Chapter 7-International Factor Movements PDF

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Chapter 7-International Factor Movements HAIDEH...

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Chapter 7- Analysis of Effects of Free Movement of Factors of Production Between Countries All our discussion so far has included the analysis of trade in goods and services while no factors of production-labor, capital, or landmove between countries. In the real world, there are movements of capital--called international capital flows-- and movement of labor-termed migration--between countries. In this chapter we study the effects of allowing for movement of these factors. To our analysis, we will add an important variant of capital movement, that of foreign direct investment abroad (FDI). The international movement of (financial) capital, termed, “foreign portfolio investment” is sensitive to changes in the macroeconomic (fiscal and monetary) policies of countries. Therefore, this topic is best studied in the macro part of the field of international economics, international finance.

Topics in this chapter include: 1. The welfare and income distribution effects of free labor (and capital) migration between two countries 2. Multinationals and Foreign Direct Investment: Location choice of firms and the welfare and income distribution effects of FDI

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1. The analysis of welfare and income distribution effects of free labor migration between two countries This analysis is viable if we make a simple assumption that labor desires to migrate to another country only if real wages--standard of living for labor-- in that country are higher. That is, the only incentive for migration is a higher real wage across the border. It becomes quickly apparent that the type of model that would generate the desire for labor migration would be an H-O type world, where one country is relatively labor abundant and the other is relatively labor scarce! If two countries are identical (as in our IRS study), then real wages would be the same and there would be no incentive to move anywhere. Of course, as we studied in chapter 3, if we have free trade in goods and services, again wages (and prices) would equalize between the trading countries, and therefore in the presence of free trade in goods, there would be no movement of labor (the factor price equalization effect). In reality of course, we argued that the discrepancy between the strict H-O model and its assumptions and our reality does keep prices and wages different even in the event of a free trade pact such as NAFTA. Thus the incentive for migration remains in spite of trade in goods and services. Let's analyze how the welfare and income distribution of the two countries are affected if we allow for the freedom of movement of labor between them. This is a model similar but not identical to the H-O model in that we assume both countries produce just one (GDP) good and that no trade in that good takes place between them. Thus the only "trade" we shall analyze will be that of 2

migration or movement of labor from one country to another. Here is the model: Consider two countries, A and B, each of which produces a single aggregate good (real GDP). This good uses two factors, labor and capital in its production process. The amount of capital in each country is given and does not change. Also capital does not move between the two economies. Given a constant returns to scale production process, with a fixed amount of capital stock, the marginal productivity of labor (MPL) in each country is a downward sloping function of the amount of labor employed. We assume that country A has more labor than country B. Therefore, country A is the labor abundant country. The total stock of labor supply in the world is L = LA + LB. We shall use the graphical analysis below to first illustrate the total level of production of the single GDP good and discuss the production and welfare effects as well as the income distribution effects of free labor migration between the two countries.

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G ra p h 7 - 1 M P LB

M P LA M P LA

M P LB

B

Re a l W

B

A C

Re a l W A

To t a l W a g e B ill f o r A L a b o r S u p p ly in B

L a b o r S u p p ly in A

Consider the total volume of production and income distribution of each country before labor migration is allowed. For each country, the area under its MPL curve up to the level of labor force is the geometric indication of the total value of output produced in that country. Indeed, the integral of the marginal productivity is simply total production, and the area below the marginal productivity of labor and up to the amount of labor employed indicates the total level of production of the single aggregate good for either economy. 4

On the horizontal axis, the total world supply of labor is shown and is divided into LA and LB. The interaction of supply of labor and the demand for labor (identified by the MPL curve) determines the real wage in each country. As A is the labor abundant country, its real wage will be low relative to real wage in B. Thus, labor desires to migrate from A to B. The total wage bill in A is shown on the graph by the rectangle spanning real wage and LA. The same goes for total wage payments made to labor in country B. As for the geometric illustration of payment of rent to the other factor, capital, it is the area below the MPL curve and above the rectangle for wage bill. It is indeed the total amount of production minus the wage bill. In order to see the effects of labor migration, let's look at the same graph, redrawn as Graph 7-2 below and illustrate the effects of labor migration on the real wage in both countries. Since labor migration is allowed, labor would move from the low wage country A to the high wage country B. As a result real wage in B falls and in A rises until the real wages in the two countries are the same, as shown by real W in Graph 7-2.

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G ra p h 7 - 2 M P LB

M P LA M P LA

M P LB

N Re a l W

Re a l W

M

B

Re a l W a g e A f te r M ig ra t io n

Re a l WA

L a b o r S u p p ly in B

L a b o r S u p p ly in A

Once migration of labor takes place, real wages will become equal and the new division of labor between the two countries is shown the amount of labor in A that joins the labor force in B (the distance between the orange line and the labor supply of country B) in Graph 7-2. How does the level of production in each country change, and how about the volume of world production after labor migration compared to before? The level of production in country A now falls to a smaller area below the MPL curve and to the left of point M in the graph. The level of production in B however picks up- due to increased labor supply - and its level of production is now the area 6

below the MPL for B and to the left of the amount of labor employed (after migration). A little care to see the changes before and after migration will make it clear that while country A's production has fallen, country B's production has risen by a larger amount. Notably, the triangular shaped area MNO is the net increase in world production (all of it in country B). If we judge welfare changes --due to movement of labor-- by the increases in total world production, then it is easy to conclude that the world welfare does increase (by the net increase in production shown on Graph 7-2 by the area MNO). How this increase is divided up between the two countries A and B is a question of distribution of net gains from free movement of labor between the two countries. One can imagine, for example, that the migrant workers who go to work in B will send part of their income as "remittances" back to their families or relatives in country A. This indeed can be a significant part of some countries' GNP (not GDP!)1, where nationals of that economy send part of their income back home. Turkey in 1950s and 60s received a large sum from its workers in Germany. Out-migration also helped relieve the unemployment problem in Turkey. How do we intuitively explain the positive welfare effects of labor migration from the labor abundant to the labor scarce country? In the labor abundant country, the MPL of the last worker is low, given the amount of fixed capital. That is the last few workers are not terribly productive. When they migrate to country B, they will indeed do more productive work, implying that the level of production these workers produce has indeed increased. The net increase in world production is shown by the area MNO in the graph above.

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The contribution of guest workers to their economy of origin goes beyond just the simple increase in GDP due to remittances. As Anghel, Piracha, and Randazzo argue: In the past twenty years the ever-growing levels of migrants’ remittances made state agencies, international organizations, scholars and practitioners to increasingly consider remittances as one of the main engines to promote globalization and growth in the developing world. By transferring home large amounts of money, information, ideas and practices, migrants and migrant organizations are often seen as able to produce significant changes in countries and localities of origin.2

Is the welfare result of labor migration similar to that of effects of free trade in goods in the H-O model? Yes! In both cases, the world production and welfare level increase. How about the income distribution effects of labor migration, and, how do these effects differ from the income distribution effects in the H-O model? As labor migration takes place out of A, the real wage for labor increases, and the real rent for capital falls (judged by the decreased area under MPL curve that illustrates share of capital in total production) in A. In B, as real wage drops with migration, the real rent on capital will increase. So clearly, the income distribution effects of labor movement from the labor abundant country to the labor scarce country are similar to the income distribution effects of trade in goods in the H-O model! That is, as long as we are looking at countries with differences of the type in the H-O model, free trade in goods produced by factors of production, and, free movement of those factors themselves gives welfare and income distribution results that are in the same direction: welfare increases (potentially) for both countries, however 8

there are income distribution effects between labor and capital. In the labor scare country, labor loses as real wage falls and in the capital scarce country owners of capital see a decline in rents they receive. The overall effects of labor migration are generally broader and in reality somewhat more complicated than a theoretical model would suggest. Migrant workers may lower wages for lower skilled domestic workers, but they may also have a positive impact on overall employment via their demand for goods and services. In other words, the presence of migrant workers increases the overall demand for goods and services and hence raises the level of output and employment in the host economy. Migrant workers who work also pay taxes, contributing to the government’s budget. However, they may also cost the local government in terms of health and education expenses.

Case in Point The effects of Arizona’s tough immigration laws Economists of opposing political views agree the state’s [Arizona’s] economy took a hit when large numbers of illegal immigrants left for Mexico and other border states, following a broad crackdown. But they also say the reduced competition for low-skilled jobs was a boon for some native-born construction and agricultural workers who got jobs or raises, and that the departures also saved the state money on education and health care. Whether those gains are worth the economic pain is the crux of the debate.2

The simple economic analysis of labor migration from developing to developed country shows the causes of migration and the 9

comparative static welfare effects of migration. The dynamic process of international labor migration, however, involves new incentives for further migration, all of which are endogenously created. For example, as one member of a family migrates to another country, his/her education about the job opportunities, living standard, laws, regulations and government social security policies in the host country may provide incentives for other family members to migrate as well. Thus the incentive for migration may no longer be the differences in real wages between the two countries, but the added institutional differences which the first wave of migrant workers will learn about. It is entirely possible then, to have migration take place from one country to another in spite of a process of development taking place in the country that originates migrant workers. A case in point is provided by Douglas Massey of the University of Pennsylvania regarding the migration process of Mexican workers into the U.S.

Case in Point “Most policy makers and citizens think Mexicans migrate to earn higher wages in the United States. The reality is more complicated. Standard economic theory begins with the assumption that markets exist, but in fact they have to be created. The operation of markets not only requires building a physical infrastructure of transportation and communication, but a social infrastructure of institutions and laws, and an ideational infrastructure of values and cultural practices. In the process of constructing an open market, old structures are cast aside and new ones are created. International migration originates in the transformations that inevitably accompany the process of economic development. Workers are displaced from traditional livelihoods and thrown onto unstable labor markets without social safety nets. Entrepreneurs are 10

forced into production without access to capital or insurance. Consumers are filled with new material aspirations but lack credit to enable mass consumption. Economic insecurity coupled with the desire to participate in the new economy as workers, producers, and consumers, lead households to search for new ways of self-insuring against risk and overcoming failures in capital and credit markets. International migration offers a means of achieving these goals. By sending a family member abroad to work, households diversify their labor portfolios to reduce risks to income, and the resulting stream of earnings can be accumulated to make up for a lack of capital and credit. International migration does not stem from a lack of economic development, but from development itself. No mater how it starts, however, migration tends to perpetuate itself over time through two intertwined processes, one operating among individuals and the other through the social networks in which they are embedded.” 3 The complexity of the issue of labor migration may help explain why, in spite of similar effects that free trade in goods and free migration of labor have on countries (both in terms of the overall welfare and income distribution effects), governments sign free trade in goods but restrict labor migration. In political economy terms, it is easier to buy clothing from another country than to have the workers from that country as migrant labor producing similar goods at home. Workers are also human beings! They demand goods and services, and pay taxes. As they bring their families to the new country and create communities of their own in their new surroundings, they create new social, cultural, even political challenges for the policy makers and the population in general. The long running experiences of Turkish migrant workers in Northern Europe after the Second World War and the recent wave of antiimmigrant sentiments and legislation in Europe is a testimony to the 11

difficulty of having labor migration, as opposed to free trade in goods and services. One final diversion between our model and the reality of labor migration is the following: above, we assumed that both countries, including the labor abundant country have full employment. Indeed, for the developing country--country A--the MPL of the last worker is fairly low. Once that worker is allowed to migrate to B, it will have a higher productivity which accounts for the increased world production due to labor migration and a higher real wage for the migrating worker. In reality, many countries, especially the developing countries, are faced with the problem of unemployment. The MPL of the unemployed worker is zero. So, the positive effects of migration-- as the worker goes from being unemployed and completely unproductive to producing a good or service in the other country --are magnified. In many ways, for countries with a large part of their labor force unemployed, labor out-migration is a good solution to relieving the unemployment problem. In addition, the workers send some part of their income home which can become a small boon to the home economy. Is it always the unemployed, possibly low productivity workers who migrate? In the last many decades, the world has seen the outmigration of not just the low skilled unemployed workers from developing countries but also the migration of highly skilled professionals to North America, Europe, Australia and the like. This is called the problem of "brain drain". Out-migration of highly skilled professionals, scientists, and entrepreneurs from a country can affect that economy adversely. Essentially, as the best qualified people leave, the average productivity and the total level of production fall in the home economy. During the oil boom of late 1970s, the oil rich countries of the Persian Gulf faced an increased demand for all types of labor from neighboring countries. There was 12

increased demand for construction workers, janitors, shopkeepers, etc., alongside with doctors, technicians, teachers, computer programmers, and other skilled type work. The large differences in pay for skilled professionals by the Arab Gulf countries led to a large outflow of professionals from Jordan, Egypt, Syria and other nearby oil poor economies. For one country, Jordan, it was estimated that nearly 1/3 of its medical professionals left the country in late 1970s to work in the Gulf countries. In this chapter so far, we have discussed the welfare and distributional issues of labor movement across countries. The next factor of production to consider is movement of capital, also called "foreign portfolio investment". While in the production process we consider physical capital, it is normally the financial form of capital that moves between countries; funds that are then used by firms in those countries to buy equipment or to build infrastructure. The analysis of the welfare effects of this type of migration or movement between countries is similar to the result of labor migration. However, financial flows between countries are greatly affected by macroeconomic environment and macroeconomic policies. For example, the changing interest rates in one country would lead to changes in the financial flows in or out of that country. A higher interest rate will bring in foreign portfolio investment while a drop in one country's interest rate would result in outflow of capital from that economy. Changes in other non-measured factors such as the level of confidence in an economy can also generate international capital flows. If a currency is overvalued and is maintained in that fashion by the government, the slightest change in exchange rate policy may undermine the confidence in the currency of that economy and lead to panic out-flow of capital owned by foreign or domestic financial investors. As such, the appropriate place for a discussion of the effects of international capital flows is in a macroeconomic context in an international finance course. 13

Instead of discussing foreign portfolio investment, below we analyze the welfare and income distribution effects of foreign direct investment.

2. Multinationals and Foreign Direct Investment: Location choice of firms and the welfare and income distribution effects of FDI When a U.S. fi...