Question

Foreign Direct Investment (FDI): Extending Specific-Factor Model

Suppose the home country exports clothing, which is produced by labour and capital, and imports food, which is produced locally by labour and land. That is, assume the specific-factor production structure of Chapter 4. Let some of the capital used in the clothing sector be provided by foreign investment. If the home country protects its food industry with a tariff, trace through the following scenarios:

1. What is the effect on factor prices, production, consumption, and trade volumes if no more foreign capital enters or leaves the country?
2. What is the further impact on factor prices, production, consumption, and trade if returns to capital in the clothing sector adjust to a given world rate of return via changes in the quantity of capital (FDI) foreigners wish to place in the protectionist country?
3. What is the effect on net home welfare in each case?

(Limit: 1 to 1 ½ single spaced pages)

Answer 1

(A).

Commodity movements and factor movements are substitutes. The absence of trade impediments implies commodity-price equalization and, even when factors are Immobile, a tendency toward factor-price equalization. It is equally true that perfect factor mobility results in factor-price equalization and, even when commodity movements cannot take place, in commodity-price equalization.

There are two extreme cases between which are to be found the conditions in the real world: There may be perfect factor mobility but no trade, or factor immobility with unrestricted trade. The classical economists generally chose the special case where factors of production were internationally immobile.

This paper will describe some of the effects of relaxing the latter assumption, allowing not only commodity movements but also some degree of factor mobility. Specifically it will show that an increase in trade impediments stimulates factor movements and that an increase in restrictions to factor movements stimulates trade.³ It will also make more specific an old argument for protection.

Trade Impediments and Factor Movements

Under certain rigorous assumptions the substitution of commodity for factor movements will be complete. In a two-country two-commodity two-factor model, commodity-price equalization is sufficient to ensure factor-price equalization and factor-price equalization is sufficient to ensure commodity-price equalization if (1) production functions are homogeneous of the first degree (that is, if marginal productivities, relatively and absolutely, depend only on the proportions in which factors are combined) and are identical in both countries; (2) one commodity requires a greater proportion of one factor than the other commodity at any factor prices at all points on any production function; and (3) factor endowments are such as to exclude specialization.⁴

These assumptions permit us to isolate some important influences deter mining the pattern of international trade and factor flows and for present purposes will be adhered to. Our first task is to show that an increase in trade impediments encourages factor movements.

Assume two countries, A and B, producing two final commodities, cotton and steel, by means of two factors, labor and capital.⁵ Country A is well endowed with labor but poorly endowed with capital relative to country B; cotton is labor-intensive relative to steel. For expositional convenience we shall use community indifference curves.

For the moment we shall assume that country B represents the "rest of the world " and that country A is so small in relation to B that its production conditions and factor endowments can have no effect on prices in B.⁶

Let us begin with a situation where factors are immobile between A and B but where impediments to trade are absent. This results in commodity- and factor-price equalization. Country A exports its labor-intensive product, cotton, in exchange for steel. Equilibrium is represented in Figure 6-1: TT is A's transformation function (production-possibility curve), production is at P, and consumption is at S. Country A is exporting PR of cotton and importing RS of steel. Her income in terms of steel or cotton is O Y.

Figure 6-1.

Suppose now that some exogenous factor removes all impediments to the movement of capital. Clearly, since the marginal product of capital is the same in both A and B, no capital movement will take place and equilibrium will remain where it is. But now assume that A imposes a tariff on steel and for simplicity make it prohibitive.

Initially the price of steel will rise relative to the price of cotton in A and both production and consumption will move to Q, the autarky (economic self-sufficiency) point. Factors will move out of the cotton into the steel industry, but since cotton is labor-intensive and steel is capital-intensive, at constant factor prices the production shift creates an excess supply of labor and an excess demand for capital. Consequently the marginal product of labor must fall and the marginal product of capital must rise. This is the familiar Stolper-Samuelson tariff argument.

(B).

Trade protectionism is defined as a nation, or sometimes a group of nations working in conjunction as a trade bloc, creating trade barriers with the specific goal of protecting its economy from the possible perils of international trading. This is the opposite of free trade in which a government allows its citizenry to purchase goods and services from other countries or to sell their goods and services to other markets without any governmental restrictions, interference, or hinderances. The objective of trade protectionism is to protect a nation’s vital economic interests such as its key industries, commodities, and employment of workers. Free trade, however, encourages a higher level of domestic consumption of goods and a more efficient use of resources, whether natural, human, or economic. Free trade also seeks to stimulate economic growth and wealth creation within a nation’s borders.

There are various methods of trade protectionism whose goal is to protect a nation’s economic well-being. These include:

Tariffs which are a tax on imports from other countries and foreign markets. Here, the government imposing the tariff is looking to restrict imports of foreign goods and services, protect its own industries and companies manufacturing such items and raise tax revenues. Tariffs could be specific in which there is a fixed tax rate or fee for each unit of a product or commodity brought into a nation. There are also ad valorem tariffs which are set as a proportion of the value of the imported product.

Quotas are a direct restriction on the number of certain goods, products, and commodities that may be permitted to be imported into a nation. This import quota is generally enforced by the issuance of import licenses to a certain group of persons or companies. There is also voluntary export restraint (VER) that acts as a trade quota imposed by an exporting nation. VERs can also come in the form of political pressure on a nation by another country in order to stop the export of goods or commodities.

Subsidies are government payments to domestic producers. This can come in the form of cash payments, low-to-no interest loans, tax breaks, and government ownership of common stock in domestic companies. Subsidies help domestic producers by having extra cash available for production of goods thereby lowering manufacturing costs and allowing these same companies to gain foreign markets.

Local content requirements may be imposed by a nation seeking to decrease imports by setting a manufacturing requirement in which a stated part or parts of a product must be made domestically. This occurs by having a percent of a product manufactured domestically or that in value terms, such as 85 percent of its value, must be made locally.

Administrative trade policies consist of bureaucratic rules, laws, and regulations designed to create serious difficulties for an importer of goods or commodities into a particular nation. Formal trade barriers can come in the form of onerous rules, regulations, administrative requirements, and paperwork to be completed. Informal trade barriers include the inspection of every product, good, and commodity entering a nation in order to check for disease or suspicious content. This can take time, effort, and may often severely damage the item being inspected. Administrative policies can also involve setting high-level health and safety standards and difficult-to-obtain import licenses for foreign producers.

Antidumping policies are enacted by a nation in order to prevent the selling of goods in a foreign market at a price far below their production costs in order to gain a substantial share of that nation’s market. Anti-dumping rules can also include regulations prohibiting the sale of goods, products, or commodities below its fair market value.

Exchange rate controls can be used to make a nation’s product cheaper abroad by lowering the value of its currency in the foreign exchange markets. The premise is that a nation can sell its currency in foreign exchange markets to the point where its loses value against other currencies. This will cause the price of imports to rise while lowering the cost of its exports. This will help a nation, whether developed or developing, increase the opportunity to sell its products and goods in foreign markets.

(C)

Tariffs are a tax placed by the government on imports. They raise the price for consumers, lead to a decline in imports, and can lead to retaliation by other countries.

• They could be a specific amount (e.g. £1 per unit.)
• Or they could be an ad valorem tax (e.g. 10% of the price)

Tariffs are an important barrier to free trade; they are often imposed to protect domestic industry from cheap imports. However, it often leads to retaliation with other countries placing tariffs on their exports.

• In this case, the tariff is P1-P2.
• The tariff leads to a decline in imports. Imports were Q4-Q1. After the tariff, imports fall to Q3-Q2.
• Consumer surplus falls by 1+2+3+4
• Government raises tariff revenue of area 3
• Domestic suppliers gain an increase in producer surplus of area 1
• The net welfare loss is (1+2+3+4) – (1+3) = 2+4

Effect of tariffs

• Without any trade, the equilibrium price is £1.80 and a quantity of 40 million
• With a tariff of £0.40, the price of imports will be £1.60.
• The quantity of imports at £1.60 is (50-30) = 20 million.
• With free trade (no tariffs) the price would be £1.20 and quantity bought 60 million.

Government tariff revenue

• Tariff revenue = tariff × q. of imports (£0.40 × 20 million) = £ 8 million

Consumer surplus

This is the difference between the price consumers pay and the price they are willing to pay; therefore we find the area of the triangle between demand curve and price

• With no trade = (£3.20 – £1.80 × 40) /2 = (£1.40 ×40)/2 = £28 million
• After tariff – (£3.20 – £1.60) × 50)/2 = £40 million
• With no tariff (free trade)- £3.20 – £1.20 × 60)/2 = £60 million
• Tariffs reduce consumer surplus by £20 million

Diagram showing the effect of tariffs on consumer surplus

Tariffs lead to a decline in consumer surplus of 1+2+3+4.

Producer surplus

The difference between the price and the price firms are willing to supply at (supply curve

• With no trade (£1.80 – £0.5) × 40)/2 = £24 million
• With tariff (£1.60-0.50) × 30)/2 = £16.5 million
• With free trade and no tariff (£1.20-0.50 × 20)/2 = £6 million.
• Tariffs increase producer surplus by £10.5 million

Welfare effect of tariffs = gain in producer surplus (£9 m) + gain in tariff revenue (£8m) – loss of consumer surplus £20m)

• Therefore net welfare loss = £3 million