Brief answers to problems and questions for review
1. Interindustry trade mainly occurs because the factors of production are not mobile from
one country to another. If the factors of production were mobile between countries, the
movement of the factors of production would expand world output and equalize factor
prices between countries. The movements of the factors of production from one country
to another is similar to factor-price equalization. Factor prices tend toward equality either
through trade or through the movement of the factors of production. As a result,
international trade is a substitute for the movement of the factors of production between
countries.
2. Foreign direct investment (FDI) represents real investments in land, nonresidential
structures, and producers’ durable equipment in a foreign country. Firms pursue FDI to
earn a higher expected rate of return on their capital. Another motive for foreign direct
investment is when a multinational corporation attempts to enter a closed or highly
restricted foreign market. High transportation costs can also induce foreign direct
investment. Multinational corporations engaged in selling a differentiated product
globally may find it more profitable to set up production facilities or subsidiaries to serve
foreign markets. Finally, multinational corporations in which production is separated into
several distinct stages of may find it profitable to set up production facilities in foreign
markets to take advantage of lower operating costs.
3. There is currently about $23 trillion worth of FDI in the world economy. In this decade,
around 85 percent of FDI originates in high-income countries. Less than 35 percent
comes from low- or middle-income countries. This makes sense as the high-income
countries tend to be capital abundant. Where the FDI flows to makes less sense in terms
of factor abundance. Nearly 50 percent of FDI flows among the high-income countries
and the minority flows to developing countries. Factor abundance alone explains the
outflows of FDI but is less useful in explaining the inflows.
4. The effect of foreign direct investment on the source country is as follows. As capital
moves out of the source country to the foreign country, the supply of capital decreases in
the source country. This reduction in the supply of capital in the source country causes an
increase in the rate of return to capital and the owners of capital in the source country
benefit. The owners of the capital that is moved to the foreign country also benefit, as the
capital invested in the foreign country earns a higher rate of return than it would have
earned if it had remained in the source country. As a result, the overall return to capital in
the source country rises. The effects of this capital movement on labor in the source
country can be negative. As capital is moved from the source country to foreign countries,
there will be less capital for labor in the source country to work with. With less capital,
the capital-to-labor ratio declines in the source country, and the productivity of labor also
declines. If the capital movement is small, its effect will be a slower rate of growth of
labor productivity in the source country. For the abundant factor, capital, the effects of
FDI on the host country are the reverse. The return to capital in the host country will
decrease as the domestic supply of capital is augmented with foreign direct investment.
As capital migrates to the host country, labor within the host country benefits from the
increased amount of capital per worker, which increases the productivity of labor in the
host country. The return to labor increases in the host country and the welfare of the labor
force increases.
© 2015 W. Charles Sawyer and Richard L. Sprinkle
5. The effects of foreign direct investment on labor in the source country can be negative.
As capital is moved from the source country to foreign countries, there will be less capital
for labor to work with in the source country. With less capital, the capital-to-labor ratio
declines in the source country and the productivity of labor also declines. If the capital
movement is small, its effect will be a slower rate of growth of labor productivity in the
source country. Because of these results, organized labor in the US has opposed investing
US capital in plant and equipment in foreign countries. These effects are similar to the
effects of international trade. If a country has abundant capital and scarce labor, the
opening of trade results in an increase in the return to capital and a decrease in wages
within the country. The scarce factor, labor, loses relative to the abundant factor, capital.
6. Even if there is no overt discrimination against foreign firms, a country’s industrial policy
tends to favor local firms at the expense of foreign firms. A country’s industrial policy
refers to the many ways in which government tax policy, direct subsidies, or trade
policies affect the development of business within a country.
7. The motives of emigrants who move voluntarily from one country to another are
generally economic in nature. Both poverty and unemployment in the source country are
considered “push” factors that lead to immigration, and the high incomes of the host
countries create a “pull” factor. Combining the “push” and “pull” factors creates an
environment conducive to the migration of labor. The welfare effects of the international
movement of labor are as follows. The source country’s labor force that does not migrate
benefits as wages rise. With less labor in the source country total output falls and the
return to the owners of capital fall, as the owners of capital pay higher wages and produce
less output. The effect of the international movement of labor on the host country is that it
gains from this process. As immigrant labor enters the host country, the existing labor
force loses, as each worker has less capital with which to work, and wages fall. With
more total labor in the host country, total output rises and the returns to the owners of
capital in the host country increase. The total output effects on the world economy are
positive.
8. In the host country, wages would tend to fall but the owners of capital would benefit. In
the source country, wages would rise and the owners of capital would lose. For the world,
economic output has increased. Output has fallen in the source country but risen in the
host country. The loss of output will be lower in the source country than the gain in
output in the host country This is because as labor is reallocated from the former to the
latter, it is moving from where its value is lower to where it is higher.
9. Immigration policy is a persistent political problem within many developed countries as
they try to balance the impact that immigration has on wages within their countries with
the total output that their countries produce. An immigration policy designed to maximize
a country’s total output would be a policy of completely open immigration. In this case a
country’s output would be maximized, but labor’s economic interest – wages – could be
harmed. This is why few countries have a totally open immigration policy. On the other
hand, few countries have a complete ban on immigration. Restricting immigration to zero
would result in a high opportunity cost in that the absence of immigrant workers (foreign
or naturalized) would result in lost output.
10. The political difficulties associated with open immigration have led countries to design
immigration policies that allow companies to use less expensive foreign labor. The guest
© 2015 W. Charles Sawyer and Richard L. Sprinkle
worker programs of Europe allow workers from developing countries to work temporarily
in the EU rather than to immigrate permanently. This policy allows firms to hire lowerskilled workers who are in short supply without the government committing to granting
these workers permanent residency.
11. For the US, offshore assembly provisions provide the most common method of using
foreign labor without allowing immigration. These provisions of the tariff schedule allow
US firms to export materials and parts to foreign countries for final assembly. When the
assembled goods are imported back into the US, duties are assessed only on the value
added in the foreign country. This allows US firms to take advantage of lower foreign
labor costs without actually importing the labor to assemble the parts domestically.
© 2015 W. Charles Sawyer and Richard L. Sprinkle