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Gainful Effects of Foreign Capital Inflow in the Presence of Intermediate Goods and Technical Efficiency of Labour Anindita Basu (Chowdhury) Department of Economics Mahishadal Raj College Mahishadal Midnapur(East) West Bengal INDIA and Kausik Gupta Department of Economics Rabindra Bharati University Kolkata West Bengal INDIA Keywords: Foreign capital inflow, Import-competing sector, Technical efficiency, Intermediate goods, Foreign enclave, Non-traded intermediate goods. JEL classification: F10, F11, F13, F21, F23 ADDRESS FOR COMMUNICATION: ANINDITA BASU (CHOWDHURY) AL-79, SECTOR-II SALT LAKE KOLKATA-700091 Telephone No (R): (033)23580470 Email: basu_anindita@rediffmail.com The present paper is part of the doctoral dissertation of Anindita Basu(Chowdhury) which is in progress at the Department of Economics, Burdwan University, West Bengal, India. Any remaining error, however, are the sole responsibility of the authors. Gainful Effects of Foreign Capital Inflow in the Presence of Intermediate Goods and Technical Efficiency of Labour Abstract: The paper attempts to examine the impact of foreign capital inflow in the presence of an intermediate goods sector which may be traded or non-traded using a general equilibrium trade model for a small open economy. Here it has been shown that the welfare improving effects of foreign capital inflow is valid in an economy with intermediate goods sector irrespective of whether it is traded or non-traded sector. Our results support the challenges of Marjit and Beladi (1997) and Marjit, Broll and Mitra (1997), Chaudhuri (2001) etc, regarding the conventional wisdom in the context of foreign capital inflow, though our framework is quite different from the frameworks of the above mentioned authors. Gainful Effects of Foreign Capital Inflow in the Presence of intermediate goods and Technical Efficiency of Labour 1. Introduction: The formation of world trade organization (W.T.O.) brought some revolutionary changes in liberalizing international trade across countries, whether developed or developing. Liberalization includes both inflow of foreign capital as well as reduction of protection to domestic industries. Empirically it has been observed that many developing economies notably the non-OECD countries, have not implemented tariff reforms to any significant extent, even after formally choosing free trade as their development strategy. This fact appears to be puzzling at the first sight. However, this phenomenon can be explained by “tariff jumping theory”1. It suggests a positive correlation between the amount of foreign direct investment (FDI) in a country and tariff rates imposed by it. So the countries which welcome huge inflow of foreign capital may be reluctant to implement tariff reform seriously. The effects of inflow of foreign capital in the developing countries have been investigated intensively by both trade and development theorists. According to both trade and development theorists the effects of inflow of foreign capital in developing economies in the presence of full repatriation of foreign capital income are, in general, discouraging. Brecher and Alejandro (1977) have analyzed the welfare effects of foreign capital inflow in a two-commodity, two-factor full employment model. Khan (1982) has re-examined this proposition in a mobile capital Harris-Todaro model with urban unemployment. Both of them have reached the conclusion that inflow of foreign capital, 1 The higher rate of return on foreign capital is the major driving force behind foreign direct investment by the multinational corporation. Along with this the protected domestic markets creates an additional incentive for the multinational corporations to invest in these countries. It helps them to jump the tariff walls and to reap a good return by serving the markets of developing countries. See for example, Motta (1992) and yanagawa (1990) for details. with full repatriation of its earning, is necessarily immiserizing if the import-competing sector is capital-intensive and is protected by a tariff. However, in the absence of any tariff, foreign capital inflow with full repatriation of its earnings does not affect welfare. An interesting question in this regard is the willingness of the developing countries to invite foreign capital inspite of its immiserizing results on welfare due to foreign capital inflow. There are a quite large number of works2 that have re-examined the Brecher- Alejandro (1977) proposition. Most of these have attempted to find out the impact of inflow of foreign capital to the final goods sector. Two interesting papers by Marjit and Beladi (1997), Marjit, Broll and Mitra (1997)3 are however exceptions in this regard. In both these works a protected intermediate goods sector, using sector specific foreign capital, has been considered. They have shown, contrary to the conventional wisdom, foreign capital inflow into the tariff distorted intermediate goods sector with full repatriation of foreign capital income is welfare improving under some reasonable conditions4. Chaudhuri (2001) has shown that the economy may experience an improvement in its welfare due to foreign capital inflow when the non-traded intermediary goods sector is sufficiently capital intensive relative to the import competing sector and a sufficiently large amount of the output of this sector is used in the export sector of the economy. Using a three-sector general equilibrium framework with two informal sectors Chaudhuri and Mukhopadhyay (2002) have shown that in the presence of labour market distortions, foreign capital inflow may be desirable both in the presence and absence of tariff protection due to its favourable impact on welfare. 2 See the works of Grinols(1991), Beladi and Marjit(1992), Datta Chaudhuri and Adhikari(1993), Chandra and Khan(1993), Gupta(1994), Gupta(1997) etc. 3 The basic difference between these two model is that former is based on a neo-classical full employment framework whereas the latter is based on a structure with Harris- Todaro(1970) unemployment. Again in case of the former it is only the intermediate goods sector, which is protected whereas in case of the latter one of the final goods sectors along with the intermediate goods sector are protected. 4 Gupta (1998) however, has considered general equilibrium framework to show that the effects of inflow of foreign capital to the tariff distorted intermediate goods sector is generally, immisering, under some reasonable conditions, in the presence of full repatriation of foreign capital income. The impact of foreign capital inflow in the presence of intermediate goods and technical efficiency of labour is relatively neglected in the literature. Though Marjit and Beladi(1997), Marjit, Broll and Mitra (1997) have considered intermediate goods they have ignored technical efficiency of labour. In this paper we first consider a tariff distorted intermediate goods sector. In the second part of the paper, however, we consider a non-traded intermediate goods sector. To capture improvement in technical efficiency we have introduced a technical efficiency function, which depends on foreign capital. The rationale behind this function is that an increase in foreign capital inflow implies foreign direct investment in the home country. As a result of foreign direct investment, resident of the host country come into contact with foreign entrepreneurs who posses superior technical skills and know-how. These new ideas lead to transfer of technology from the foreigners to the residents of the host country and it takes place through observation, discussion, and training. This transmission can be considered as a spillover effect on the residents of the host country leading to improvement in technical efficiency of labour force5. The analysis of the present paper is based on a static full employment framework of the Heckscher-Ohlin-Samuelson type where the economy is broadly divided into domestic enclave and a foreign enclave6. The first part of our paper shows that, under some reasonable conditions, inflow of foreign capital is welfare improving when the intermediate goods sector is protected and there is full repatriation of foreign capital income. These results support the challenge of Marjit and Beladi (1997) and Marjit, Broll and Mitra (1997) regarding the conventional wisdom in the context of foreign capital inflow. However, here we have used a framework which is different from the frameworks of the above mentioned authors. 5 See Koizumi and Kopecky (1977). Findlay (1978) has also used this ‘contagion hypothesis’ in his theoretical analysis of technology transfer and relative backwardness. 6 This inclusion of measurement of labour in efficiency unit makes a difference from Gupta’s (1998) model. Contrary to Gupta (1998) we find that introduction of technical efficiency function gives us results which are opposite to that of conventional wisdom. In recent years, many developing countries are interested to attract foreign capital into non-traded intermediate goods sector the products of which are required to produce manufacturing product. Unfortunately, economists have given little attention to analyze the impact of foreign capital inflow in the presence of non-traded intermediate goods. In the second part of the paper our objective is to analyze the welfare effects of foreign capital inflow when such capital flows to both the final goods producing and non-traded intermediate goods producing foreign enclave. This inclusion of foreign enclave makes a difference from Chaudhuri’s (2001) model. Contrary to Chaudhuri (2001) here we have used Heckscher-Ohlin-Samuelson type full employment framework instead of Harris- Todaro frame work with urban unemployment. Welfare effects of foreign capital inflow have been examined in this set-up. It has been found that, contrary to the conventional immiserizing result, inflow of foreign capital is welfare improving under some reasonable conditions. The plan of the paper is as follows. Section 2 deals with the model of foreign capital, traded intermediary and technical efficiency of labour. The comparative static analysis regarding the effects of increase in foreign capital inflow of the above model is also considered in this section. Section 3 specifies the model of foreign capital with non- traded intermediate goods. The comparative static analysis regarding the effects of increase in foreign capital inflow of the above model is also considered in this section. Finally the concluding remarks are made in section 4. 2. Foreign Capital, Traded Intermediary and Technical Efficiency of Labour: 2.1 The Model: We consider a small open economy consisting of three sectors in a Heckscher- Ohlin- Samuelson Framework. One of these three sectors produces intermediate goods and the other two sectors produce final goods. All these three sectors use labour (L), which is perfectly mobile among the sectors. Domestic capital (KD) has been considered as mobile only between agricultural goods sector, A and intermediate goods sector, I, but foreign capital (KF) is specific to manufacturing goods sector, M7. Thus agricultural sector uses domestic capital, labour and intermediate goods as inputs whereas manufacturing sector uses foreign capital, labour and intermediate goods as inputs. Here endowment of L and KD are exogenously given. Due to the assumption of small open economy the economy is a price taker in the world market. All the prices are normalized to unity. All the products are traded. Here two final products are exported and that amount of intermediate goods which fails to meet-up the entire demand generated by the two final goods sector is imported. The intermediate goods is protected by a tariff. All markets are assumed to be perfectly competitive. The entire foreign capital income is repatriated. Thus most interesting part of the paper is the introduction of the technical efficiency function of labour8 and it is assumed to be a function of foreign capital. For specifying our model on the basis of the above assumption we use the following notations. Xi = product produced by the ith sector, i = A, M, I XI* = amount of import of intermediate goods w = common wage rate of labour in all sectors r = rate of return on domestic capital rF = rate of return on foreign capital9 7 The fact that foreign capital is sector- specific is a common assumption in the existing literature. See the works of Young and Miyagiwa (1987, 1992), Datta Chowdhury and Adhikari(1993) Gupta and Gupta (1998) e.t.c. The existence of a joint sector, where foreign capital and domestic capital exist side by side is not considered here. This is nothing more than a simplifying assumption. 8 See the works of Gupta (1999), Chaudhuri (2005) e.t.c. in this regard. 9 Our implicit assumption is that rF ≥ rFw, where rFw is the exogenously given world rate of return on foreign capital. For this reason foreign capital will be invested in the small open economy but due to government control the amount of foreign capital which enters in this country is also fixed at a particular point of time. It may be noted in this connection that in many developing countries we find that the shift towards more liberalized regime is a gradual one instead of drastic shift. Drastic policy changes may lead socio-political tension in the economy in the short run. The assumption of exogenously given foreign capial stock can thus be justified as the government directly regulates the entry of foreign capital. See Marjit (1994) for details. See also Gupta and Gupta (1998). L = fixed endowment of labour h(.) = technical efficiency function of labour KD = fixed endowment of domestic capital KF = Fixed amount of foreign capital aji =quantity of jth factor for producing one unit of output in the ith sector. j = L, K and i= A, M, I (we consider variable coefficient technology) ji = proportion of jth factor used in the production of the ith sector = Proportional change = the measure of real national income t = rate of tariff on the intermediate goods sector Competitive equilibrium condition in the product market for the three sectors implies the following equations. waLA + raKA + (1+t)aIA= 1 (1) waLI + raKI = (1+t) (2) waLM + rFaKM + (1+t) aIM = 1 (3) The sector specificity of foreign capital is given by the following equation aKMXM = KF (4) Mobility of domestic capital can be expressed as aKIXI+aKAXA=KD (5) The technical efficiency of each worker is assumed to be a positive function of the amount of foreign capital in the economy and is given by h(KF), h>0 i.e. Labor endowment is expressed in efficiency unit and it is thus a function of foreign capital. We write the labor endowment of the economy in efficiency units as aLAXA+ aLIXI + aLMXM =Lh(KF) (6) Here equation (4), (5), and (6) imply that there exists full employment in the factor market. Demand-supply equilibrium for the intermediate goods gives us aIAXA + aIMXM = XI + XI* (7) It is important to mention that our measure of welfare in this small open economy is national income at world prices10, , and it is expressed in the presence of full repatriation of foreign capital income as follows. = wLh(KF) + rKD + tXI* (8) Given (1 + t) from equation (1) & (2) we can determine w & r and then from equation (3) we can determine the value of rF. Thus the factor prices are determined independently of factor endowments i.e. the model is completely decomposable. Hence we can solve for the equilibrium values of the input output coefficients. From equation (4) we can determine XM as KF is given and then equation (5) & (6) can be used to find out the value of XA & XI. From equation (7) we can thus determine XI* and finally from equation (8) the value of national income can be obtained. 2.2. The Comparative Static Effects: In this section we want to examine the impact of foreign capital inflow on the level of output of each sector as well as on the national income of the domestic economy. From equation (4) we get dXM/dKF = 1/aKM. ˆ ˆ It implies X M / K F = (KF /XMaKM) (9) ˆ ˆ Since aKM is positive so X M / K F >0. Now using this result and differentiating (5) and (6) we can get [see appendix 1] ˆ ˆ X I / K F = -[KA{(hKF/h) - LM}]/ (10) ˆ ˆ X A / K F = [KI{(hKF/h) - LM}]/ (11) Where = KILA-KALI >0 iff KI/LI > KA/LA. This implies that the intermediate goods sector is more capital intensive compared to final goods sectors, which uses domestic capital. ˆ ˆ ˆ ˆ Under the above assumption X I / K F < 0 and X A / K F > 0 iff (hKF/h) >LM. 10 The indirect welfare function of the economy depends on prices and national income. In case of a small open economy with given prices, real national income can be treated as a proxy for welfare. . See for example, Chaudhuri (2001),Chaudhuri and Mukhopadhyay (2002a, 2002b), Gupta (1994, 1997) etc. Using equation (9), (10) &(11) and after some simplification from equation (7) we can get ˆ ˆ ˆ ˆ ˆ ˆ ˆ ˆ X I * / K F = [(XI/XI*) {IA X A / K F + IM X M / K F - X I / K F }] = (XI/XI*) [{(hKF/h) – LM}{(IAKI + KA)/ } + {IM(KF /XMaKM)}] [See appendix 1] ˆ ˆ Under the assumption =KILA-KALI>0 the value of X I * / K F >0 if (hKF/h) > LM. From equation (8) we find that d/ dKF = wLh + tdXI*/ dKF The value d/dKF is dependent on the value of dXI*/dKF (since h is positive). Under ˆ ˆ some reasonable assumption we have shown that the value of X I * / K F is positive i.e. inflow of foreign capital leads to increase in import demand of intermediate goods. Thus real national income increases due to inflow of foreign capital in the economy. The economic intuition behind the results can be explained as follows. An increase in foreign capital stock (KF) leads to an increase in the output of manufacturing sector (XM), which draws labour away from other sectors as the input output coefficients remains unchanged10. This increase in production of XM creates a shortage of effective labour supply in the other two sectors. Under the assumption that the intermediate goods sector (I-sector) is more capital intensive than the final agricultural goods sector (A-sector) we find, following Rybczynski Theorem, that production of intermediate goods sector increases and the production of agricultural goods sector falls. On the other hand, owing to improvement in technical efficiency of the workforce associated with increase in foreign capital, the labour endowment of the economy in efficiency unit increases. This produces another Rybczynski effect, which leads to an expansion of agricultural sector and a contraction of intermediate goods sector. Thus in this model two opposite Rybczynski effects are generated. The net result, which is called net output effect, is dependent on the relative strength of these two opposite effects. This net output effect would be a contraction of the sector ‘I’ and expansion of the sector ‘A’if the former effect 11 As the model is decomposable i.e. factor prices are determined independently of factor endowment. is less than the effect of the latter. This happens if (hKF/h) > LM i.e. technical efficiency functionwith respect to capital is highly elastic. Increase in the levels of XA and XM due to foreign capital inflow implies an increase in the demand of intermediate goods. As the output of sector I falls it implies an increase in the demand for imported intermediaries due to an increase in inflow of foreign capital. Hence, under certain reasonable conditions the amount of imported intermediate goods rises. As the tariff rate t on the intermediary is given, it implies that there is an increase in tariff revenue from intermediate imports as a result of inflow of foreign capital. The increase in foreign capital stock leads to an increase of labour income through an improvement in technical efficiency. However this inflow of foreign capital leads to no change in the domestic capital income. Thus total domestic factor income [wLh(KF)+rKD] increases. The combined result implies an increase in real national income of the economy. In case of a small open economy with given prices, real national income can be treated as a proxy for welfare. Hence an inflow of foreign capital raises welfare under some reasonable assumptions. We summarise our results in the form of the following proposition. Proposition 1: Given the assumption that (i) there is full repatriation of foreign capital income, (ii) there is tariff protection to the intermediate goods sector, I, which uses domestic capital and (iii) technical labour efficiency is a positive function of foreign capital, an inflow of foreign capital to the manufacturing goods sector is welfare improving if and only if intermediate goods sector is more domestic capital intensive than agricultural goods sector and (hKF/h)>LM i.e. technical efficiency function with respect to capital is highly elastic. 3. Foreign Capital and Non-traded Intermediary: 3.1. The Model: We consider a small open economy consisting of four sectors in a Heckscher-Ohlin- Samuelson Framework. One of these four sectors produces intermediate goods and the other three sectors produce final goods. All these four sectors use labour (L), which is perfectly mobile among the sectors. Domestic capital (KD) has been considered as mobile only between domestic manufacturing sector, M and the agricultural sector, A and foreign capital (KF) has been considered as specific to the foreign enclave though it is mobile between two sectors of foreign enclave, the non-traded intermediate goods sector, F1 and a final goods sector, F2. Here the domestic manufacturing sector, M produces its commodity (XM) with the help of labour, domestic capital and non-traded intermediate goods. The agricultural sector, A produces agricultural commodity (XA) with the help of labour and domestic capital. Both the sectors within foreign enclave use labour and foreign capital to produce their product. The per-unit requirement of the intermediate input is assumed to be technologically fixed in the manufacturing sector12. Let us now assume that labour in the manufacturing sector earns a contractual wage rate w , while the wage rate in the other three sectors and the payment to capital are market determined. Here contractual wage rate is assumed to be higher compared to competitive wage rate. Owing to our small open economy assumption, we consider prices of all final goods to be given internationally. On the other hand, the price of the non-traded intermediary produced in sector F1 is endogenously determined. We assume that the manufacturing sector is the import-competing sector of the economy and is protected by a tariff. Price of the agricultural product is considered as the numeraire and its price is set equal to unity. Production functions exhibit constant returns to scale with diminishing marginal productivity to each factor. All inputs are fully employed. The entire foreign capital income is repatriated. For specifying our model on the basis of the above assumptions we use the same notations as used in section 2 of this paper. Here we just mention the additional notations relevant for the present model. Xi = product produced by the ith sector, i = A, M, F1, F2 w = contractual wage rate of manufacturing sector Pi = world price of the ith commodity, i = M, A and F2 PF1 = endogenously determined price of the non-traded intermediary θij = distributive share of the jth input in the ith industry 12 It is just a simplifying assumption. It rules out the possibility of substitution between the non-traded intermediary and other factors of production in the final goods sector. The general equilibrium is represented by the set of following equations. w aLM + raKM + aF1MP F1 = PM (1+ t ) (12) waLA + raKA = 1 (13) waLF1 + rFaKF1 = PF1 (14) waLF2 + rFaKF2 = PF2 (15) Equations (12), (13), (14) and (15) are the competitive equilibrium conditions. They imply that unit cost of production of each commodity must equal its domestic price in equilibrium. The demand for the non-traded intermediary must equal to its supply, so we have aF1MXM = XF1 (16) Here only aF1M is fixed though other aji are variable and are functions of relevant factor prices. Full employment of labour implies the following equation aLMXM + aLAXA + aLF1XF1 + aLF2XF2 = L (17) Full utilization of domestic capital in the economy implies that aKMXM + aKAXA = KD (18) Full utilization of foreign capital inflow in the capital recipient economy implies that aLF1XF1 + aLF2XF2 = KF (19) There are eight endogenous variables in the system: w, r, rF, PF1, XM, XA, XF1, XF2. The parameters of the system are: PM, aF1M, L, KD, KF, t, which are exogenously given. Thus we have eight independent equations [equations (12) to (19)] to solve for eight unknowns. Given the prices of the products of sectors M, A, F2 from equations (12), (13), (14) and (15) we can determine the values of four variables r, PF1, w, rF. Here the factor prices are determined independently of factor endowments. Thus the decomposability property is valid in our model. Once factor prices are known the input-output coefficients are also known. Equations (16), (17), (18) and (19) then can be solved for XM, XA, XF1 and XF2. Before going into comparative statics, we note that national income at world prices, , expressed in the presence of full repatriation of foreign capital income as follows. = w aLM.XM + w (aLAXA + aLF1XF1 + aLF2XF2) + r.KD – t.XM.PM = w.L + ( w - w).aLM.XM + r.KD – t.XM.PM (20) In equation (19) [w.L + ( w - w).aLM.XM] is the aggregate wage income of the workers. The term r.KD is the income from domestic capital stock. Here t.X M.PM measures the cost of tariff-protection to the import-competing sector13. 3.2. The Comparative Static Effects: In this paper we are interested to reanalyze the impact of increase in foreign capital inflow on the level of output of each sector as well as on the level of welfare in a small open economy. Given the fact that aF1M is fixed we get from equation (16) the following relation ˆ ˆ XM X F1 (21) Totally differentiating equation (17), (18), and (19), using equation (21) and after some algebraic simplifications (see appendix 2 for details) we get the following three expressions. ˆ ˆ KM X M + KA X A = 0 (22) ˆ ˆ ˆ KF1 X M + KF2 X F2= K F (23) ˆ ˆ ˆ (LM+ LF1) X M + LA X A + LF2 X F2= 0 (24) Solving equations (22), (23) and (24) by Cramer’s rule and after some algebraic simplification we can get [see appendix 2 for details] ˆ ˆ ( X M / K F ) = LF2/[(KF1LF2 – KF2(LF1 - |λ|/KA)] = LF2/[(LF1LF2 {(KF1/LF1) – (KF2/LF2)}+ |λ|(KF2/KA)] (25) 13 The imposition of a tariff on the import-competing sector artificially raises the domestic price of the formal sector’s product from its world price, which lead to a misallocation of resources between the two sectors. Producers would produce more (less) of the importable (exportable) commodity vis-à-vis their free trade levels. t.XM.PM measures the loss in the economy’s welfare resulting from this inefficiency in production. ˆ ˆ ( X F2/ K F ) = {|λ| -(LF1KA)}/[KA{(KF1LF2) – (KF2LF1)} + KF2|λ|] = {(LAKM - LMKA) - (LF1KA)}/ [KALF1LF2{(KF1/LF1)–(KF2/LF2)+ KF2|λ|] (26) ˆ ˆ ˆ ˆ ( X A / K F ) = - (KM/KA) ( X M / K F ) = -LF2KM/KA[(LF1LF2 {(KF1/LF1) – (KF2/LF2)}+ |λ|(KF2/KA)] (27) where |λ| = LAKM - LMKA>0 as manufacturing sector is assumed to be more capital intensive compared to agricultural sector i.e. (KM /LM) >(KA /LA). Again it is to be noted that manufacturing sector uses labour both directly as well as indirectly through use of non-traded intermediary goods as production of one unit of manufacturing sector requires aF1M units of non- traded intermediary goods which also requires aLF1 units of labour in its production. Thus domestic capital-labour ratio for manufacturing sector is given by KM/(LM+LF1). We assume that not only (KM/LM) > (KA /LA) but also KM/(LM+LF1)>(KA/LA). Finally we assume that the non-traded intermediate goods sector is more (foreign) capital-intensive than the final goods sector that uses foreign capital i.e. (KF1/LF1) > ˆ ˆ ˆ ˆ ˆ ˆ (KF2/LF2). Thus ( X M / K F ) >0, ( X F2/ K F ) >0 and ( X A / K F ) <0. As from equation (21) ˆ ˆ we find that X M X F1 ˆ ˆ we can say that ( X F1/ K F ) >0. Since the system posses the decomposable property, factor prices and hence factor coefficients remain unaltered owing to foreign capital inflow. However, inflow of foreign capital produces a change in the output composition of the economy. In order to interpret the impact of foreign capital inflow on welfare of the economy we need to find out the impact of such an inflow on the output level of sectors F1 and F2. Under the assumption that sector F1 is more (foreign) capital-intensive than sector F2 we find that, for given XM and XA, output of sector F1 increases and output of sector F2 falls. We can refer to it as Rybczynski effect. However, it is to be noted that the output level of sectors M and A do not remain constant. In fact due to the fixed coefficient nature of subcontracting we find that aF1M is fixed so that the output of manufacturing sector increases as much as the ˆ ˆ increase in output of non-traded intermediary. This implies that X M X F1. Increase in output of the M sector should be matched by decrease in output of the A sector as domestic capital stock is given. However, if we argue that as the output of sector F2 falls due to an increase in foreign capital we can say that the effective labour endowment for sector M, A, and F1 increases. This is because reduction in XF2 implies reduction in aLF2XF2 so that (L-aLF2XF2) increases. Here we assume not only sector M is more (domestic) capital-intensive than sector A so that (aKM/aLM)>(aKA/aLA) but also aKM/(aLM+aLF1)>(aKA/aLA). ˆ ˆ Noting that X M X F1 ˆ ˆ we can express the change in output level in terms of X M , X A and ˆ X F2. As a reduction in XF2 implies an increase in effective labour endowment we can argue that this increase in effective labour endowment is actually meant for sectors M, A. Thus, by applying Rybczynski theorem we can say output of sector M will increase and output of sector A will fall. Combining the two Rybczynski effects we thus finally ˆ ˆ ˆ ˆ ˆ ˆ ˆ ˆ conclude that ( X M / K F ) >0, ( X F2/ K F ) >0, ( X A / K F ) <0 and ( X F1/ K F ) >0. If inflow of foreign capital with full repatriation of foreign capital income takes place welfare of the economy would be affected owing to two possible effects: labour reallocation effect and distortionary effect due to tariff protection. From equation (20) it follows that d/dKF = (dXM/dKF)[( w - w).aLM - t.PM] [see appendix 2] (28) As a result of foreign capital inflow we find that the output of the domestic import- competing manufacturing sector increases. An expansion of this sector has two opposite effects on national income. On one hand an expansion of the import-competing sector ‘M’ implies an increase in employment14 aLM.XM. Thus aLM(dXM/dKF) implies increase in employment in sector ‘M’ due to an increase in KF. The workers of sector ‘M’ enjoy a wage rate w , which is higher than the wage rate w, in rest of the economy. As the increase in employment in sector ‘M’ is at the cost of reduction in employment15 in 14 aLM remains unchanged as a result of increase in KF due to decomposability property. 15 ˆ ˆ It is to be noted that as X M X F1, an increase in employment in sector ‘M’ implies an increase in employment in sector F1. sectors A and F2, the labour reallocation effect due to a change in output (and hence change in employment ) measured in terms of wage differential ( w - w) is given by( w - w)aLM. In other words ( w - w).aLM..(dXM/dKF) measures the increase in national income due to ‘labour reallocation effect’. We can thus interpret ( w - w).aLM as the marginal impact of gain in national income due to ‘labour reallocation effect’ for one unit increase in output of sector ‘M’ due to unit increase in foreign capital. So far we have considered the favorable effect of an increase in output of sector ‘M’ on national income. However, it is to be noted that sector ‘M’ is the import-competing sector and it is protected by a tariff. Hence, its expansion raises the distortionary cost of protection given by t.PMdXM/dKF. Here t.PM is the distortionary cost of protection when output of sector ‘M’ increases by one unit due to unit increase in foreign capital inflow. We refer to it as the ‘distortionary effect due to protection’. Hence, the net effect of increase in output of sector ‘M’ depends on the relative strength of the two effects: the “labour reallocation effect” and “distortionary effect due to protection”. ˆ ˆ Thus ( X M / K F ) >0 implies (dXM/dKF) >0 which again implies from equation (27) that d/dKF >0 if and only if ( w - w)aLM > t.PM. It is to be noted that in the presence of full tariff liberalization (a situation of free trade) we have t=0 and (d/dKF) is unambiguously positive. We have already mentioned earlier that in case of small open economy national income can be considered as a proxy for welfare. Thus we can interpret that an inflow of foreign capital raises welfare iff ( w - w)aLM > t.PM. We summarize our results in the form of the following proposition Proposition 2: Under the assumptions (i) the import-competing manufacturing sector is more(domestic) capital–intensive than the agricultural sector (ii) the non-traded intermediate goods producing sector of the foreign enclave is more (foreign) capital intensive than the final goods producing sector of the foreign enclave, an inflow of foreign capital raises the level of welfare of a small open economy if and only if the “labour reallocation effect” dominates over the “distortionary cost of tariff protection” as a result of this inflow. 4. Concluding Remarks: In this paper we have shown that given full repatriation of foreign capital income, the effect of foreign capital inflow is welfare improving under some reasonable conditions in the presence of an intermediate goods sector irrespective of whether it is traded or non- traded. Marjit and Beladi (1997), Marjit, Broll and Mitra (1997) have challenged the immiserizing effects of inflow of foreign capital by considering sector specific foreign capital for the tariff-ridden intermediate goods-sector. By ruling out this assumption of sector specificity of foreign capital to the tariff ridden intermediate goods sector, under certain reasonable conditions Gupta (1998) has shown that the immiserising effects of foreign capital inflow is still valid. In the first part of our paper we have introduced the technical efficiency function in a general equilibrium model proposed by Gupta (1998) and have shown that the welfare improving effects of foreign capital inflow are still valid in an economy with tariff ridden intermediate goods sector. In the second part of our paper we have introduced a four sector general equilibrium model with foreign enclave which comprises non-traded intermediate goods sector and a final goods sector and have shown that the welfare improving effects of foreign capital inflow are still valid in an economy with intermediate goods sector. Our results may influence the policy makers who are interested to drive the economy towards full liberalization to get favourable impact on national welfare. Our results are specially significant for developing economies which are interested to invite foreign direct investment for the intermediate goods sector like infrastructure. This paper would have been more interesting if it has been assumed that the supply of foreign capital to our small economy is a positive function of the net rate of return of capital. In this case we can examine the impact of the change in tax rate on foreign capital income on welfare. We shall take up this issue in our future research agenda. Appendix 1 ˆ ˆ ˆ ˆ 1.1. Derivation of the expressions for ( X I / K F ), and ( X A / K F ) . Totally differentiating equation (5) and (6) we get the following two expressions. aKIXI +aKAXA=KD (5) aLIXI + aLAXA+ aLMXM = Lh(KF) (6) Now differentiating (5) & (6) we get (aKMXI/KD)(dXI/XI) + (aKMXA/KD)(dXA/XA)=0 {aLMXI/Lh(KF)} (dXI/XI) + {aLXXA/Lh(KF)} (dXA/XA) + {aLYXM/Lh(KF)} (dXM/XM) =(LhdKF/KF)/{Lh(KF)/KF} ˆ ˆ or, KI X I + KA X A = 0 ˆ ˆ ˆ ˆ LI X I + + LA X A + LM X M = (h K F KF)/h(KF) ˆ ˆ KI X I + KA X A = 0 ˆ ˆ ˆ ˆ LI X I + LA X A = (h K F KF)/h(KF) - LM X M ˆ ˆ ˆ ˆ KI X I / K F + KA X A / K F = 0 ˆ ˆ ˆ ˆ ˆ ˆ LI X I / K F + LA X A / K F = (hKF)/h(KF) - LM X M / K F ˆ ˆ From equation (4) of the text we get X M / K F = (KF /XMaKM) ˆ ˆ ˆ ˆ KI X I / K F + KA X A / K F = 0 ˆ ˆ ˆ ˆ LI X I / K F + LA X A / K F = (hKF)/h(KF) – (LM KF)/( XMaKM) By using Cramer’s rule we get ˆ ˆ X I / K F = -[KA{(hKF/h) - LM}]/ ˆ ˆ X A / K F = [KI{(hKF/h) - LM}]/ Here = KILA-KALI ˆ ˆ 1.2. Derivation of the expressions for ( X I */ K F ) Now we can consider equation (7) aIAXA + aIMY = XI + XI* (XAaIA/KF)(dXA/dKF) (KF/XA)+ (XMaIM/KF)(dXM/dKF) (KF/XM) = (XI/KF)(dXI/dKF)(KF /XI) + (XI*/ KF)(dXI*/dKF)( KF /XI*) ˆ ˆ ˆ ˆ ˆ ˆ ˆ ˆ IA X A / K F + IM X M / K F = X I / K F + (XI*/XI)( X I */ K F ) ˆ ˆ ˆ ˆ ˆ ˆ ˆ ˆ X I */ K F = (XI/XI*)[(IA X A / K F ) + (IM X M / K F ) – ( X I / K F )] ˆ ˆ It implies X I */ K F = (XI/XI*)[(IAKI/ ){(hKF/h) - LM} + IM(KF/XMaKM) + (KA/){(hKF/h) - LM}] ˆ ˆ X I */ K F = (XI/XI*)[{(hKF/h) – LM}{(IAKI + KA)/ } + {IM(KF /XMaKM)}] ˆ ˆ So X I */ K F > 0 If {(hKF/h) > LM} Appendix 2 ˆ ˆ ˆ ˆ ˆ ˆ 2.1. Derivation of the expressions for ( X M / K F ), ( X F2/ K F ) and ( X A / K F ) . Totally differentiating equation (17), (18), and (19), using equation (21) we get the following three expressions. ˆ ˆ KM X M + KA X A = 0 (22) ˆ ˆ ˆ KF1 X M + KF2 X F2= K F (23) ˆ ˆ ˆ (LM + LF1) X M + LA X A + LF2 X F2= 0 (24) ˆ ˆ From equation (22) we can write X A = - (KM/KA) X M (22)´ Putting the value of (22)´ and rearranging the above equation (24) we can get ˆ ˆ [(LMKA + LF1KA - LAKM) /KA] X M + LF2 X F2 = 0 ˆ ˆ (LF1KA - |λ|)/KA] X M + LF2 X F2 =0 (24)´ where |λ| = LAKM - LMKA>0 as manufacturing sector is more capital intensive compared to agricultural sector. Solving equation (23) and (24)´ by crammer’s rule we can get ˆ ˆ ( X M / K F ) = LF2/[(KF1LF2) – (KF2/KA)(LF1KA - |λ|)] = LF2/[(KF1LF2 – KF2(LF1 - |λ|/KA)] = LF2/[(LF1LF2 {(KF1/LF1) – (KF2/LF2)}+ |λ|(KF2/KA)] ˆ ˆ Under the assumption (KF1/LF1) > (KF2/LF2) and |λ| >0 we find that ( X M / K F ) >0. ˆ ˆ ( X F2/ K F ) = -[(LF1KA - |λ|)/KA]/[(KF1LF2) – (KF2/KA)(LF1KA - |λ|)] = {|λ| -(LF1KA)}/[KA{(KF1LF2) – (KF2LF1)} + KF2|λ|] ={(LAKM - LMKA)-(LF1KA)}/[KALF1LF2{(KF1/LF1)–(KF2/LF2)+KF2|λ|] Under the assumption (KF1/LF1) > (KF2/LF2)}, |λ| >0 and KM / (LM+LF1) > (KA/LA) we ˆ ˆ find that ( X F2/ K F ) >0. ˆ ˆ ( X A / K F ) = -LF2KM / KA[(LF1LF2 {(KF1/LF1) – (KF2/LF2)}+ |λ|(KF2/KA)] ˆ ˆ Under the assumption (KF1/LF1) > (KF2/LF2) and |λ| >0 we find that ( X A / K F ) <0. 2.2. Derivation of the expressions for (d/dKF) = w.L + ( w - w).aLM.XM + r.KD – t.XM.PM d/dKF = ( w - w).aLM.dXM/dKF - t.PMdXM/dKF = (dXM/dKF)[( w - w).aLM - t.PM] REFFERENCES: Beladi, H. and Marjit, S. 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