Chapter 5shakim/docume… · Web view · 2009-10-15I. Introduction. II. International Trade...

CHAPTER 5International Factor Movements

CHAPTER OUTLINE

I. IntroductionII. International Trade Versus International Factor Movements

factor movements as a substitute for trade migration equalizes returns

migration in a large country similar to factor-price equalization welfare effects

III. International Movements of Capital introduction

FDI Tables 5.1 and 5.2

A. Reasons for the International Movement of Capital rate of return natural resources trade barriers transportation costs differentiated products disintegration of the production process

B. Welfare Effects of the International Movement of Capital source country host country Figure 5.1

C. Capital Movements and Public Policy restrictions

approval industry specific restriction industrial policy incentives

IV. International Movements of Labor Table 5.3

A. Reasons for the International Movement of Labor push vs. pull PASSPORT: Immigration to America Before the Revolutionary War

B. The Welfare Effects of the International Movement of Labor host vs. source country Figure 5.2

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PASSPORT: Does Immigration Lower Wages?C. Immigration and Public Policy

gains vs. losses PASSPORT: The Brain Drain offshore assembly PASSPORT: The Outsourcing Debate

V. The Multinational CorporationA. The Importance of MNCs — Table 5.4B. Reasons for the Existence of MNCs

types of participation exports licensing joint ventures wholly owned subsidiary

OLI approachC. Public Policy Toward Multinational Corporations

bans to national treatment tax issues PASSPORT: The World’s Largest Multinational Corporations — Table

5.5

TEACHING NOTES AND TIPS

I. Introduction

Notes So far, we have assumed that labor and capital could not move among countries. The purpose of the chapter is to see what happens if we relax that assumption.

Teaching TipAgain, emphasize the link between international economics and regional economics. In this chapter we are moving the two closer together by allowing factors to move among countries just like they do among regions of a country.

II. International Trade Versus International Factor Movements

Notes This section is designed to illustrate what happens if factors can move from one country to another. Using the familiar India and U.S. example, international factor prices move towards equality just like factor-price equalization in Chapter 3.

Teaching TipInternational trade is less efficient than the international movement of the factors of production. The thought experiment at the end of the section is designed to show that free trade without factor movements is inferior to allowing the factors to move about freely.

International Factor Movements 98

III. International Movements of Capital

Notes The first part of the section discusses the prevalence of FDI in the world economy. The reasons for FDI are given as being a function of differing factor proportions, natural resources, trade barriers, transportation costs, differentiated products, and the ability to vertically disintegrate the production process. The second part shows that the movement of capital reduces the welfare of labor and increases the welfare of the owners of capital in the source country. The effects are the reverse in the host country. The welfare effects are very similar to the effects of international trade: the abundant factor gains relative to the scarce factor.

Teaching TipIn a democracy it is little wonder that government’s court investment from outside the area, state, or country. Most voters gain from the addition to the local stock of capital.

IV. International Movements of Labor

Notes

The section starts with the data on the migration of labor in the world economy. Next, the basic reasons for migration that are economic in nature are given. The welfare effects of migration are explained for both labor and capital in both countries. Again the effects are similar to those of international trade: the abundant factor in each country gains and the scarce factor loses. In this case the public policy implications of the analysis are covered in terms of balancing the gains as a whole to the losses for a group. The boxed feature "Passport: Immigration to America Before the Revolutionary War" that describes the British government reaction to losing labor is a good example of how governments could react. The boxed feature "Passport: Does Immigration Lower Wages" shows that immigration in the U.S. hasn’t been shown to have a substantial impact on overall wages. The final part of the section goes over OAP and the potential to use foreign labor without importing it.

Teaching TipImmigration may have a tendency to reduce the rate of growth of wages but at the same time it may increase the rate of growth of GDP. Have the students think about immigration policy as a political tradeoff between these two conflicting tendencies.

V. The Multinational Corporation

Notes MNCs are responsible for some of the movements of capital and labor in the world economy. The first part of the section discusses the various ways that a company can be a MNC. The OLI approach explains the existence of MNCs in terms of: the Ownership of an intangible asset, Locational advantages, and Internalization. The next part of the section covers the regulation of MNCs in terms of a continuum running from a ban on the one side to perfect national treatment on the other. There is a final brief discussion of transfer pricing for the accounting students.

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Teaching TipPick a well-known MNC such as IBM and analyze it in terms of the OLI approach. This will work for almost any MNC.

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 production may find it profitable to set up production facilities in foreign markets to take advantage of lower operating costs.

3. 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.


4. 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 U.S. has opposed investing U.S. 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.

5. 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.

6. Because wages paid to existing workers within a country decline as a result of immigration, domestic labor will oppose open immigration. However, owners of capital favor open immigration as their returns increase due to additional output and lower labor costs. A country’s immigration policy should try to balance lower wages with higher total output. Immigration may lower wages but immigration augments the country’s total output.

7. 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 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 lower-skilled workers who are in short supply without the government committing to granting these workers permanent residency. For the U.S., offshore assembly provisions provide the most common method of using foreign labor without allowing immigration. These provisions of the tariff schedule allow U.S. firms to export materials and parts to foreign countries for final assembly. When the assembled goods are imported back into the U.S., duties are assessed only on the value added in the foreign country. This allows U.S. firms to take advantage of lower foreign labor costs without actually importing the labor to assemble the parts domestically.

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8. Large multinational firms exist because of the efficiencies derived from internalizing certain activities as opposed to contracting them out to a second party. Among other things, managing a firm involves deciding which activities the firm will carry out itself and which activities will be contracted out to external firms or individuals. Aside from this fundamental issue a firm may decide to operate business units outside the home country for reasons related to the firm’s specialization. Many large firms find it necessary to be horizontally or vertically integrated. With both horizontal and vertical integration, firms may find it profitable to set up business units in other countries to service their customers more efficiently or to reduce costs. Firms that sell goods and services in foreign countries or that produce goods in foreign countries for sale domestically must decide how they want to control their assets in the foreign country. The main choices include: 1) the firm can export its product to a foreign firm and let the foreign firm handle all aspects of selling it in the foreign market; 2) the multinational corporation may set up a wholly owned subsidiary to serve the foreign market; and 3) the firm can establish joint ventures with a firm in the foreign market.

9. The OLI approach is a framework that explains why multinational corporations engage in foreign direct investment. The O in OLI stands for ownership, commonly ownership of an intangible asset. L in the OLI framework represents locational advantages. Finally, I in the OLI framework represents internalization or the firms’ propensity to perform functions internally that outside firms could do. The OLI approach provides a useful way of thinking about the activities of multinational corporations. Most of the time, one or more of these three factors can explain the activities of a firm in foreign markets.

10. National treatment of a firm by the host country means that the multinational corporation is treated as though they were a domestic firm without making a legal and/or regulatory distinction between a domestic firm and a foreign-owned firm. National treatment is the most desirable situation for a multinational corporation, as market forces would determine foreign direct investment flows without being either hindered or induced one way or another.

11. In most countries, including the U.S., there are restrictions on the activities of foreign-owned firms in various industries. Such restrictions may include the percentage of the industry that foreign firms can own; the percentage of the firm’s output that must be exported; and the firm’s ability to repatriate profits. The point here is that for a number of reasons most countries choose to treat foreign-owned firms differently than they treat domestic firms.

12. The firm would have an incentive to try to transfer income (profits) from Germany to the U.S. Since these transactions are occurring intrafirm, it becomes possible for the firm to lower the price of intrafirm inputs from Germany and effectively lower the foreign subsidiary’s profits. The profit would have been transferred back to the U.S. and taxed at a lower rate.


MULTIPLE-CHOICE QUESTIONS

1. The international movement of factors of production:a. is prohibited by the Geneva Convention.b. is completely free of restrictions everywhere in the world.c. would tend to make the prices paid to factors of production among countries

move further apart over time.* d. would tend to make the prices paid to the factors of production among

countries more similar over time.

2. Which of the following statements is true?a. International trade is a substitute for the movement of the factors of production.b. The international movement of the factors of production tends to make the prices

paid to factors of production among countries more similar over time.c. The U.S. would be worse off if factors of production could not move freely

among the 50 states.* d. All of the above

3. Why is international trade viewed as a “second best” alternative when compared to the movement of the factors of production?

* a. Being able to move the factors of production would increase world output.

b. International trade has too many problems associated with it.c. Resources are best used with international trade.d. Factors of production are cheaper and easier to acquire.

4. When the factors of production are immobile between countries:a. it is difficult to conduct trade with another country.b. specialization is faster in developing countries.c. trade is not based on comparative advantage.

* d. one country’s factor endowments can differ from another country’s factor endowments.

5. International trade is a substitute:a. for many kinds of government rules.

* b. for the movement of the factors of production among countries.c. for interregional trade.d. for product differentiation.

6. Worldwide, foreign direct investment:* a. inflows and outflows are concentrated among developed countries.

b. inflows and outflows are concentrated among developing countries.c. inflows are concentrated among developing countries while outflows are

concentrated among developed countries.d. inflows are concentrated among developed countries while outflows are concentrated

among developing countries.

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7. Foreign direct investment is:a. the purchase of durables, nondurables, and services by foreign entities.b. exports of shipping, travel, and tourism.

* c. the setting up of plants/factories in foreign countries.d. acquisition of bonds and/or stocks in one country by citizens of another country.

8. Setting up plants/factories in foreign countries is known as _____.* a. foreign direct investment

b. foreign trade in goods and servicesc. foreign trade in merchandised. foreign portfolio investment

9. Which of the following would be an example of FDI?a. A Bolivian investor buys a German government bond.b. An American buys a new Swedish car.

* c. A French firm builds a plant in Nebraska.d. A Canadian investor buys a French equity.

10. What percentage of foreign direct investment originates in developed countries?* a. 90%

b. 75%c. 55%d. 40%

11. Multinational corporations pursue direct foreign investment because:a. it is easier to build factories overseas than domestically.

* b. overseas investments are expected to yield higher rates of return.c. the return on capital is higher where capital is abundant.d. all of the above

12. Which of the following is not a reason for the existence of FDI?a. The need to jump over tariff and nontariff barriers to tradeb. The industry is vertically integrated.c. The industry is horizontally integrated.

* d. Taxes are higher in the host country than they are in the source country.

13. Which of the following would be an example of a company engaging in FDI as a result of the industry being horizontally integrated?a. Alcoab. Royal Dutch Shell

* c. Wal-Martd. British Petroleum


14. Foreign direct investment represents:a. foreign investment in financial capital.b. foreign investment in stocks.c. foreign investment in bonds.

* d. foreign investment in land, nonresidential investment, and durableequipment.

15. FDI and producing in a foreign country may be preferable to exporting:a. since most managers of domestic plants wish to leave to other countries.b. since machinery and buildings are usually more extravagantly built in foreign

countries.c. since production is increased due to high labor skills.

* d. in order to serve consumer tastes and preferences in the foreign market.

16. Some motives for FDI are:a. the extraction of natural resources.b. a multinational corporation attempts to jump over trade restrictions.c. high transportation costs.

* d. all of the above

17. Foreign direct investment is:* a. the purchase of foreign real investment in land, nonresidential investment,

or producer’s durable equipment by a domestic firm.b. domestic residents investing funds in foreign capital markets.c. foreigners investing capital in U.S. capital markets.d. tourists going to foreign countries and purchasing goods and services.

18. Which of the following are reasons for the international movement of capital?a. Firms want to earn the highest expected rate of return on their investment.b. Some natural resources are limited only to a specific part of the world.c. Foreign investments eliminate tariffs and high transportation costs.


19. Which of the following is not a reason for FDI?a. Horizontal product differentiationb. Extraction of natural resourcesc. High transportation costs

* d. A lower rate of return in the host country

20. Which of the following statements is true?a. FDI benefits labor in the source country.b. FDI benefits capital in the source country.

* c. FDI benefits labor in the host country.d. FDI benefits capital in the host country.

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21. FDI reduces the welfare of _____ in the source country and increases the welfare of _____ in the host country.a. labor; capital

* b. labor; laborc. labor; capitald. capital; capital

22. With respect to capital movements between countries, owners of capital in the source country:

* a. benefit as capital is removed from their country.b. are harmed as capital is removed from their country.c. benefit as capital flows into their country.d. are harmed as capital flows into their country.

23. With respect to capital movements between countries, owners of capital in the host country:a. benefit as capital is removed from their country.b. are harmed as capital is removed from their country.c. benefit as capital flows into their country.

* d. are harmed as capital flows into their country.

24. With respect to capital movements between countries, labor in the source country:a. benefits as capital is removed from their country.

* b. is harmed as capital is removed from their country.c. benefits as capital flows into their country.d. is harmed as capital flows into their country.

25. With respect to capital movements between countries, labor in the host country:a. benefits as capital is removed from their country.b. is harmed as capital is removed from their country.

* c. benefits as capital flows into their country.d. is harmed as capital flows into their country.

26. The effect of the international movement of capital does not include:a. the supply of capital declines in the source country.b. an increase in the rate of return to capital in the source country.c. the productivity of labor declines in the source country.

* d. an increase in the rate of return to capital in the host country.

27. Which of the following is one of the effects of FDI on the host country?a. The return to labor will tend to fall.b. The return to capital will tend to rise.

* c. The return to labor will tend to rise.d. The price of land will tend to fall.


28. The source countries for labor tend to be:* a. developing countries.

b. developed countries.c. industrialized countries.d. OECD countries.

29. The “push factor” that economists use to explain international labor movements is caused by:a. low educational opportunities in the home country.

* b. low incomes in the home country.c. high incomes in the foreign country.d. higher educational opportunities in the foreign country.

30. The “pull factor” that economists use to explain international labor movements is caused by:a. low educational opportunities in the home country.b. low incomes in the home country.

* c. high incomes in the foreign country.d. higher educational opportunities in the foreign country.

31. Which of the following is true concerning the push and pull factors that lead to the migration of labor from a foreign country?a. The push factor is sufficient to induce migration.b. The pull factor is sufficient to induce migration.

* c. Both the push and pull factors need to occur for migration to take place.d. Either the push or pull factor is sufficient for migration to take place.

32. If immigration were to lead to an inflow of workers then:* a. wages would fall and payments to capital would rise.

b. wages would fall and payments to capital would fall.c. wages would rise and payments to capital would rise.d. wages would rise and payments to capital would fall.

33. If workers emigrate from Mexico to the U.S., which of the following statements would be false?a. There will be more workers in the U.S. and fewer in Mexico.b. The K/L ratio in Mexico will rise.c. The wages of American workers will tend to fall.

* d. The K/L ratio in the U.S. will tend to rise and the welfare of the owners of capital will tend to be reduced.

34. Virtually all countries restrict immigration because of:* a. the potential losses to the existing labor force.

b. the potential gains to the existing labor force.c. the potential losses to the owners of capital.d. the concern for the losses to the country the workers are leaving.

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35. When labor migrates out of a country the effects in that country are:a. the return to the remaining labor force increases.b. the return to the owners of capital falls.c. the return to the owners of capital rises.

* d. both A and B

36. The migration of academians, scientists, and professionals from low-income to high-income countries is known as:a. intellectual migration.b. intelligence migration.

* c. brain drain.d. professional plundering.

37. The migration of academians, scientists, and professionals from low-income countries to high-income countries is known as:a. intellectual migration.

* b. the brain drain.c. professional plundering.d. human capital imperialism.

38. Who would likely oppose policies that allow foreign workers to immigrate more freely?a. Domestic capital owners

* b. Domestic laborc. Both domestic labor and capital ownersd. Neither domestic labor nor capital owners.

39. Migration of labor causes:a. a decline in total output in the source country.b. an increase in the return to capital in the host country.c. a decline in the productivity of labor in the host country.


40. A country’s immigration policy:a. should help immigrants get their green card.b. should be based on providing lower wages for the immigrants than for its natural

citizens.* c. should balance the negative impact on its natural citizens with higher total

output.d. should focus on immigrants with few labor skills.


41. A way to minimize the political difficulties associated with open immigration is:a. to restrict international investment is developing countries.b. to increase foreign direct investment in services.

* c. to design policies that allow a multinational firm to use less expensivelabor in a manner that does not allow immigration.

d. to create and enforce new tariffs and quotas along with immigration laws that deter international trade.

42. With respect to the movement of labor between countries, owners of capital in the source country:a. benefit as labor migrates from their country.

* b. are harmed as labor migrates from their country.c. benefit as labor migrates into their country.d. are harmed as labor migrates into their country.

43. With respect to the movement of labor between countries, owners of capital in the host country:a. benefit as labor migrates from their country.b. are harmed as labor migrates from their country.

* c. benefit as labor migrates into their country.d. are harmed as labor migrates into their country.

44. With respect to the movement of labor between countries, labor in the host country:a. benefits as labor migrates from their country.b. is harmed as labor migrates from their country.c. benefits as labor migrates into their country.

* d. is harmed as labor migrates into their country.

45. With respect to the movement of labor between countries, labor in the source country:* a. benefits as labor migrates from their country.

b. is harmed as labor migrates from their country.c. benefits as labor migrates into their country.d. is harmed as labor migrates into their country.

46. The offshore assembly provisions of the U.S. tariff code:a. allow firms to drill for oil tax free within 300 miles of the U.S. coast.b. enable countries to hire lower skilled workers on a nonpermanent basis for

assembly of products.* c. allow special tariff treatment for firms to export U.S. made parts

to foreign countries for assembly and re-exportation back to the U.S.d. is a provision designed to protect U.S. firms by taxing foreign firms for using U.S.

made parts that require offshore assembly.

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47. Sales by foreign affiliates in the world economy are approximately:a. $1.3 trillion.b. $7.0 trillion.c. $10 trillion.

* d. $17.7 trillion.

48. Which of the following are reasons for multinational corporations to pursue foreign direct investment?a. Tariffs and foreign government lawsb. High returns and foreign government lawsc. Product differentiation and exchange rates

* d. High returns and tariffs

49. Which of the following is not part of the OLI framework for analyzing why MNCs exist?a. Ownership of Intangible Assets

* b. Wholly Owned Subsidiariesc. Internalizationd. Locational Advantages

50. Which of the following is not a reason for a firm to be a MNC?a. Ownership of intangible assetsb. Locational advantagesc. Vertical integration

* d. Operational integration

51. If a firm owns an extremely valuable intangible asset then the most sensible form in which it would become a multinational would be:a. a joint venture where it owns 49 percent of the joint venture.b. a licensing agreement.

* c. a wholly owned subsidiary.d. to sell its products through the World Bank.

52. If a MNC owns a valuable intangible asset, then the preferred form of FDI would likely be:

* a. a wholly owned subsidiary.b. a licensing agreement.c. a joint venture where the foreign firm owns 51 percent.d. a joint venture where the foreign firm owns 50 percent.

53. Which statement concerning the OLI approach is not true?a. O denotes ownership of an important asset.b. L denotes a locational advantage.

* c. I denotes international economies of scale.d. I denotes internalization.


54. Coca-Cola has chosen to be a multinational firm because:a. there is not enough sugar available in the U.S.b. it is a vertically integrated firm.c. it wanted to take advantage of cheaper foreign labor.

* d. it owns a valuable intangible asset.

55. O in the OLI approach refers to:a. overseas.b. organization.

* c. ownership.d. officers.

56. L in the OLI approach refers to:a. labor.

* b. location.c. leverage.d. liability.

57. I in the OLI approach refers to:a. intraindustry trade.b. interindustry trade.

* c. internalization.d. internationalization.

58. National treatment:a. means that domestic firms are taxed at a lower rate than foreign firms.b. means that foreign firms are taxed at a lower rate than domestic firms.c. is more prevalent in developing countries than in OECD countries.

* d. means that foreign firms and domestic firms are both treated the sameway.

59. Which of the following statements would best capture the essence of the term national treatment?a. We will treat your firms the way that you treat our firms.

* b. We will treat your firms the way we treat our domestic firms if you will treat our firms the way you treat your domestic firms.

c. We will extend most favored nation status to all countries.d. We will use reciprocity in the treatment of each other’s firms.

60. The treatment of foreign investors as if they were domestic investors is known as:a. intraindustry regulation.b. Linder regulation.

* c. national treatment.d. offhand treatment.

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61. The regulation of MNCs that is the preferred form of regulation is known as:a. transfer pricing.b. internalization.c. nonpreferential tax subsidization liability.

* d. national treatment.

62. Which of the following is not a common restriction on the activities of MNCs?a. Ownership restrictionsb. Export requirementsc. Local-content requirements

* d. National treatment

63. The phenomenon of changing internal prices in a firm in order to minimize the firm’s global tax liability is known as:a. internalization.b. national treatment.

* c. transfer pricing.d. export of tax requirements.

64. Transfer pricing refers to:a. risk diversification.b. the pricing of the technology transferred to the host country.

* c. the artificial overpricing of inputs shipped to a foreign subsidiary in a higher tax country.

d. the pricing of a multinational stock on the NYSE.

65. Suppose that the corporate income tax rate is 60 percent in Germany and 35 percent in the U.S. If a German firm had a wholly owned subsidiary in the U.S., then which of the following statements would be true?a. The firm would charge the American subsidiary high prices on anything

purchased from the parent firm in Germany. * b. The firm would charge the American subsidiary as low a price as it could

justify to the German tax authorities.c. The firm would never sell anything to the American subsidiary because of tax

complications involved in these types of transactions.d. The firm would allocate as much as possible of the firm's activities such as

research and development to the American subsidiary.


66. Suppose that the corporate tax rate is 10 percent in the U.S. and 40 percent in Canada. Which of the following statements would be true?a. Canadian firms with U.S. subsidiaries would tend to try to increase corporate

profits in Canada.* b. A firm headquartered in Canada would tend to charge a U.S. subsidiary

low prices for any goods and services sold to it.c. A U.S. subsidiary of a Canadian firm would try not to show a profit.d. Canadian firms would try to charge their U.S. subsidiaries as high a price as

possible for any goods or services they sell to them.

67. XYZ is a multinational firm operating in the U.S. and Mexico. The tax on firm profits in Mexico is 76% and the U.S. taxes profits at 39%. Rather than declare all of the firm’s profits in Mexico, XYZ’s accountants suggest that they raise the price of the inputs and effectively lower the profits of the Mexican subsidiary. The accountants are promoting what practice?a. National treatmentb. Fuzzy accounting

* c. Transfer pricingd. Localization

TRUE FALSE QUESTIONS

1. T Factor prices tend toward equalization either through international trade or through the actual movement of the factors of production between countries.

2. T International factor flows tend to lower the incomes of those factors in the host country that are close substitutes.

3. T The international movement of factors of production is a substitute for international trade.

4. T A former president of Mexico once said that the U.S. could either import Mexican products or import Mexican workers. Is this statement essentially true or false?

5. F International factor flows tend to lower the incomes of those factors in the source country that are close substitutes.

6. T Nearly 75% of foreign direct investment is received by the world’s developed countries.

7. F FDI always flows from capital-abundant countries to capital-scarce countries.

8. F The return to capital in the host country will tend to increase as the domestic supply of capital is augmented with foreign capital.

9. T The majority of FDI flows from high-income countries to other high-income countries.

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10. F Foreign direct investment is mostly a function of banks and other financial institutions.

11. F Horizontal product differentiation is not related to FDI.

12. F Foreign direct investment represents investment by foreigners in domestic real estate, foreign currency, and foreign financial capital.

13. T Direct investments by U.S. firms in Europe constitute movements of capital from the United States to Europe.

14. T If a Mexican company built a plant in Georgia, this would be an example of FDI.

15. T FDI tends to lower the welfare of the owners of capital and increase the welfare of labor in the host country.

16. F FDI tends to raise the welfare of the owners of capital in the host country.

17. T FDI tends to lower the welfare of the owners of capital in the host country.

18. T FDI tends to raise the welfare of the owners of capital in the source country.

19. F FDI tends to lower the welfare of the owners of capital in the source country.

20. T The effects of FDI in a host country that is labor abundant are similar to the effects of exporting labor-abundant products.

21. T FDI tends to enhance the welfare of the owners of capital and harm the interests of labor in the source country.

22. F Countries never restrict FDI because it is so obviously in their best interests not to do so.

23. F A person might move from Botswana to Italy because of pull factors in Botswana and push factors in Italy.

24. F Immigration to America before the Civil War occurred for very different reasons than modern immigration does.

25. T If labor migrates from India to the U.S., then the welfare of workers in India will tend to rise and the welfare of the owners of capital in India will tend to fall.

26. T Domestic labor would likely oppose policies that allowed foreign workers to immigrate more freely.

27. F The movement of labor into the U.S. drastically reduces the wages of all Americans.

28. T An immigration policy designed to maximize the GDP of the home country would be a relatively open policy that would augment the supply of domestic labor.


29. F An immigration policy designed to maximize domestic GDP would be a relatively closed policy designed to augment the supply of labor.

30. T Immigration may lower domestic wages, but it also augments the total output of the country.

31. T The “brain drain” is a phenomenon that occurs when highly-skilled professionals migrate to developed countries.

32. F The “brain drain” refers to the intensive labor input required for some types of production.

33. T The economic output of the world tends to increase as a result of the international migration of labor.

34. T Offshore assembly provisions allow the utilization of foreign labor by multinational firms without allowing immigration.

35. F The migration of skilled and highly skilled workers from OECD countries to developing countries is known as the “brain drain.”

36. T The guest worker programs of Europe allows foreign workers to work temporarily in the EU but are not allowed to permanently immigrate.

37. T The offshore assembly provisions of the U.S. tariff code allow for duties to be accessed only on the value added on products assembled in a foreign country.

38. F Multinational corporations are defined as firms that export to ten or more foreign countries.

39. T A licensing agreement between a multinational corporation and a foreign firm may give the foreign firm access to new technology.

40. F A vertically integrated firm would almost never be a MNC because the organizational costs of going overseas are simply too high.

41. T The acronym for John Dunning’s explanation of the existence of MNCs is OLI.

42. F The ownership of a valuable intangible asset has nothing to do with FDI.

43. F MNCs never internalize any operation that could theoretically be delegated to an outside firm.

44. T Multinational corporations engaged in selling a differentiated product may find it more efficient to set up production facilities abroad to serve foreign markets.

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45. F A multinational corporation that has separated production into several distinct stages is horizontally integrated.

46. T Transfer pricing is the practice by MNCs of changing internal prices in order to minimize the firm’s global tax liabilities.

SHORT ANSWER ESSAY

1. What is foreign direct investment? List and discuss the reasons that firms may engage in foreign direct investment.

2. Suppose that Brazil is a capital-abundant country and Paraguay is a labor-abundant country. Describe the potential migration of the factors of production between the two countries. Explain the potential effects on the returns to capital and labor in each country.

3. The international movement of the factors of production is a substitute for international trade. Explain this statement.

4. Briefly describe the flows of FDI between developed and developing countries.

5. List and explain the reasons for the international movements of capital.

6. Describe the effects of FDI on the return to capital in the source and host countries. Next describe the effects on the labor force in both countries.

7. Many government entities are in the business of recruiting investment. Explain why the public sector is interested in attracting capital investment.

8. Briefly describe the movements of labor in the world economy.

9. Describe the reasons for the international movement of labor.

10. A former President of Mexico once said that the U.S. could either import Mexican products or import Mexican workers. Explain why this statement is essentially true.

11. Discuss the effects of immigration on the incomes of the various factors of production.

12. Why do MNCs exist?

13. Describe the OLI approach to FDI.


BRIEF ANSWERS TO SHORT ANSWER ESSAY

1. Foreign direct investment (FDI) represents real investments in land, nonresidential structures and producers’ durable equipment. The investor is not furnishing financial capital but is directly investing in the firm’s plant and equipment and actively managing that investment. This investment usually is in the form of a domestic corporation opening a foreign subsidiary or buying control of an existing foreign firm. Firms pursue FDI to earn a higher expected rate of return. That’s one rationale for the flow of foreign direct investment. There are other general reasons for firms in particular industries to engage in foreign direct investment. For example, the extraction of natural resources may entail foreign direct investment. 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. In addition, 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 may find it profitable to set up production facilities in foreign markets to take advantage of lower operating costs.

2. Labor would tend to flow from Paraguay, where labor is relatively cheap, to Brazil. Capital would tend to flow from Brazil, where capital is relatively cheap, to Paraguay. The international movement of labor would stop at the point where the return to labor in the two countries equalized. A similar process would occur with respect to capital.

3. 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 migration of labor and capital would tend to equalize factor prices. Factor prices tend toward equality either through trade or through the movement of the factors of production. This means that international trade is a substitute for the movement of the factors of production.

4. We can measure the impact of flows of foreign direct investment in a number of ways. In 2002, FDI inflows reached $651 billion. The total value of the stock of FDI by 2002 was $7.1 trillion. More than 92 percent of FDI originated in developed countries and developing countries received approximately 21 percent of the world's FDI. In addition, the world’s developed countries received nearly 75 percent of the foreign direct investment.

5. One rationale for the flow of FDI is that firms pursue FDI to earn a higher expected rate of return. . There are other general reasons for firms in particular industries to engage in FDI. For example, the extraction of natural resources may entail foreign direct investment. Another motive for FDI is when a MNC attempts to enter a closed or highly restricted foreign market. High transportation costs also induce FDI. In addition, MNCs engaged in selling a differentiated product globally may find it more profitable to set up production facilities or subsidiaries to serve foreign markets. Finally, MNCs in which production is separated into several distinct stages of production may find it profitable to set up production facilities in foreign markets to take advantage of lower operating costs.

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6. The welfare effects of capital flows on the source and host countries are 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 within 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 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. The effects in 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 flows. 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. These effects are similar to the effects that international trade has on a country’s factor prices and its distribution of income.

7. Many governments recruit FDI because as a labor abundant country the return to capital in the host country will decrease as the domestic supply of capital is augmented with FDI flows. 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. These effects are similar to the effects that international trade has on a country’s factor prices and its distribution of income.

8. Only 75 million people throughout the world resided outside their country of birth in 1965. By 2000, the number of immigrants residing in a new country had grown to more than 150 million. From 1965 to 1975 immigration increased at an annual rate of 1.2 percent. More recently the annual rate of growth of immigration has increased to approximately 2.6 percent. Currently, immigrants constitute approximately 3 percent of the world’s population. In Western Europe and North America immigrants represent almost 10 percent of the total population. Approximately 21 million immigrants live in France, Germany, Canada, Australia, and the U.K. There are more than 25 million immigrants living in the U.S.

9. The source countries that labor tends to leave are predominantly developing countries. GDP per capita in these countries is low relative to developed countries. Looking at the world economy, 75 percent of the world’s population is earning only 25 percent of the world’s income. Immigrants want to leave their home countries where the standard of living may be so low they are living in poverty or close to it. With respect to the immigration of skilled labor, some developing countries are producing more highly-trained people than their economy has work to employ them. In these cases, workers


with advanced degrees in developing countries may have high rates of unemployment and may seek employment in developed countries. Both poverty and unemployment are considered “push” factors that lead to immigration. These push factors would not be very important if the distribution of income among the world’s economies were fairly similar. However, approximately 75 percent of the world’s output and income originates in only 26 countries with less than 25 percent of the world’s population. The high incomes in these countries create a “pull” factor. Labor from developing countries can improve their standard of living by moving to a developed country where the standard of living is higher. Likewise, workers from low-income countries may seek to migrate to a middle-income country. For a worker in a low-income country, the standard of living in a middle-income country may seem affluent. Combining the “push” factors of poverty and unemployment in developing countries together with the “pull” factor of higher wages and a higher standard of living in developed countries creates an environment conducive to the migration of labor. Neither the “push” factors nor the “pull” factors by themselves are sufficient to induce labor to move from their home country to a foreign country. Both groups of factors need to be present for migration to occur.

10. Interindustry trade between the U.S. and Mexico mainly occurs because the factors of production are not mobile from one country to another and factor prices differ between the two countries. It is this difference in factor prices that is the basis for trade between the two countries. If the factors of production were mobile between countries the migration of labor and capital between countries would tend to equalize factor prices between countries. Factor prices tend toward equality either through trade or through the movement of the factors of production. To a large extent, this means that international trade is a substitute for the movement of the factors of production between countries.

11. Consider the situation in which a country has an abundance of labor when compared to the U.S. Under these conditions, U.S. wages would be higher than wages in the other country, and labor would migrate to the U.S. This migration would affect both countries. The workers in the other country who do not migrate to the U.S. benefit and the returns to the owners of capital in other country fall, as the owners of capital pay higher wages and produce less output. The U.S. gains in this process. As immigrant labor enters the U.S, the existing labor force in the U.S. loses, as each worker has less capital with which to work. The capital-to-labor in the U.S. falls, resulting in a decrease in labor’s productivity. With this decrease in labor productivity, wages in the U.S. fall. With more total labor in the U.S., total output rises. The returns to the owners of capital in the U.S. increase, as the owners of capital pay lower wages and produce more output.

12. Large multinational firms exist because of the efficiencies derived from internalizing certain activities as opposed to contracting them out to a second party. Managing a firm involves, among other things, deciding which activities the firm will carry out itself and which activities will be contracted out to firms or individuals external to the firm. Aside from this fundamental issue a firm may decide to operate business units outside the home country for reasons related to the firm’s business specialization. Many large firms find it necessary to be horizontally or vertically integrated. With both horizontal and vertical integration, firms may find it profitable to set up business units in other countries to service their customers more efficiently or to reduce costs. Firms that sell goods and

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services in foreign countries or firms that produce goods in foreign countries for sale domestically must decide how they want to control their assets in the foreign country. The motivations for foreign direct investment and the reasons for the existence of multinational corporations are similar but not identical. Firms “go multinational” for reasons beyond the motivations for FDI, and the most popular method of analyzing this phenomenon is John Dunning's OLI approach.

13. The OLI approach is a framework that explains why MNCs engage in FDI. The O in OLI stands for ownership, commonly ownership of an intangible asset. L in the OLI framework represents locational advantages. In some cases, it may be in the firm’s global interests to locate outside the home country including natural resources, cheaper inputs, and various natural and legal barriers to trade. Finally, I in the OLI framework represents internalization. Internalization refers to firms’ propensity to perform functions internally that outside firms could do. The OLI model provides a useful way of thinking about the activities of MNCs. Most of the time, one or more of these three factors can explain the activities of a firm in foreign markets.

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