whole increase.

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 International Labor Movement (cont.)

• 3. Redistribution makes some groups better

off while others will be worse off
 Foreign landowners become better off, because
they will have more labor to work with, MP of land
increase and result in more reward to land-owners.
 Domestic land-owners become worse off, because
they will have less labor to work on their lands,
resulting in low MP of land and a resultant less
reward.

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 Week 16
(Lecture 2)
Chapter 7 (Cont.)

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 Extending the Analysis

• Making the simple model relatively more complex now

by taking two goods instead of a single good, 1 being
labor intensive and the other one as land intensive.
• Under the assumption of two good model now, trade
offers an alternative to factor movement.
• The Heckscher-Ohlin model predicts that trade in
goods is an alternative to factor mobility.
 Services from factors of production are “embodied” in goods,
so that the value of goods reflects the value or productivity of
factors of production that produced them.

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 Extending the Analysis (cont.)

• Trade in goods would lead to factor price equalization

even without factor mobility.
• If this happens then there is no incentive for the labor to
cross the borders.
• In reality, however, trade can be substitute for factor
movement but not a perfect substitute.(On account of
barriers to trade in form of transportation cost, tariffs and
NTBs)
• Furthermore, in reality complete factor price equalization
is restricted on account of barriers to trade, difference in
technology , differences in resource endowments.

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 Extending the Analysis (cont.)

• Even extending the model does not change

basic result; trade in factors is similar to trade
in goods (in purely economic terms )
• It occurs for same reasons (e.g., differences
between the countries ) and yield the same
results( e.g. increasing world output as a
whole along with distributional
consequences).

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 International Borrowing and Lending

• Besides labor, other factor of production like

capital can also move across the countries.
• By capital movement, we mean only the
borrowing and lending among different
countries.
• Analysis of capital movement or financial
transaction will be a part of second half of this
book that will be covered in International
Finance course.
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 International Borrowing and Lending

• International borrowing and lending can be

interpreted as intertemporal trade.
• This kind of trade is not of current exchange
of goods and services among the countries
but it’s the trade in goods today for goods in
future.
• Thus intertemporal trade represents trade off
between the current goods Vs the future
goods.
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 International Borrowing and Lending

• A country is engaged in intertemporal trade

through borrowing and lending.
• A country that is scarce in resources, trade its
future consumption for current consumption.
• Current consumption would be high at the expense
of future consumption, as the country meets
current consumption through borrowing aboard
and these funds needs to be payed back with
principal amount as well as interest rate.

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 International Borrowing and Lending
• A country that is rich in resources, trade its current consumption for future
consumption.
• Future consumption would be high at the expense of current consumption, as the
country is lending one and would be the recipient of earlier extended borrowed funds
or debt in the future.
• It further implies that lending country is exporting the current consumption for importing
the future consumption or it has a comparative advantage in current consumption.

 Financial capital is a source of funds used to build physical capital (e.g., factories and
equipment).

• International capital mobility can be interpreted as intertemporal trade:

 trade of goods consumed today by borrowers
in return for goods consumed in the future
by lenders.

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 Foreign Direct Investment

• Foreign direct investment refers to international flow

of capital where by a firm in one country creates or
expands its subsidiaries in another country.
• It not only involves the transfer of resources but
acquisition of the control as well, that’s why FDI is
conducted through the establishment of multinational
corporations.
• If a foreign company invests in at least 10% of the
stock in a subsidiary, that would be classified as a
multinational corporation.

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 Theory of Multinational Corporations

• Why are multinational corporations created

and why do they undertake direct foreign
investment?
• We rephrase these questions into those
dealing with
1. Location: why is a good produced in two
countries rather than in one country?
2. Internalization: why is production in different
locations done by one firm rather that by
separate firms?

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 Theory of
Multinational Corporations (cont.)
• Why production occurs in separate locations
is often determined by
 the location of necessary factors of production:
• mining occurs where minerals are;
• labor intensive production occurs where relatively large
pools of labor live.

 transportation costs and other barriers to trade

may also influence the location of production.

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 Theory of
Multinational Corporations (cont.)
• Internalization occurs because it is more profitable
to conduct transactions and production within a
single organization than in separate organizations.
Reasons for this include:
1. Technology transfers: transfer of knowledge or
another form of technology may be easier within a
single organization than through a market
transaction between separate organizations.
 Patent or property rights may be weak or non-existent.
 Knowledge may not be easily packaged and sold.

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Theory of
Multinational Corporations (cont.)
2. Vertical integration involves consolidation
of different stages of a production process.
 Vertical integration would involve consolidation of one
firm that produces a good that is used as an input for
another firm.
 For example, having tyre manufacturers(upstream
firm) and automobile manufacturers (down stream
firm )consolidate into one organization to make
automobiles may be more efficient than having them
as separate organizations.
 This kind of arrangement may be more efficient than
having production operated by separate firms (avoid
monopoly conflicts, coordination problems if
supply/demand uncertain, risk of price fluctuations).
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