Capital Mobility
May Damage your Economy

It is well known that in a competitive small open economy, tariff protection lowers domestic welfare. It is also generally accepted that such an economy will gain by allowing international mobility of capital and labour. Taken together, these two results might suggest that an economy in which capital is internationally mobile would stand to welfare loss from protection than one which prohibits the free movement of capital.

In Discussion Paper No. 58, Programme Director Peter Neary and Frances Ruane demonstrate that precisely the opposite is true under very general conditions. They find that except in the case where the economy is driven to specialise in production or in trade, international capital mobility must raise the cost of protection in a competitive, small open economy. They demonstrate this surprising result in a very general model. No restrictions are placed on the number of goods and factors, the degree of vertical integration in production, the factor intensities of the import-competing sectors, or on whether capital is mobile into import-competing or exporting sectors.

Neary and Ruane's result has a straightforward explanation. In the absence of capital mobility, protection reduces welfare for two reasons. First, there is a 'consumption loss', as consumers are obliged to pay more for imports. Second, there is also a 'production loss', as protection induces domestic industry to concentrate on the 'wrong' outputs. This reallocation of resources away from export industries is profitable from a private point of view, but it lowers national welfare since home production of import substitutes is more costly to the economy as a whole than direct importation.

How are these traditional costs of protection affected if capital is internationally mobile? Clearly, the consumption loss is the same in both cases: for a given tariff level, the extra costs incurred by consumers are unaffected by the supply behaviour of the economy. However, the production loss is different when capital is mobile. The ability of capital to move internationally raises the 'flexibility' or the supply responsiveness of the economy. In the absence of distortions this serves to raise welfare, but following the imposition of a tariff it leads the economy to specialise to a greater extent in the 'wrong' direction. It is this enhanced supply response which leads to the surprising general result. The argument does not hinge on whether capital is mobile into and out of the exporting or import-competing sectors. If capital used in the import- competing sectors is internationally mobile, protection encourages it it to move in, whereas if capital used in the exporting sectors is internationally mobile, protection encourages it to move out. In both cases, the net outcome is that a greater proportion of resources used domestically is devoted to the production of import substitutes.


International Capital Mobility, Shadow Prices and the Cost of Protection
J Peter Neary and Frances P Ruane

Discussion Paper No. 58, March 1985 (IT)