Univerzita Karlova v Praze Fakulta sociálních věd. Institut ekonomických studií. Diplomová práce Martin Kopecký

Transcription

1 Unverzta Karlova v Praze Fakulta socálních věd Insttut ekonomckých studí Dplomová práce 2007 Martn Kopecký

2 Unverzta Karlova v Praze Fakulta socálních věd Insttut ekonomckých studí DIPLOMOVÁ PRÁCE Labor Costs n Industralzed Countres Is There a Convergence? Vypracoval: Martn Kopecký Vedoucí: Ing. Mchaela Erbenova, Ph.D. Akademcký rok: 2006/2007

3 Acknowledgements I would lke to express my grattude to Mrs Mchaela Erbenova for supervsng my dploma thess and for all the valuable comments and suggestons. I do hereby declare that ths dploma thess s work of my own and that I have used only the lsted bblography. Prague, May 21, 2007 Martn Kopecký

4 ABSTRAKT Dplomová práce pojednává o konvergenc mzdových nákladů mez 21 vyspělých zemí v období Naše pojetí konvergence se opírá o Samuelsonovu (1948) hypotézu vyrovnání cen faktorů produkce mez ekonomkam (Factor Prce Equalzaton Theorem). Dále se zabýváme nadnárodním společnostm a jejch funkcí v snžování rozdílů ve vybavenost produkčním faktory a rovněž jejch vlvem na produktvtu a mzdové náklady v hosttelské zem. V emprcké část testujeme doposud poměrně zřídka zkoumanou hypotézu konvergence mzdových nákladů. Naše výsledky potvrzují, a to poměrně významně, hypotézu konvergence mzdových nákladů a to jak v případě jednotlvých zemí tak pro panelová data. Dále odhadujeme, že země střední a východní Evropy mají před sebou období přblžně 10 (ČR, Maď) až 15 let (SK, Pol) k tomu, aby přešly od konkurenceschopnost založené na nízkých nákladech a mzdách ke kvaltatvně založené konkurenceschopnost. ABSTRACT Ths dploma thess focuses on labor cost convergence. We nterpret convergence wthn the framework of Samuelson s (1948) Factor Prce Equalzaton Theorem, n whch free trade equalzes factors reward. Further, we consder the role of multnatonal enterprses as they serve as medators of factor prce convergence by transferrng factor endowment and by affectng productvty and wages n the host country. Fnally, we emprcally test convergence hypothess by applyng unt root tests for a group of 21 ndustralzed countres for We have found that labor costs convergence s surprsngly well supported by the data both for ndvdual countres and for panel data. Smlarly, we estmate that countes n Central and Eastern Europe have 10 (CR, Hun) to 15 years (SK, Pol) to move from low-wage, low cost based compettveness to qualty-based compettveness. Keywords: Labor Costs, Convergence, Factor Prce Equalzaton JEL classfcaton: F 11, F 43

5 Contents: I. Introducton Motvaton for studyng labor cost Defnton of Convergence...2 II. Factor Prce Equalzaton Factor Prce Equalzaton Theorem Assumptons and Implcatons FPE reconsdered FPE n New Trade Theory Internatonal Moblty of Labor Internatonal Moblty of Captal Factor Prce Equalzaton-Survey of Lterature Stolper-Samuelson Theorem Factor Prce Convergence Summary III. Moblty of Captal, Multnatonal Enterprses and Factor Prce Equalzaton Foregn Drect Investments Factor Prce Equalzaton and Moblty of Captal FDI and Wages-Survey of Lterature Foregn Drect Investment and Productvty FDI and Productvty-Survey of Lterature Home Country and MNE Summary IV. Labor Cost Convergence, Exchange Rate and Transton Countres Wage n Internatonal Comparson Nomnal Exchange Rate Real Exchange Rate RER and wages Transton Economes and Real Exchange Rate Balassa-Samuelson Effect and Transton Countres Real Apprecaton and Excessve Wage Growth Undervalued Wages & Transton Structural Factors of Real Apprecaton Balassa-Samuelson Effect, Real Apprecaton-Emprcal Assessment...40

6 4.5 Transton Economes and Real and Nomnal Convergence Internatonal Comparson and Converson Factors Summary...48 V. Labor Cost Convergence-Emprcal Assessment Defnton of Convergence Cross-Country and Tme Seres Approach Survey of Lterature Augmented Dckey Fuller Test-Methodology Data Emprcal Analyss Sgma Convergence Results-Augmented Dckey Fuller Test Panel Data Analyss Panel Tests-Methodology Results-Panel Data Convergence Clubs Central and Eastern European Countres Concluson...75 VI. Concluson...77 Appendx A-FPE set...79 Appendx B-Wage Level...79 Appendx C-Dploma Thess Proposton Bblography...82 Fgures, Tables, Graphs...90 Lst of Abrevatons...90

7 Introducton I. Introducton Increasng nternatonal trade, reducton n trade barrers and contnung economc ntegraton are lkely to be stmulatng for the convergence process of labor costs and wages. Ths s especally true for the European Unon gven ts ncreasng moblty of frms and producton factors as well as ts far-reachng poltcal and economcal ntegraton. Stll, the effects of these processes on labor costs and on ther convergence are rarely studed, n partcular, as contrasted to the large body of lterature on output convergence (e.g. Barro and Martn 1991, Mankw et al. 1992, Evans 1996). We would lke to brdge ths gap and focus on how labor costs evolve n the long-run. One of the reasons why t has been studed less frequently s the fact that economc theory does not concentrate on wage (labor costs) convergence n sense of provdng a coherent theoretcal framework. Nevertheless, there are two possbltes for studyng labor costs convergence on theoretcal bass. Frst, the approach we pursue, s to nterpret labor cost convergence n terms of Factor Prce Equalzaton Theorem (Samuelson 1948). The second possblty nvolves studyng labor cost convergence as a part of real convergence based on conventonal growth theory and on productvty dfferental. We have chosen the frst approach as the European Unon s a sutable area for the Factor Prce Equalzaton Theorem based on ts long hstory of economc and poltcal ntegraton, ts smlar factor endowments, and creaton of free trade area ncludng elmnaton of trade barrers (1968), common currency (1999) and ongong effort to creatng common market. 1.1 Motvaton for studyng labor cost For nternatonal comparson of wages s useful to perceve labor costs from the poston of multnatonal enterprse whch s assessng countres accordng to ther labor costs levels to make a decson where to locate producton faclty. Global companes compare labor cost carefully across countres n decdng on ther nvestments. Accordng to KPMG (2004) labor represents 56 to 72% of locaton-senstve costs n manufacturng and 75-85% for nonmanufacturng. Gven such a hgh share of labor n the costs of producton process, t s not a surprse that low wage countres enjoy strong nflow of foregn nvestments and stand at the center of offshorng or overseas sourcng busness. There s wdespread evdence that labor cost and unt labor cost are key determnants of foregn nvestment to low wage countres (e.g. Bevan and Estrn, 2004). In 2005, labor costs n the Central and Eastern Europe (CEE) are 1/2 1

8 Introducton (Slovena) to 1/7 (Latva) of those n EU-15 average. Abraham (2000) states labor costs are wdely perceved as a key determnant of nternatonal compettveness. Furthermore, entrepreneurs are seekng to take advantage of labor arbtrage-a process of shftng from expensve to cheaper labor assocated wth the shft of locaton of producton. Dunnng (1993) dentfed labor costs as a key locaton determnant for effcency seekng multnatonal companes. In other words, locaton of producton s a part of corporate strategy. To explot the cost advantage of low wage hubs such as NMS, t s crtcal whether such compettve advantage s tme persstent, or how fast wll the labor cost dfferental narrow. For nstance, The Economst (2003/369) predcts that: A further threat to eastern Europe s offshorng busness les n the forthcomng entry nto the EU of countres lke the Czech Republc and Poland. That s sure to narrow wage dfferentals wth the rest of Europe and eradcate much of the ratonale for offshorng there. Costs are a major factor nfluencng the costs of goods produced by a country relatve to those of ts tradng partners and consequently ts nternatonal compettveness (Dean and Sherwood 1993). Moreover, as clamed by Eurostat (2001): labor costs consderably nfluence the choces of poltcal, economc and socal decson makers, as they account for some two-thrds of the producton costs of goods and servces. Moreover, knowledge of labor cost levels s an essental tool n the strategc plannng of nvestment, producton, employment polcy or wage levels n collectve barganng. For decson makers are then labor costs mportant to ensure they are kept under control n as they are one of the key predctor of nflaton (cost-push model) as the share of labor costs s approxmately 2/3 of the total value added. 1 Smlarly mportant are labor costs for unemployment. In addton to that, wage, a prncpal component of labor costs s the major determnant of workers welfare and standard of lvng, whch also projects to aggregate demand etc. 1.2 Defnton of Convergence The convergence hypothess has become an ntrgung topc for research and s beng appled to number of studes of ncludng ncome, productvty, prce level studes of convergence. Hence, there are also several approaches and defntons as well as methodologes for testng convergence. Intutvely, the general defnton of convergence s that the dfference between 1 The labor share n costs for the prvate US busness sector (excludng government enterprses) averaged 67 percent over the 20-year perod from 1982 to 2001 (BLS 2006). Ths mples the very central poston of labor costs on frm s proftablty. 2

9 Introducton two varables decreases and ultmately becomes zero. Formally, two random varables y t and x t converge (n probablty) f lm P ( y t t x t > δ ) = 0 where δ > 0. As far as emprcal testng concerns, the man dvdng lne s between crosscountry and tme-seres approach. We prefer the tme-seres approach, whch examnes the long-run relatonshp n movements of labor costs between country and country j. In other words, we ask how persstent s the dfferental between countres and sample average (EU- 15). If the stochastc convergence s to take place, the dfferental between country and country j cannot contan unt root 2. Our analyss s dvded nto fve chapters. In the second chapter, we descrbe Samuelson s (1948) semnal Factor Prce Equalzaton Theorem, whch proposes a framework n whch flows of goods replace mmoble factors of producton and equalzes factors reward. Thrd chapter consders the role of multnatonal enterprses and moblty of captal as a brdgng elements between countres capable of transferrng technology and knowledge captal. In the fourth chapter we consder the role of nomnal and real convergence and dffcultes connected wth makng reasonable nternatonal comparson. Fnally, n the ffth chapter we emprcally test labor cost convergence applyng both ndvdual tme seres tests and panel data approach. Ths wll be done for EU-15 as well as for countres of Central and Eastern Europe. 2 The term unt root refers to a soluton of dfference equaton that needs to be wthn a unt crcle for soluton to be stable,.e. to ensure convergence (see Enders 1995: Chapter I). We wll dscuss defnton of convergence and methodology of tme seres test n secton 5.1 and

10 Chapter II Factor Prce Equalzaton II. Factor Prce Equalzaton Obvous startng pont for dscusson of factor prce convergence s Samuelson s (1948) semnal factor-prce-equalzaton-theorem (FPE) that postulates necessary condtons under whch flows of goods replace mmoble factors of producton and equalze factors reward. After presentng prncpal features of the FPE model we wll dscuss consequences when some of the rather strngent assumptons are relaxed and pont to more recent approaches of New Trade Theory. Then we focus on the moblty of producton factors and, toward the end, we revew the FPE lterature. 2.1 Factor Prce Equalzaton Theorem Hardly any dscusson of nternatonal trade dares not to begn wth the fundamental law of comparatve advantage that clams that trade pattern s based on relatve and not on absolute effcency n producton. Such an advantage may be technologcal as n Rcardo s model or based on factor-endowment. The factor endowment models are based on work of Heckscher (1933) and Ohln (1933). These authors stress mportance of factor endowments n determnng patterns of trade and have facltated debate on trade and ts mpacts on the earnngs of the factors of producton. Ohln argues that trade would brng factor prces closer together but not necessarly equalze them. Samuelson (1948) bulds on ther work and formalzes suffcent condtons under whch factor prces wll eventually become equal. The synthess of these models s called Heckscher-Ohln-Samuelson model (HOS). HOS s a general equlbrum model and as wll become clear, t mples trade n goods and moblty of producton factors as perfectly substtutable. In what follows, we present the smplest verson n case-two countres, two factors of producton (captal and labor), two products as presented n Samuelson (1948) and Hong (1996) Assumptons and Implcatons 1. Producton functon s lnear and homogenous wth constant returns to scale; technology s dentcal for both countres. Margnal productvty of factors s postve and dmnshng. Unlke the comparatve advantage models of Rcardo the assumpton of dentcal technologes ensures that access to technology s not the bass of comparatve advantage. 4

11 Chapter II Factor Prce Equalzaton 2. Factors of producton are homogenous and therefore factor endowment s determned solely by quantty. 3. Factors are n fxed supply, moble between ndustres wthn a country at no cost and nternatonally mmoble. 4. Perfect competton n the goods 3 and factor markets, no transport costs or barrers to trade. Hence, commodty prces are equalzed across the countres. 5. Goods can be dvded along the factor ntensty. That means that products dffer n ther factor requrements (captal, labor ntensve). Moreover, t s assumed that there are no factor-ntensty reversals 4 and that the number of goods s at least as hgh as the number of productve factors. 6. The factor endowments among countres are suffcently smlar. Ths mples that both countres produce both goods under free trade Fnally, consumers have dentcal preferences; ther demand s homothetc ensurng that the proporton n whch goods are consumed s determned by prces and not by ncome. In other words, f the commodty prces are equalzed, then for gven proporton of world ncome a country has, country s aggregate consumpton equals exactly ts proporton of world ncome. Assumptons 1 to 7 ensure that nternatonal trade leads to factor prce equalzaton. Fgure 2.1 descrbes the mechansm n case. It shows two box dagrams of factor endowments wth dmensons labor (L) and captal (K). Further, t shows for each country a contract curvea set of ponts wth effcent producton of both goods Y and X 6 for two countres. For Country 1 t s 0 x 0 y lne, for Country 2 0 x 0 y lne. In autarky, a country can produce anywhere on ts contract curve. Country 1 produces at pont S and Country 2 at pont S. 3 In orgnal verson, servces are dsregarded; however, as long as same servces are tradable to the same extent n both countres and countres do not specalze the results reman unchanged. 4 Factor ntensty reversal means that gven product there exsts no wage/rental rato such that product s captal ntensve for hgher return ratos and relatvely labor ntensve for lower factor return ratos. 5 Put t dfferently, endowments have to lay wthn the same dversfcaton cone- a set of all factor endowments consstent wth producton of two goods and cost-mnmzng producton methods. See Deardoff and Courant (1990) for more on ths ssue. 6 Contract curve conssts of tangental ponts of soquants of producton of goods X, Y and hence t s a set of ponts wth margnal rates of techncal substtuton of K and L equal for both goods.e. there s no possblty to relocate factors of producton n order to ncrease producton of one good keepng the amount of second good constant. 5

12 Chapter II Factor Prce Equalzaton Fgure 2.1: Factor prce equalzaton K Country 1 0 y S Country 2 0 y S 0 x L Producton n Country 1 employs more captal-ntensve methods of producton for both goods. More captal per unt of labor s used n every sector n Country 1. Ths can be seen from the slope of lnes S0 x, S 0 x and S0 y, S 0 y respectvely, and therefore relatve prce of labor wll be hgher n Country 1 than n Country 2 and the prce of captal wll be relatvely hgher n Country 2 than n Country 1. If countres open up to the free trade, then accordng to Heckscher-Ohln theorem Country 1, where captal s relatvely cheap, exports the captal ntensve good Y and Country 2 (wth relatvely cheap labor) exports labor ntensve good X. Country 1 moves along ts contract curve toward 0 x, whle Country 2 expands producton of X and moves toward 0 y. Ths s accompaned by ncreasng prce of captal and labor n Country 1 and 2 respectvely. At the free trade equlbrum, flow of goods equalzes prces of goods X and Y. Fgure 2.2 depcts possble trade equlbrum T and T. These ponts le on the same lne and T 0 y and T0 y are parallel (soquants of producton not shown). At these ponts factor ntenstes (K/L) n ndustres equal across countres. Assumpton of dentcal producton functons wth constant returns to scale mples equalzed margnal products, and hence equalzaton of real factor rewards. Ths was formalzed nto Stolper-Samuelson Theorem (Samuelson 1948), whch declares that f relatve prce of good ncreases (good Y for Country 1), then the real returns to ntensvely used factor ncrease (captal for Country 1), whle factor prce of the other declnes (labor). For Country 2 the shft n regme from autarky to free trade means export of labor ntensve good X and therefore the prce of labor goes up. Overall, prce of labor (and also rental prce 6

13 Chapter II Factor Prce Equalzaton of captal) converges. Trade s hence a perfect substtute for factor moblty. As long as there are tradng equlbrum such as T and T, the factor prce wll be equal both relatvely and absolutely; margnal productvtes of captal and real wages across countres are equalzed. Equalzed factor prces are then compatble wth factor and commodty market clearng; FPE s Pareto optmal. There are several ponts worth mentonng. Frst, at the trade equlbrum, as sad above, ndustres have same factor ntenstes. Therefore, n the Fgure 2.2 ponts T and T lne on the same lne gong from the orgn 0 x and lnes T 0 y, T0 y are parallel. However, dentcal factor ntenstes cannot be reached for any arbtrary combnaton of producton and therefore the FPE s not always fulflled. Let us assume that world demand for good X has ncreased. Fgure 2.2: Free Trade Equlbrum K Country 1 0 y Country 2 S 0 y T E S T 0 x L Both countres rase ther producton of good X (move upward ther contract curves towards 0 y and 0 y ). Factors of producton shft from ndustry Y to ndustry X. For suffcently large ncrease n demand, Country 2 wll reach 0 y and become fully specalzed n the producton of X. At the same tme, Country 1 produces at E. If the demand ncreases even further, ncrease n demand and relatve prce of X Country 1 s somewhere between ponts E and 0 y and factor ntenstes dffer snce Country 2 cannot shft any factor from ndustry Y to X. Snce Country 1 s relatvely labor scarce, the relatve prce of labor wll go up beyond pont E and the FPE wll no longer hold. 7

14 Chapter II Factor Prce Equalzaton Set of factor endowments for whch dentcal factor ntenstes can be reached (and n whch FPE does hold) s called cone of dversfcaton. Ths s a set of ponts for whch 1. Both goods are produced n both countres. 2. Economes employ all of ther resources (domestc demand=domestc supply, factor markets clear). 3. Frms mnmze costs (optmzng employed factor ntenstes) for each sector. 4. Goods market clears (world demand=world supply). For these endowment ponts under no factor moblty trade s able to replcate a stuaton whch s dentcal to free movements of factors and hence n whch factor rewards are equalzed.7 However, the cone of dversfcaton (FPE set) s restrcted and t depends on the relatve factor endowments between tradng partners. Were the relatve factor endowment too dfferent, factor prce equalzaton when movng from autarky to free trade does not occur. The level of dfference s condtoned both on endowment (ntal factor prces, socost lne) and on technology (soquants of producton). By the concept of cones of dversfcaton Samuelson (1948) has formally shown that convergence of labor costs s lkely to be expected for countres that are smlar n factor endowment. Second, Fgure 2.2 suggests that the greater the dfference n ntal factor endowments, the greater the probablty of complete specalzaton among countres. If Country 2 were even more labor abundant, then ts contract curve 0 x 0 y would shft eastward. The area wth equlbrum tradng ponts under ncomplete specalzaton and constant captal would then declne. The dagonal lne 0 x 0 y can then eventually blend n wth the TT lne and Country 2 would fully specalze n labor-ntensve producton. No ponts of tradng equlbrum under ncomplete specalzaton are then possble; factor prce equalzaton does not take place. Thrd, even f the FPE does not occur, trade stll decreases dfferences n factor prces. Country 1 as relatvely captal abundant exports captal-ntensve goods and the prce of captal goes up. The same s true for Country 2 where prce of labor ncreases untl the complete specalzaton n the labor-ntensve good X at pont 0 y s reached. In ths sense, product trade s an ndrect competton between the same factors n dfferent countres. Samuelson (1971) presents a slghtly dfferent model, a dynamc Specfc-Factors Model, n whch each sector uses a productve factor not used n the other whle both make use of a factor that s freely moble between sectors. For example, agrculture uses land, 7 These ponts are also called ntegrated equlbrum. See Appendx for a descrpton of cone of dversfcaton. 8

15 Chapter II Factor Prce Equalzaton manufacturng captal and both ndustres employ wthn-sector moble labor. In such settng transton from autarky to free trade wll nduce partal factor prce equalzaton n the sense of a reducton n factor prce dfferences among countres rather than complete equalzaton. Such a tendency we shall call factor prce convergence (FPC). Ths has been known to Mundell (1957) who postulated that perfect moblty of commodtes causes equalzaton of commodty prces. 2.2 FPE reconsdered Presented model provdes a strong predcton about the evoluton of factor rewards gven free trade s allowed. As the model s logcally consstent and yelds remarkable results, we have to consder look on ts relevancy especally n terms of assumptons. Some of the bggest shortcomngs nclude the assumptons of constant returns to scale and perfect competton n nternatonal trade. Untl now, we assumed that trade s explaned by comparatve advantage ether n technologcal dfferences or n factor endowments. Followng ths reasonng trade should be greater the greater the dfferences between countres. However, emprcal evdence speaks more n favor of the opposte (see Greenaway and Wnters 1994, Chapter 3). The stylzed facts show that the majorty of trade takes place between countres smlar n technology and factor endowments. EU, USA and Japan account for a hgher proporton of world trade than ther proporton of world ncome (Keller et al. 2003). Lkewse, the ntra-ndustry trade, a country smultaneously exportng and mportng products of the same ndustry, accounts for phenomena that comparatve advantage fals to explan. Fnally, yet mportantly, multnatonal frms are takng consderable share of nternatonal trade. They enjoy frm specfc advantages and ncreasng economes of scale, whch are central explanaton of specalzaton. Altogether, t seems natural to enhance the analyss of factor prce equalzaton under mperfect competton and the economes of scale and consder the role of multnatonal enterprses FPE n New Trade Theory Increasng returns to scale and mperfect competton n nternatonal trade are a phenomenon largely proposed n New Trade Theory. For us s the key concern how, f at all, wll the results of FPE be modfed n models wth ncreasng returns to scale and mperfect competton. These aspects were prncpally developed by Helpman and Krugman (1985). They pay attenton to the fact that that:...economes of scale provde an ncentve for specalzaton and trade over and above such reasons as nternatonal dfferences n factor endowments. 9

16 Chapter II Factor Prce Equalzaton (bd: 131). Ths fact complcates our analyss n a sense that trade equlbrum wthout FPE can arse; unqueness of FPE soluton s usually not preserved. There are several approaches how to nclude ncreasng returns to scale nto FPE. One of them regards ncreasng returns as beng external to the frms n gven ndustry. Ths allows us to keep the assumpton of perfect competton n product market. Under such crcumstances, the FPE set s defned and therefore can be shown that factor prces can be (not must be) equalzed. On the contrary to the prevous case, there are several patterns of specalzaton and trade permssble, factor content of trade s not unquely determned. Intutvely, we can magne an example when labor costs n Country 1 are lower than n Country 2. Accordng to Stolper-Samuelson Theorem, Country 1 should produce, f not all, then at least some of labor ntensve good X. Nevertheless, due to decreasng average costs of producton n the producton of X, Country 2 can produce all of X wth external economes despte cost dsadvantage n labor supply. The other approach n modelng wage equalzaton n NTT concentrates on contestable markets, where gven the threat of entry from potental compettors monopolstc frms are forced to charge average cost prces. Snce there are stll ncreasng returns to scale n some ndustres, the producton n these ndustres wll be through trade located n one country. It can be shown that as n prevous case there are multple equlbrums possble wth no necessary equalzed factor prces. Untl now, we mplctly assumed that all of produced goods are tradable. To nclude nontradable commodtes such as some of servces, we assume that they are produced wth the same factors as tradable ones. If trade equalzes factor prces, also prces both of tradable and non-tradable goods wll be equalze. However, as Deardoff and Courant (1990) prove, the sze of cone of dversfcaton s adversely affected by the number of non-tradable commodtes. Hence, the lkelhood of FPE decreases as the number of non-tradable goods ncreases. Ths has mportant mplcaton. If nowadays many of servces are becomng tradable, the sze of cone of dversfcaton grows and the lkelhood of FPE rses owng to the trade effect of servces. Especally for the EU trade n servces, f at least partly approved, would mean consderable mpetus for FPE. In the New Trade Theory models FPE analyss was generalzed beyond two countres, two goods case. Helpman and Krugman (1985) deal wth multple countres and goods and conclude that t does not alter results as long as countres are not too dfferent n ther factor endowments and the number of goods at least equalzes the number of productve factors. If countres dffer, the equlbrum arses wth more than one cones of dversfcaton. Then the 10

17 Chapter II Factor Prce Equalzaton countres wthn the same cone tend to reach FPE, equalzaton of factor prces between the cones does not happen. Deardoff (2001) explores whether economc growth tends to nduce countres to the decreasng number of cones, ths s based on assumpton that factor endowment s not constant, rather t evolves n tme. Hs results prompt that n neoclasscal growth model there s no evdence that economc growth should brng countres factor endowments closer together. Multple cones are necessary. Ths has two mplcatons. Frstly, as economc growth s not, on average, lkely to brng factors endowments closer together then one of the key assumptons of FPE remans unfulflled. Then we may observe lttle convergence or even dvergence even n the long run. Secondly, t makes sense to explore convergence n a broad sample as well as n sub-samples and ths way search for groups of mutually convergng countres whch are not too dfferent n ther endowment Internatonal Moblty of Labor Internatonal trade s certanly not the sngle source of labor cost convergence. Relaxng assumpton of nternatonally mmoble producton factors, flows of ether labor or captal s apt to exert nfluence on factors reward. Robert Mundell (1957) formalzed ths dea: a perfect moblty of factors results n factor prce equalzaton and, even when commodty movements cannot take place, n a tendency toward commodty prce equalzaton. Addtonally, nternatonal flows of productve factors at the same tme lead to convergence of factor endowments; smlarly nternatonal flows of technology lead to convergence of producton technology. Altogether, moblty of factors make countres more smlar and hence draw nearer to common cone of dversfcaton. Economsts usually agree on the fact that mpact of mgraton on the average standard of lvng s postve 8 and a majorty of studes has found postve effect on economc welfare of the destnaton country (Klenman 2003). At the same tme, there are consequences on dstrbuton of ncome, whch depend among others on flexblty, openness to world trade, degree of regulaton. Magntude of economc gans expands wth the degree of mgrant labor complementarty. Assumng constant returns to scale, mmgrants wll affect economc growth n the long run only f they are dfferent from the exstng labor force n terms of ther mx of skll, otherwse they just augments the populaton. 8 A mgrant by relocatng from a place where she s less productve to a place where she s more productve ncreases producton and hence she benefts standard of lvng of the communty as well as of her own. 11

18 Chapter II Factor Prce Equalzaton Most studes conclude that the overall economc mpacts of mmgraton are postve, yet relatvely modest (Smth and Edmonston 1997). However, even f the overall balance s postve, there can be some groups wth labor force negatvely affected. Fears arse that partcularly low sklled mgraton may adversely affect poston of ther domestc counterparts. For USA, Card (1990) detected that there s only a weak relatonshp between natve wages and the number of mmgrants both for sklled and unsklled workers on state or cty level. For UK, Dustmann et al. (2002) conclude that any strong evdence that mmgraton has any large adverse effect on employment or wages s mssng. Also studes by Borjas (1994), Hanson and Slaughter (1999) and Fredberg and Hunt (1995) confrm that factor prces are rather nsenstve to mgraton. Klenman (bd) therefore deduces that consstent wth a large body of evdence for other countres the fears of large and negatve employment and wage effects on the resdent populaton are not easly justfable. Regardless how mportant labor mgraton theoretcally seems to be, emprcal evdence does not back t as a one of the key varables of FPE mechancs. Certanly, there are obstacles both formal and nformal to perfect moblty of labor. On the other hand, second producton factor, captal, s hghly moble, that way can substtute for labor moblty n adjustment towards FPE, and t may even be the case that moblty of captal nfluences labor cost more than moblty of labor Internatonal Moblty of Captal Moblty of captal belongs to leadng characterstcs of globalzaton (UNCTAD 1998). Its movements should ensure effcent allocaton of resources and eventually equalze rskadjusted rates of return on captal globally. In addton to that, captal moblty contrbutes to hgher rate of accumulaton (augmentng captal-labor rato); t transfers technology and operatonal procedures. It s necessary to dstngush between varous knds of factor moblty that, n fact, can sway convergence to dvergence and vce versa. Short-term fnancal flows comprse of volatle and lqud captal prmarly based on acquston of nstruments traded on fnancal markets. Although capable to contrbute to long-term productvty growth, t s usually assumed they are less vgorous n decreasng varaton of labor costs. In some cases, they can be detrmental to trade balances, exchange rates and subsequently to the economy as a whole. Foregn drect nvestment (FDI), on the other hand, are connected wth flow of real resources amed at yeldng long-run proft on nvestment, they are presumably less volatle, and can 12

19 Chapter II Factor Prce Equalzaton bolster convergence by facltatng technology transfers and spllovers and hence ncreasng productvty of labor. Ther mportance s clear, for example the World Bank (1996) consders FDI as a drvng force behnd economc convergence. Moreover, flows of captal affect dfferently both recpent and country of orgn and therefore are especally relevant for potental convergence of labor cost. For those reasons we wll devote complete next chapter to exploraton of FDI and multnatonal enterprses and ther effects on FPE. 2.3 Factor Prce Equalzaton-Survey of Lterature Now, snce we have dscussed the FPE model, we are fnally n a poston to turn to the emprcal examnaton of factor prce equalzaton. We focus on Stolper-Samuelson Theorem and then on emprcal evdence for or aganst factor prce convergence (equalzaton) Stolper-Samuelson Theorem Ths theorem s a necessary condton for Samuelson s (1948) verson of FPE. However, Samuelson s successors have extended FPE for ncreasng returns to scale and mperfect competton and permtted factor prce equalzaton wthout t. Besdes, rather than for equalzaton as a long-run equlbrum emprcal studes look for factor prce convergence as a process possbly leadng to equalzaton. Helpman and Krugman (1985) as well as Brown et al. (1993) queston the Stolper-Samuelson Theorem and have shown both theoretcally and emprcally that reward of country s scarce factor tend to ncrease rather than decrease snce gans from ncreasng returns to scale can accrue to all factors ncludng the scarce one. For North Amerca Free Trade Area Brown s study comes to the dentcal results for dfferentated products and mperfect competton. Thompson (2003) n hs survey of trade models (ncludng varous types of market competton, models wth specfc factors of producton) concludes that beyond two factor model there s no presumpton that for a country trade wll force the reward of ts scarce factor to decrease. Hence, emprcal evdence suggests that for Samuelson s orgnal model, support s rather lmted Factor Prce Convergence To explore FPE, there are two major drectons of research. The frst set of studes focuses on FPE across group of countres. For OECD countres Mokhtar and Rassekh (1989) fnd sgnfcant evdence of factor prce convergence n aggregated manufacturng data. Trade 13

20 Chapter II Factor Prce Equalzaton openness was found as the strongest factor that contrbuted to decreasng wage varaton. Jung and Dorodan (1995) use Johansen s contegraton framework for testng labor costs convergence n manufacturng for eght OECD countres and they fnd support for convergence. Davs (1992) examnes convergence across ndustres n developed and developng countres and concludes that despte a trend to common mean due to nternatonal trade, convergence s to a large part reserved to rch countres. Smlarly, lterature does not show any long-run convergence trend between developed and developng countres (UNCTAD 1998). O Rourke et al. (1996) concludes that convergence has been demonstrated both by convergence of relatve factor-prce as well as relatve scarcty of labor and land between for USA, Sweden, Australa, Germany, UK, France, Denmark. They assgned such development to ncreasng ntegraton of world markets where trade served as a substtute for factor mgraton. For the successve perods evdence s consderably weaker. The second set of studes tests FPE across regons of partcular country. Results vary; the hypothess of convergence fnds lttle support as argued by Tomura (2005) for Japan, Bernard et al. (2002) for Unted Kngdom, Bernard and Schott (2002) for the USA. These studes reject the hypothess that all regons wthn the country face the same relatve factor prce. For the case of UK, three dstnctve regonal prces were found. Besdes dfferent cones of dversfcaton, dspartes n wages emanate from heterogeneous products or regonspecfc dfferences n total factor productvty due to of dstnctve technologes and mmoble factors of producton. For USA, Bernard and Schott (2002) uncover that wage dfference across regons ncreases wth the dfference n ndustry structure and lkewse they dscover at least three dfferent cones of dversfcaton for USA. The fact that there are persstent wage dfferences and wth dfferent ndustry mx authors explan by dfferent exposton to nternatonal trade. On the other hand, Webber (2001) nvestgates wage convergence among 57 EU-regons between and hs fndng supports the hypothess that economcally ntegratng economes face a progressvely smlar level of factor rewards. To my knowledge, lterature does not deal wth the possble dscrepancy of results n FPE studes among countres and wthn ndvdual states. Potental explanaton may be the dstrbuton of regon n dfferent cones of dversfcaton. For example, Prague and Northern Bohema dffer n factor endowments as well as n the producton and therefore the FPE s unlkely. On multnatonal level such regonal dspartes balance mutually vs-à-vs smlar regonal structure and the overall pcture turns to convergence. 14

21 Chapter II Factor Prce Equalzaton 2.4 Summary Factor Prce Equalzaton Theorem provdes a clear answer for the evoluton of factor rewards under nternatonal trade. If FPE holds, than the margnal productvtes of captal and real wage are dentcal across countres. We have presented Samuelson s orgnal constructon and reconsdered t by the lenses of New Trade Theory. Whle n the former model equlbrum s unque wth the dentcal set of factor prces over all the countres, n the latter case equlbrum wth FPE s just one of the possble outcomes. It seems plausble that due to numerous exstng cones of dversfcaton, factor prce equalzaton through the process of convergence arses among groups of suffcently smlar countres. Ths dea was also acknowledged n the survey of lterature, where the tendency of real factor rewards to converged was confrmed manly among countres employng smlar technologes, havng smlar factor endowment wth mutually low barrers to trade. Role of labor moblty does not seem to be an mportant determnant of labor cost convergence. 15

22 Chapter III Multnatonal Enterprses and FPE III. Moblty of Captal, Multnatonal Enterprses and Factor Prce Equalzaton Moblty of captal and multnatonal enterprses (MNE) 9 are worth consderng n the process of factor prce equalzaton. Besdes nternatonal trade, they represent a brdgng element between countres; they promote closer lnkages among economes and have potental to transfer factor endowments (technology, expertse, know-how etc.). They serve as medators of factor prce convergence. Therefore, consderng both foregn drect nvestments (FDI) and multnatonal enterprses enrches our analyss by two elements whch steer economes (ther cones of dversfcaton) closer together and whch subsequently contrbute to the factor prce convergence. Multnatonal (transnatonal) enterprses, major orgnators of FDI, are becomng ncreasngly promnent n the world s economy. In 2000, world s ten largest MNE produced nearly one percent of world s GDP and one hundred largest MNE are responsble for more than four percent of world GDP (UNCTAD 2002 n Mündler 2006). In addton to, MNE grow rapdly and spread ther actvtes on worldwde scale. It s not a surprse that FDI reflect more promnently the lnkages between economes than nternatonal trade (e.g. Cuyvers et al. 2002). Our dscusson wll proceed as follows. Frst, we brefly consder types of FDI and ther roles n host country. Then, we focus on what the theory says about captal flows and ther mpacts on FPE. Survey of lterature follows n order to quantfy consequences of FDI on wages and productvty n recpent countres. Fnally, the effects on home country are consdered. 3.1 Foregn Drect Investments Foregn drect nvestments can be generally nterpreted n two ways. The frst one consders FDI as a flow of captal from home to host countres. These flows transfer ownershp n the host country and are ncluded n the balance of payments as flows and stocks. The second approach regards FDI as regular operatons (producton, sales etc.) of MNE s new afflate 9 As multnatonal enterprses, we consder frms wth own operatons n more than one country. Contrary to them, natonal enterprses (NE) perform own operatons n just sngle country. For ths reason a Czech frm exportng abroad and employng local dstrbutors there s not a MNE. As foregn drect nvestment, we thnk of actvtes performed by MNE to secure assets abroad. Flow of physcal captal s not necessary-fdi may not be source of addtonal fnance to the host country. Throughout the chapter, we focus prmarly on the FDI. Shortrun fnancal flows, speculatve captal or portfolo nvestment certanly deserves attenton as well but they are usually regarded as less conducve (sometmes even preventng) to convergence and we wll not dscuss them unless explctly stated. 16

23 Chapter III Multnatonal Enterprses and FPE after the acquston has taken place. Perhaps, ths latter concepton s more relevant for our subject as convergence s result of actvtes rather than result of sole nvestment flow. However, as Lpsey (2002) notes, ths second aspect s substantally more dffcult to control for, as the data are not always avalable. From the pont of vew of host country, FDI are dvsble accordng to ther poston n the producton chan. We dstngush between vertcal and horzontal nvestments. For horzontal FDI, producton s located n parent company and n producton plants abroad, all focusng on smlar set of actvtes. Vertcal FDI, n contrast, explot nternatonal factor prce dfferentals; operatons are dvded nto the headquarter servces and producton. Whle the former manages frm s knowledge assets and support functons (skll ntensve labor) n countres, where sklled labor s relatvely cheaper, the latter focuses manly on producton of output (manual labor) n low cost countres. In other words, actvtes are located accordng to ther factor ntensty. Emprcal lterature agrees that horzontal FDI are the most abundant of all FDI and that most of them take place between developed countres. For example, Markusen (1995) calculates that more than 80 per cent of FDI s drected to ndustralzed countres. Market sze, dstance and trade costs explan these flows satsfactorly well. Factor prce dfferences (wage dfferences) dd not turn out to be an mportant determnant of horzontal FDI (Branard 1997, Gaston and Nelson 2002). Therefore, models of horzontal FDI usually employ assumpton of equalzed factor prces (see Claro 2005). For vertcal FDI wage dfferental s essental. Helpman (1984) n hs semnal model of multnatonal enterprses shows orgnaton of vertcal FDI. Snce there are cross-country dfferences n factor endowments, there are also cross-country dfferences n factor prces (no FPE). Labor cost dfferental enables MNE to take advantage of geographcal dvson of producton, whch s at the outset catalyzed through FDI. In equlbrum, captal moblty has equalzed real factor rewards as well as enlarged factor endowment set. Regardless of partcular type of nvestment, FDI take three man functons n the host country. Frst, MNE as orgnators of FDI possess so-called knowledge captal (e.g. Dunnng 1977). Ths s a frm specfc advantage such as technology, management sklls, scale economes etc. enablng MNE to successfully compete abroad. Authors confrm and emphasze the role of knowledge rather than captal as key component of nvestment flows (e.g. Markusen 2002). Second, some parts of knowledge captal may spll over to domestcally owned enterprses makng them more compettve and also provdng tghter lnkng of the host country to the world economy. As t has come clear from the second chapter, convergence of employed 17

24 Chapter III Multnatonal Enterprses and FPE technologes s one of presumptons for presence n the same cone of dversfcaton and hence for convergence of factors rewards. Thrd, FDI may provde an addtonal source of captal allowng nvestment beyond the level of domestc savngs and expanson of host country producton. Inflow of captal leads to swtch of producton methods and to convergence of factor endowments and factor ntenstes. 3.2 Factor Prce Equalzaton and Moblty of Captal As we know from prevous chapter, Heckscher-Ohln-Samuelson (HOS) model assumes that factors are nternatonally mmoble; yet, trade stll equalzes commodty and factor prces. In the followng, we focus on the complementary stuaton, namely whether captal moblty alone s n HOS world capable of achevng factor prce equalzaton even f nternatonal trade s prohbted. 10 Ths queston was for a frst tme formally answered by Mundell (1957) n hs artcle on captal moblty and factor prce equalzaton. In the followng, I present treatment by Hong (1996, Chapter 15). Let us assume that free trade has ensured FPE, holdng captal and labor nternatonally mmoble. Such equlbrum s depcted by pont E n the Fgure 3.1. Further, we assume that Country 2 mports captal-ntensve good Y and exports labor-ntensve good X. In such a case, removng barrers to captal movement does not nduce any flows snce returns to factors are already equalzed. If now relatvely less captal-abundant Country 2 mposes a prohbtve tarff on captal ntensve good Y, the prce of Y rses relatve to the prce of X 11. There s no trade at all n models. Subsequently, Stolper-Samuelson effect takes place: factors move from labor-ntensve ndustry that produces good X to captal- ntensve ndustry producng Y. As a result, there s an excessve supply of labor and excessve demand for captal. Producton of good Y grows and that of X declnes, country moves down along ts contract curve to autarky pont A. 10 The HOS world refers to the model presented n the precedng chapter ncludng all the employed assumptons. The only modfcaton s prohbton of nternatonal trade here. See secton n the prevous chapter for the comprehensve descrpton of the assumptons n orgnal model. 11 Model assumes that Country 1 does not respond by levyng a counter tarff, the tarff ncrease s unlateral. If ere s a response, captal flows cannot equalze factor rewards snce the nterest payment to Country 1 wll be subject to these trade mpedments. 18

25 Chapter III Multnatonal Enterprses and FPE Fgure 3.1: Captal Flows-Country 2 K 0 y K 0 y E E A 0 x L In autarky, relatve factor ntensty K/L has fallen n comparson to free trade equlbrum,.e. margnal product of captal ncreases and the margnal product of labor decreases. As there are no mpedments to factor movement, Country 2 enjoys nflow of captal and factor endowment set s enlarged by the addtonal amount of captal that equalzes margnal products n both countres. Factor endowment set expands to 0 x L0 y K. For graphcal tractablty, although results are vald generally, t s comfortable to assume that Country 2 s small relatve to Country 1 so that margnal product there remans unchanged and thus also factor proportons and commodty prces. In equlbrum then, factor proportons n HOS must be the same and hence the new equlbrum, E, les on ntersecton of E0 x and lne parallel to 0 y E. Factor flows from Country 1 to Country 2 have equalzed both factor rewards and commodty prces even wthout free trade. It s not a concdence that, ceters parbus, Country 2 consumes the same mx of goods as under free trade (commodty prces and factor rewards reman unchanged); however, now Country 2 needs to ncrease producton n order to fnance payments of nterest to Country 1. It can be shown that these results are applcable for any postve value of tarff as well as that they are ndependent from sze of tradng partners. In the lne of presented argument, we can magne that labor scarce Country 1 ntroduces a tarff on labor-ntensve good X. As a result, prce of X ncreases and owng to Stolper- Samuelson argument margnal product of labor grows and that of captal falls. If there s a perfect moblty of labor, labor force mgrates to Country 1 untl margnal products are equalzed and factor rewards are the same. Ths result s even more robust than the one of captal moblty. Snce, f workers as owners of productve factor settle n Country 1 and consume ther ncomes there, results of FPE s vald regardless whether Country 2 responds 19

26 Chapter III Multnatonal Enterprses and FPE by levyng a counter tarff on good Y. Mundell (bd) formulates these fndngs n the way that trade mpedments gve rse to movement of producton factors wth the dentcal results as unrestrcted trade wth factors nternatonally mmoble. In HOS world, factor prce equalzaton s suffcent to ensure commodty prce equalzaton and vce versa. Snce we have dscovered that captal flows alone (gven the assumptons of Heckscher- Ohln-Samuelson model) are capable of achevng factor prce equalzaton, nternatonal trade s not a necessary condton anymore. It s valuable to explore what other, less restrctve, models prompt about captal flows and labor reward. Brown et al. (2002) summarze theoretcal mplcatons of captal moblty and survey relevant models on captal moblty and factor rewards. Ther study ncludes varatons of two-sector Heckscher-Ohln-Samuelson model, Specfc Factor Model or model wth multple cones of dversfcaton. Table 3.1 reports ther fndngs. All but one model shows a nonnegatve relatonshp between wages and captal nflow. Let me brefly comment on some of the models. In the case of small country wth two cones of dversfcaton, captal nflow leaves wages ntact. Ths s caused by the fact that wthn the same cone, FPE holds and gven the HOS assumpton, there are not any ncentves for captal to move. Between the cones, FDI from captal-abundant country to labor-abundant country stuated n dfferent cones wll be favorable to factor prce convergence. Wages wll grow and returns to captal fall whle the opposte happen n home (captal-abundant) country. In other words, FDI rases captal stock n a host country. For suffcently large nflow, country grows to dfferent, hgher, cone wth hgher output and hgher wages. Table 3.1: Effects of FDI on Host Country Wages Model (sectors x factors) Small Country 2-Country Model One sector (1 x 2) + + HOS (2 x 2) specalzed + + Specfc Factors (2 x 3) + + HOS ( 3+ x 2 ) two-cone, dversfed 0 + Feenstra-Hanson (nfnte x 3) Sklled labor + + two cone, dversfed Unsklled labor + - Source: Brown et al. (2002: 51), small country s defned as a country that takes prces as gven 20