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Export processing zones and backward linkages
Journal
of Development
Economics
43 (1994) 369-385.
Export processing linkages Musleh-ud
North-Holland
zones and backward
Din*
The Johns Hopkins University, Baltimore, MD, USA Received July 1992, final version
received
March
1993
This paper develops a model for a small developing economy which establishes Export Processing Zones (EPZs). The model explicitly incorporates an intermediate goods-producing sector in the analysis to evaluate the contribution of foreign capital inflow in the EPZs in engendering backward linkages in the host economy. It is shown that if the intermediate good is internationally traded, then an increase in foreign capital inflow in the EPZs has no effect on national income of the host country. However, if the intermediate good is non-traded, then there exist possibilities for improvement in national income of the host country as a result of increased foreign investment in the EPZs. Key words: Export
processing
zones; Backward
linkages;
Non-traded
goods
JEL classijcation: F20
1. Introduction Export processing zones or duty free zones1 are areas where domestic and foreign firms locate their production facilities for manufacture, assembly or processing of goods. Recently, several LDCs have adopted policies designed to attract foreign investment in these zones in order to diversify their production structure and promote non-traditional exports. For a developing economy, formation of EPZs seems to be an attractive option for several reasons. Firstly, it is well known that most LDCs are characterized by the presence of a large labor intensive sector, mainly agriculture, and possibilities for industrial expansion are limited by scarcity of capital. In this scenario, foreign capital paves the way for industrialization and the country can expand its industrial base through EPZs. Secondly, EPZs can stimulate Correspondence to: Dr. M.-u. Din, Department of Economics, The Johns Hopkins University, Baltimore, MD 21218, USA. *I am indebted to Professors M. Ali Khan and Bruce W. Hamilton for encouragement and advice. I also wish to thank two anonymous referees for their thoughtful and constructive comments. Any errors or omissions are solely my responsibility. ‘The terms export processing zone and duty free zone are used synonymously in the literature. 0304-3878/94/$07.00 0 1994 Elsevier Science B.V. All rights reserved SSDI 0304-3878(93)EOO52-Y
370
M.-u. Din, Export processing zones and backward linkages
the domestic sectors through linkages with the rest of the economy. These linkages are established through the local purchases of domestically produced intermediate goods and are vital for the domestic primary-producing activities. Thirdly. EPZs can alleviate the problem of unemployment in the host country by expanding employment opportunities. Finally, EPZs lead to the introduction of advanced technology in the host country. Export processing zones in LDCs are also attractive to foreign investors since they can lower their production costs by undertaking production and component assembly activity in low wage developing economies. There are a few theoretical studies which have carried out systematic investigation of the role of EPZs in developing economies. In a pioneering study, Hamada (1974) conducted an economic analysis of duty free zones using a 2 x 2 Heckscher-Ohlin model. The study concluded that foreign producers would locate in the zone only if they accept a lower return than domestic capital, and that an exogenous movement of foreign capital into the zone would lower the host country’s welfare.’ Hamilton and Svensson (1982) extended Hamada’s model to study welfare effects of capital inflow either into the zone or into the rest of the economy in the host country. The study showed that both types of capital inflow will lower host country’s welfare. Miyagiwa (1986) analysed the question of direct subsidies to the EPZ using a 3 x 3 model and derived conditions under which establishment of an EPZ can increase welfare of the host country. Specifically, it was shown that the welfare of the host country will increase if the ratio of the subsidy for the EPZ to the subsidy for the domestic import-competing sector via tariff protection is smaller than the ratio of the impact of the export subsidy on the output of the import-competing good to its impact on the output of the EPZ. Young (1987) introduced imported intermediate inputs in the standard 2 x 2 model and considered the effects of reducing tariff on the use of imported intermediate inputs in the EPZ. The study showed that a reduction in tariff on intermediate inputs would attract resources from the domestic zone which can lead to a deterioration in the host country’s welfare. Young and Miyagiwa (1987) considered the welfare effects of the formation of EPZs in a setting which allows for the existence of urban unemployment a la Harris-Todaro [see Khan (1987) and the references therein]. They showed that the national income of the host country will increase as a result of a reduction of duty on imported intermediate inputs in the EPZ. Young (1992) also focused on a country suffering from urban unemployment and derived conditions for optimal wage and taxation policies pertaining to EPZs. ‘In a comment on Hamada’s model, Rodriguez (1976) considered the possibility of capital mobility between the duty free zone and the rest of the economy and showed that the economy will attain the same level of welfare as can be achieved under an overall free trade regime.
M.-u. Din, Export processing zones and backward linkages
371
One of the major objectives for forming EPZs in several LDCs is to spur domestic primary producing-activities through backward linkages created by the processing activities of EPZs. 3 The present paper examines the effect of EPZs on sectoral output levels, factor rewards and national income of the host country within the framework of a three-sector general equilibrium model which incorporates an intermediate goods-producing sector. Section 2 presents the model. Sections 3 and 4 respectively consider positive and normative aspects of changes in foreign capital inflow in the EPZs when the intermediate good is internationally traded and when it is a non-traded good. Section 5 offers some concluding remarks.
2. The model Consider a small developing economy which faces exogenous prices of final goods and has fixed amounts of labor and capital. There are two zones in the economy: the domestic zone and the EPZ. The domestic zone also produces a third produces two goods, X, and X,. The country commodity, X3. We shall assume that X3 is exclusively produced in the EPZ which is established by an inflow of foreign capital. To study the implications of backward linkages created by the EPZs, we explicitly introduce an intermediate good in our model. We assume that X, is a pure intermediate good which is used in the production of X, and X,. Production of X, requires labor and domestic capital while labor, domestic capital and intermediate good are used in the production of X,. Sector 3 utilizes labor and intermediate good as well as foreign capital, which is assumed to be exogenously given and sector specific. Domestic capital is mobile between the two sectors of the domestic zone while labor is mobile among all three sectors of the economy. To sharpen focus, we assume that the amount of intermediate good required to produce a unit of final output is fixed in each final goodsproducing sector.4 It is assumed that production functions are linearly homogeneous and exhibit diminishing returns to changes in factor proportions. Furthermore, it is assumed that all the three commodities are produced at a positive output price vector and that perfect competition prevails in the economy. Since all the markets are assumed to be perfectly competitive and there are constant returns to scale, the zero profit condition in each sector implies that 3There are several empirical and descriptive studies which have pointed out that formation of EPZs is one of the several policy measures designed to establish production facilities which rely heavily on domestically produced intermediate goods. See, for instance, Spinanger (1984) Balasubramanyam (1988) and Warr (1989). “This assumption is commonly made in studies which deal with intermediate goods in a general equilibrium setting. See, for instance, Batra and Casas (1973) and Jones and Spencer (1989).
M.-u. Din, Export processing zones and backward linkages
372
unit cost is equal expressed as:
to the
price
of the
output.
These
conditions
can
be
(1)
where return amount The capital
P2 =%2w+~K2~+CX,Pl,
(2)
P3=%3W+%3~3+CC3Pl,
(3)
pi (i= 1,2,3) is the price of the ith sector’s output, w is wage, r is to domestic capital, r3 is return to foreign capital and uij indicates the of ith input required per unit of jth output. full employment conditions for labor, domestic capital and foreign are:
%,X1
+%2X,
%1X,
+%,X,=x,
(5)
~3x3
=
(6)
+%.3x,
(4)
=T,
K,,
where 9 and % respectively denote endowments of labor and domestic capital and K, is foreign capital in the EPZ. Aggregate demand for the intermediate good, X,, can be written as X,=u,,X, Finally,
national
(7)
+43x3.
income,
y, is given by
y=wLz++z.
(8)
This completes the specification of our model.5 We conclude this section by noting that our analysis below crucially hinges on the relative factor intensities of the three sectors. Since a comparison of factor intensities involves three sectors as well as asymmetry in the number of factors employed across sectors, it is instructive to proceed by clearly defining the factor intensities to avoid any ambiguity. Definition
1. Sector 2 if and only if
1 is said to be labor
(capital)
intensive
relative
to sector
5Notice that if the intermediate good is internationally traded, then we have eight equations determining eight endogenous variables which comprise three factor rewards, three sectoral outputs, demand for the intermediate good and national income. However, if the intermediate good is non-traded, then the price of the intermediate good also becomes endogenous which can be determined by supplementing the above equations by an equilibrium condition for the intermediate good which ensures equality of supply and demand for the intermediate good. Hence, our model is completely determined in both cases.
M.-u. Din, Export processing zones and backward linkages
373
where Li and Ki respectively denote employment of labor and capital in the ith sector, oij is value share of ith factor in jth sector and Aij is proportion of ith factor employed in the jth sector. We now turn to analyse the issue of backward linkages created by the establishment of processing activities of EPZs in the host economy. In what follows, we will focus only on the changes in foreign capital inflow which accompany the emergence of EPZ in the economy. We will consider the cases when the intermediate good is internationally traded at exogenously given price and when it is a non-traded good whose price is endogenously determined by the domestic supply and demand conditions. These cases have diverse implications for domestic resource allocation, income distribution and national income of the host country. A detailed solution of the model is presented in the appendix. 3. Internationally traded intermediate good If the intermediate good is internationally traded along with the final goods, then the economy takes their world market prices as given due to the small country assumption. Therefore, an analysis of changes in foreign capital inflow is fairly simple. We begin by recording the following result.6 Proposition I. If the intermediate good is internationally traded, then an increase in foreign capital inflow in the EPZ leaves national income of the host country unchanged. Furthermore, an increase in foreign capital inflow will lead to an increase (decrease) in the output of intermediate good zf and only if the intermediate good is capital (labor) intensive relative to good 2. The intuition is simple. From eqs. (1)<3), we note that our model is decomposable in that domestic factor endowments and foreign capital play no role in the determination of factor prices. Since national income equals payments to domestic factors of production, changes in foreign capital inflow do not affect national income of the host country. On the other hand, at constant output prices, an increase in foreign capital inflow will attract labor from the domestic sectors of the economy. This reduction in the availability of labor in the domestic sectors will reduce the output of the labor-intensive sector and raise that of the capital-intensive sector through the Rybczynski 6Notice that the assumption of lixity of input coefficients for the intermediate good is not really required for the results reported in this section since techniques of production are fixed anyway by exogenously given output prices and price of intermediate good.
374
M.-u. Din, Export processing zones and backward linkages
effect. It is worth emphasizing here that these changes in the output of the intermediate goods-producing sector stem only from the resource movement effect induced by foreign capital inflow in the EPZs. In other words, domestic demand conditions in the market for intermediate goods play no role in providing the stimulus to the intermediate goods-producing sector. This is because at exogenously fixed price, any gap between the supply of and the demand for the intermediate good is fully absorbed by changes in its volume of trade. Therefore, there is no room for demand-induced expansion in the intermediate goods-producing sector in this scenario. 4. Non-traded intermediate good We now analyse the case when the intermediate good is non-traded. We will distinguish two cases depending upon relative factor intensity of the intermediate goods-producing sector. Below we investigate the effects of foreign capital inflow on the host country’s primary-producing activities, income distribution and national income. 4.1. Income distribution
effects
In this section we examine the role of foreign capital inflow in the determination of factor prices. First consider the case when the intermediate good is labor-intensive relative to good 2. The following result summarizes the effects of foreign capital inflow on domestic factor rewards. Proposition 2. Suppose sectors 2 and 3 use a non-traded intermediate good which is labor-intensive relative to good 2. Then an increase in foreign capital inflow in the EPZ will raise wages and lower returns to both domestic and foreign capital in the host country. The economic interpretation of the above result is as follows. Since the intermediate good is non-traded, p1 is endogenous in our model. An increase in foreign capital inflow into the EPZ raises demand for the intermediate good which in turn raises its price. This price increase attracts both labor and domestic capital to the intermediate goods-producing sector. Now the increased demand for labor not only comes from the intermediate goodsproducing sector but also from the export processing zone. Since the endowment of labor is tixed, labor must be released from the capitalintensive sector (X,) which is unable to release enough labor to match the increase in the demand for labor. Consequently, excess demand for labor emerges and, therefore, wages must rise to satisfy the full employment condition for labor. On the other hand, more domestic capital is released from sector 2 than can be absorbed in the labor-intensive intermediate goods-producing sector. This creates an excess supply of domestic capital
M.-u. Din, Export processing zones and backward linkages
375
which culminates in lower return to domestic capital. Furthermore, as both the wage rate and the price of intermediate good have risen. at constant output price of sector 3, return to foreign capital must fall to maintain positive production of good 3. Now we turn to analyse the case when the intermediate good is capitalintensive. Our objective here is to see how Proposition 2 gets modified in this case. But unlike the case of labor-intensive intermediate good, we can not proceed further without making an additional assumption about relative factor intensities of other sectors of the economy. Particularly, we need Assumption 1. Sector 3 uses a higher sector 2. More formally,
labor
to intermediate
good ratio than
We can now state Proposition 3. If the intermediate good is capital-intensive then Proposition 2 continues to hold under Assumption I.
relative to good 2,
Notice first of all that, at constant output prices and for a given price of intermediate good, an increase in foreign capital inflow attracts labor from the domestic zone which dampens production of the labor-intensive sector (X,) and raises that of the capital-intensive intermediate goods-producing sector (X,). Furthermore, the foreign capital inflow also leads to an increase in the demand for intermediate good by the EPZ. However, since production of X, has decreased, industry 2 is forced to reduce its demand for the intermediate good. To determine the net impact on aggregate demand for the intermediate good we note that, by Assumption 1, sector 2 is relatively intensive in the use of the intermediate good and hence a decline in its output releases more intermediate good than can be absorbed by the EPZ. Therefore, aggregate demand for the intermediate good is depressed. Expansion in the output of the intermediate goods-producing sector coupled with a fall in the demand for its output creates an excess supply of the intermediate good which exerts a downward pressure on its price. The decline in the price of capital-intensive intermediate good prompts a withdrawal of both labor and domestic capital from this sector. At constant factor prices, more domestic capital and less labor is released than can be absorbed in other sectors of the economy. Consequently, wages must rise and the return to domestic capital must fall to satisfy the full employment conditions for labor and domestic capital. As for return to foreign capital, notice that the configuration of higher wages and lower price of the
376
M.-u. Din, Export processing
zones and backward
linkages
intermediate good makes changes in return to foreign capital ambiguous. However, Assumption 1 is sufficient to determine that return to foreign capital falls to support a positive production level of good 3.
4.2. Foreign
capital and primary
production
In this section we consider the effects of changes in foreign capital inflow in the EPZs on the output of domestic primary-producing activities. We begin by considering the case when the intermediate good is labor-intensive. Recall that in the present setting, foreign capital affects factor rewards through endogenous adjustment of the price of the intermediate good. Therefore, foreign capital will influence the output of intermediate good in two ways. First, at constant output prices and for a given price of the intermediate good, an exogenous increase in foreign capital inflow in the EPZ attracts labor from the domestic sectors. This reduction in the availability of labor in the domestic zone depresses the output of the laborintensive intermediate goods-producing sector via the Rybcyznski effect. Second, since the price of X, increases as a result of capital inflow, output of X, increases through this price effect. Therefore, the net impact of a change in foreign capital depends on the relative magnitudes of the resource movement effect and the price effect. We can, however, identify a necessary and sufficient condition under which the output of intermediate good will increase as a result of higher investment in export processing zone. Consider the following result. Proposition increase
4. An increase in foreign capital inflow in the EPZ will lead to an in the production of labor-intensive intermediate good if and only if
where E, is the elasticity of supply of the intermediate good, Ed is the absolute value of aggregate elasticity of demand for the intermediate good, and Atj is the allocative share of ith input in jth sector.
The above proposition brings out a necessary and sufficient condition for the output of intermediate good to increase as a result of investment in EPZs’ processing activities. It is evident that the higher the own price elasticity of supply, the greater the likelihood that domestic primary production will be stimulated as a result of formation of EPZs. Similarly, a lower price elasticity of demand contributes towards offsetting the contractionary resource movement effect by amplifying the positive price effect. In fact, Proposition 4 provides precisely the condition under which the positive price
M.-u. Din, Export processing zones and backward linkages
377
effect outweighs the contractionary resource movement effect, thereby raising the output of the intermediate good. It is important to see how the above result is modified when the intermediate good is capital-intensive. First observe that, contrary to the case of labor-intensive intermediate good, the resource movement effect will be expansionary in this case. This is because, at constant output prices and a given price of intermediate good, an increase in foreign capital inflow withdraws labor from the domestic zone which leads to an increase in the output of the capital-intensive intermediate goods-producing sector through the Rybczynski effect. To pin down the other effect of foreign capital inflow which originates from the endogenous adjustment of the price of intermediate good, we have to invoke Assumption 1. As shown in the previous section, in the case of capital-intensive intermediate good, this assumption is sufficient to establish that an increase in foreign capital inflow leads to a decline in the price of intermediate good which depresses the output of the and intermediate goods-producing sector. So in this case, the necessary sufficient condition for the output of intermediate good to increase is modified as follows. Proposition 5. Suppose the intermediate good is capital-intensive relative to good 2 and Assumption I holds. Then an increase in foreign capital inflow in the EPZ will lead to an increase in the output of intermediate good if and only if
The above result indicates that an increase in foreign capital inflow in the EPZs will lead to an increase in the output of capital-intensive intermediate good if and only if the expansionary resource movement effect dominates the negative price effect. A lower elasticity of supply and a higher elasticity of demand for the intermediate good enhances this possibility by mitigating the negative price effect. Propositions 4 and 5 provide some insight into the effects of foreign capital inflow in the EPZs on host country’s primary-producing activities which are non-traded. Specifically, these results put into question the widely held notion that expansion in export processing zones will automatically stimulate the domestic intermediate goods-producing sector through increased demand for the intermediate good. It is evident that the effect of foreign capital inflow in the EPZs on the domestic primary goods-producing sector is far from definitive and this is true regardless of the relative factor intensity of the intermediate goods-producing sector. The ambiguous effect of a foreign capital inflow arises due to the fact that while an expansion in the
378
M.-u. Din, Export processing zones and backward linkages
EPZs may generate additional demand for the intermediate good, it also withdraws productive factors from the domestic zone which may lead to a contraction in the output of the intermediate goods-producing sector.7 The above results highlight the fact that there are several factors which ought to be taken into account if the objective of formation of EPZs is to stimulate the domestic economy through backward linkages. The price elasticities of supply and demand for the intermediate good as well as the allocative shares of productive factors in the three sectors become instrumental in determining both direction and magnitude of change in the domestic intermediate goodsproducing sector. 4.3. Foreign capital and national income The following result summarizes the effect of foreign EPZs on national income of the host country.
capital
inflow
in the
Proposition 6. If the intermediate good is non-traded, then an increase in foreign capital inflow will unambiguously raise national income, provided that the intermediate good is relatively labor-intensive. However, if the intermediate good is capital-intensive, then Assumption 1 is sufficient to guarantee an improvement in national income. The above result can be explained as follows. Recall that if the intermediate good is non-traded, the factor rewards are not independent of factor supplies. In the case of labor-intensive intermediate good, we have shown that an increase in foreign capital inflow exerts an upward pressure on the price of intermediate good which in turn raises wages and lowers returns to domestic capital. Furthermore, increased demand for labor by the EPZ also puts an upward pressure on wages. Consequently, labor gains more than what capital loses so national income rises. On the other hand, if the intermediate good is capital-intensive, we have shown that an increase in foreign capital inflow will lead to a decline in the price of intermediate good provided Assumption 1 holds. This decline in the price of capital-intensive intermediate good again raises wages and lowers returns to domestic capital. But labor’s gain more than compensates for the decline in capital’s income which leads to an improvement in overall national income. The above result clearly shows the possibility of an improvement in national income of the host country as a result of formation of EPZs by taking into account backward linkages through the use of domestically produced intermediate goods by the EPZ. This is in contrast to earlier studies which show that the movement of foreign capital in the EPZ will harm the host country. ‘1 am thankful
to an anonymous
referee for emphasizing
this point
M.-u. Din, Export processing zones and backward linkages
379
5. Concluding remarks This paper has undertaken an economic analysis of the role of foreign capital inflow in the EPZ in engendering backward linkages in the host country. We have laid out a simple three-sector model of a small developing economy which allows us to study both positive and normative aspects of foreign capital inflow in the EPZ in a broader perspective which takes into account interdependence between the EPZ and the domestic zone in the form of local purchases of domestically produced intermediate goods by the EPZs. We have shown that if the intermediate good is internationally traded, then an increase in foreign capital inflow in the EPZs triggers a resource movement effect which culminates in higher (lower) production of the intermediate good depending upon whether it is capital (labor) intensive. However, results are not as sharp if the intermediate good is non-traded. In this case, we have shown that foreign investment in EPZs’ processing activities may stimulate the domestic production of intermediate good depending upon the relative magnitudes of the price elasticities of supply and demand for the intermediate good. Furthermore, we have shown that if the intermediate good is internationally traded, then foreign capital inflow in the EPZs leaves national income of the host country unchanged. On the other hand, if the intermediate good is non-traded, then national income unambiguously increases provided the intermediate good is labor-intensive. This conclusion remains valid in the case of capital-intensive intermediate good under the additional assumption that sector 3 uses a higher labor to intermediate input ratio than sector 2. It is appropriate to conclude this paper by highlighting some of the limitations of our analysis. Firstly, our analysis is based on the assumption that technical coefficients for the intermediate good are fixed in both the final goods-producing sectors. A more interesting, and analytically challenging, case emerges when these coefficients are allowed to be variable. Generalization of the results to the case of variable coefficients constitutes an important area for future research. Secondly, we have focused our analysis on the case of a pure intermediate good. This assumption does not really matter in the case of an internationally traded intermediate good but becomes critical when it is non-traded. It is worthwhile to investigate how our analysis gets modified when the non-traded good is also available for domestic consumption. We leave this question for future work. 6. Appendix This appendix provides detailed derivations of the results reported in the text. We proceed by solving eqs. (l)-(3) for given pi. Totally differentiating eqs. (1)+3), holding p2 and p3 fixed, we obtain the following system:
M.-u. Din, Export processing
380
[I/;z:]
=[!2;
:,:
;,I
zones and backward
linkages
[;],
where a caret over a variable denotes percentage change, is the value share of the ith input in the jth sector: O,,=-
i.e. i = 8x1~ and Oij
OiUij
Pi ’ where wi is price of the ith factor. The above prices. These solutions can be written as
system can be solved for factor
~=101-‘P,B1>
(A.1)
i= -Iol-l/L,i)l,
(A.2) (A.3)
where )Ol=O K3 (0 Ll 0 K2defined below:
h=°K3(0L2
0 L2 0 Kl ) is determinant
of the system
and CLiare as
(A.51
+0,20Ll)>o~
(A.61
~r3=0,3(0L10K2-0L20K1)+0L3(0K2+0x20K1)~
The cost minimizing conditions along with the assumption that input coefficients for the intermediate good are fixed give the following relationships between changes in input coeffkients for labor and capital and factor prices: tiLi = - OKifJi(iv- i), aKi=otiOi(k-i), ti L3=
(A.7) i= 1,2,
(A.8) (A.9)
-°K3cr3(iv-i3),
(A.lO)
21,, =O,,a,(G-Pi,), where gi is the elasticity and is defined as oi=Tp
We assume
^ aKi
of substitution
between
labor
and capital
^ -aLi
w-i
i
(A. 11)
.
that labor
in sector
and capital
are substitutes
so that gi > 0.
381
M.-u. Din, Export processing zones and backward linkages
Totally
differentiating
the full employment
i,,$
+&2r22+/2L3r2s=9-{<iL1
&&
+&&
rz, =I?,
conditions +&&
=2-{&&
(4)<6), we obtain +%L3&*s},
(A.12) (A. 13)
+&&2},
(A. 14)
-l&j.
Setting $? = 2 = 0, substituting eqs. (A.l)-(A.3) in the expressions for changes in input coeffkients and using the resulting expressions in the above equations we obtain the following system:
[k!J;;~;;jI”]
where 71j are as defined
=[:;:
‘,I
;‘I
[i;],
below:
~L=kv+PL,)(~L1~K1~,
+3,L,B,,az)+(~~+~,3)~L3eK3~3,
(A. 15)
%=(PW+Pu,)(&I&1~.1
+&Z~L2~*)7
(A.16)
71K3
(A. 17)
=(CLw+P(r3)~L3~3~
Solving the above system, the sectoral output levels:
we obtain
the following
expressions
for changes
in
(A.18)
rz, =(-I~I~‘n,,~,,)rZ,+&,a,, r22=(1~1-1~Klj’L3)IZ3-i)l{l~(-1leJ-’(;IK1~L+;1L1~K+~KI~,3n,3)>,
(A.19) z3 =I?,
(A.20)
-lel-‘7CK3i)l,
is determinant of the above system, where )l(=iL,&-&lE.LZ elasticity of supply of the intermediate good which is defined as
and E, is the
(A.21)
~,=~~~~‘l~l~‘(i.,,~~+~,,~,+j.,,~,,n,,).
Next totally differentiating eq. (7) and using the assumption that input coeffkients for the intermediate good are fixed, changes in aggregate demand for the intermediate good can be expressed as &$z,
(A.22)
+ LX3& = rz,.
Substituting eqs. (A.19) and (A.20) in the above equation following solution for aggregate demand for the intermediate
we obtain good:
the
382
M.-u. Din, Export processing
rZd=((p&&& where E,, is the aggregate is given by
linkages
+Ax3)RJ_Ed@l, elasticity
Ed=13’1~tlel-‘{n,,(n
Differentiating we have
zones and backward
equilibrium
of demand
(A.23) for the intermediate
K1711,+~L171K+~K1~L371K3)+)~1~x371K3}.
(A.24)
condition
good,
for the market
for intermediate
(A.25)
rz, =rz,. On substituting
good and
the solutions
for 2,
and 2, we obtain (A.26)
F1= *&, where + is defined
as (A.27)
Proof
of Proposition
1.
The fact that national income remains unchanged follows from decomposability of the model. Setting il =0 in eq. (A.18) and noting that 1~\<( >)0 as intermediate good is relatively capita1 (labor) intensive immediately proves the second assertion. Proof
of Proposition
2
Substitution of eq. (A.26) in eq. (A.lHA.3) tive static results:
~=lOlW,
yields
the following
compara-
(A.28)
(A.29)
(A.30)
Observe that the expressions pL, and pL, are positive regardless of the relative factor intensity of the intermediate good. If the intermediate good is laborintensive, (81>O, [A(> 0 and ,u~~~0. It follows that rci > 0, E, > 0, ed > 0 and
M.-u. Din, Export
hence Ic/>O. Having eqs. (A.2&0.30). Proof of Proposition It is convenient as follows:
determined
processing
zones and backward
these signs,
the result
383
linkages
readily
follows
from
E*
and $
3 to proceed
by rewriting
the expressions
for pr3,
(A.32) (A.33)
Notice that zK > 0 regardless of the relative factor intensity of the intermediate good. If the intermediate good is capital-intensive, (AI~0, lf9(<0 and hence I%l(~l >O. Furthermore, under Assumption 1, pr3 >O and hence nK3 and zL are positive. Also, since 3,,,&-&,/1,, >O by Assumption 1, it follows that E, >O, ed>O and $ ~0. Having pinned down signs of these expressions, the result immediately follows from eqs. (A.28)-(A.30). Proof of Proposition Substituting
4
eq. (A.26) in eq. (A.18) and using eq. (A.27) we have (A.34)
Since 1~1,E, and cd are positive, %> &d
it follows that %,/I?,
>O iff
J”K& ~x2’&1&3
(A.35) +&3/4’
On substituting the expression condition reported in the text. Proof of Proposition It is convenient
for 121,we obtain
5 to rewrite eq. (A.34) as
the necessary
and sufficient
M.-u. Din, Export processing
384
In this case, under Assumption the right-hand side is positive.
Proof of Proposition Totally
zones and backward
linkages
1, E, > 0, E,,>O and the first bracketed term on Since 121~0, it follows that X,/Z?, >0 iff
6
differentiating
eq. (8) we have
(A.38) On substituting we obtain
eqs. (A.28) and (A.29) and using the definitions
=~(BI-18,,{w~(8,,+8,,8,,)-r~(B,,+8,,8,,)}.
of p,,, and pP
b4.39)
Now notice that w5! = xi”= r piXieLi and rs =cf= i piXiQKi. Upon substituting these values in the above expression and a little manipulation yields the following expression for change in national income of the host country:
Notice that if the intermediate good is labor-intensive, then the above expression is unambiguously positive. To determine its sign when the intermediate good is capital-intensive, we can rewrite the above equation as
(A.41)
=lCllel-1r3{eKl(e~3~x2-6)L2ex3)+6)L3~K*+eL1~K1}.
The above expression
is positive
under
Assumption
1.
References Balasubramanyam, V.N., 1988, Export processing zones in developing countries: Theory and empirical evidence, in: D. Greenaway, ed., Economic development and international trade (St. Martin’s Press, New York) 157-165. Batra, R.N. and F.R. Casas, 1973, Intermediate products and the pure theory of international trade: A neo-HeckscherrOhlin framework, American Economic Review 63, 297-311. Hamada, K., 1974, An economic analysis of the duty-free zone, Journal of International Economics 4, 225-241.
M.-u. Din, Export processing
zones and backward
linkages
385
Hamilton, C. and L.O. Svensson, 1982, On the welfare effects of a ‘duty free’ zone, Journal of International Economics 13, 45-64. Jones, R.W. and B.J. Spencer, 1989, Raw materials, processing activities and protectionism, Canadian Journal of Economics 22,469486. Khan, M. Ah, 1987, Harris-Todaro model, in: J. Eatwell, P. Newman and M. Milgate, eds., The new Palgrave (McMillan, New York). Miyagiwa, K., 1986, A reconsideration of the welfare economics of a free-trade zone, Journal of International Economics 21, 337-350. Rodriguez, CA., 1976, A note on the economics of the duty free zone, Journal of International Economics 6, 385-388. Spinanger, D., 1984, Objectives and impact of economic activity zones: Some evidence from Asia, Weltwirtschaftliches Archiv 120, 64-88. Warr, P.G., 1989, Export processing zones, The economics of enclave manufacturing, World Bank Research Observer 4, 65-88. Young, L., 1987, Intermediate goods and formation of duty-free zones, Journal of Development Economics 25, 369-384. Young, L., 1992, Unemployment and the optimal export processing zone, Journal of Development Economics 37, 3699385. Young, L. and K.F. Miyagiwa, 1987, Unemployment and the formation of duty-free zones, Journal of Development Economics 26, 397405.
of Development
Economics
43 (1994) 369-385.
Export processing linkages Musleh-ud
North-Holland
zones and backward
Din*
The Johns Hopkins University, Baltimore, MD, USA Received July 1992, final version
received
March
1993
This paper develops a model for a small developing economy which establishes Export Processing Zones (EPZs). The model explicitly incorporates an intermediate goods-producing sector in the analysis to evaluate the contribution of foreign capital inflow in the EPZs in engendering backward linkages in the host economy. It is shown that if the intermediate good is internationally traded, then an increase in foreign capital inflow in the EPZs has no effect on national income of the host country. However, if the intermediate good is non-traded, then there exist possibilities for improvement in national income of the host country as a result of increased foreign investment in the EPZs. Key words: Export
processing
zones; Backward
linkages;
Non-traded
goods
JEL classijcation: F20
1. Introduction Export processing zones or duty free zones1 are areas where domestic and foreign firms locate their production facilities for manufacture, assembly or processing of goods. Recently, several LDCs have adopted policies designed to attract foreign investment in these zones in order to diversify their production structure and promote non-traditional exports. For a developing economy, formation of EPZs seems to be an attractive option for several reasons. Firstly, it is well known that most LDCs are characterized by the presence of a large labor intensive sector, mainly agriculture, and possibilities for industrial expansion are limited by scarcity of capital. In this scenario, foreign capital paves the way for industrialization and the country can expand its industrial base through EPZs. Secondly, EPZs can stimulate Correspondence to: Dr. M.-u. Din, Department of Economics, The Johns Hopkins University, Baltimore, MD 21218, USA. *I am indebted to Professors M. Ali Khan and Bruce W. Hamilton for encouragement and advice. I also wish to thank two anonymous referees for their thoughtful and constructive comments. Any errors or omissions are solely my responsibility. ‘The terms export processing zone and duty free zone are used synonymously in the literature. 0304-3878/94/$07.00 0 1994 Elsevier Science B.V. All rights reserved SSDI 0304-3878(93)EOO52-Y
370
M.-u. Din, Export processing zones and backward linkages
the domestic sectors through linkages with the rest of the economy. These linkages are established through the local purchases of domestically produced intermediate goods and are vital for the domestic primary-producing activities. Thirdly. EPZs can alleviate the problem of unemployment in the host country by expanding employment opportunities. Finally, EPZs lead to the introduction of advanced technology in the host country. Export processing zones in LDCs are also attractive to foreign investors since they can lower their production costs by undertaking production and component assembly activity in low wage developing economies. There are a few theoretical studies which have carried out systematic investigation of the role of EPZs in developing economies. In a pioneering study, Hamada (1974) conducted an economic analysis of duty free zones using a 2 x 2 Heckscher-Ohlin model. The study concluded that foreign producers would locate in the zone only if they accept a lower return than domestic capital, and that an exogenous movement of foreign capital into the zone would lower the host country’s welfare.’ Hamilton and Svensson (1982) extended Hamada’s model to study welfare effects of capital inflow either into the zone or into the rest of the economy in the host country. The study showed that both types of capital inflow will lower host country’s welfare. Miyagiwa (1986) analysed the question of direct subsidies to the EPZ using a 3 x 3 model and derived conditions under which establishment of an EPZ can increase welfare of the host country. Specifically, it was shown that the welfare of the host country will increase if the ratio of the subsidy for the EPZ to the subsidy for the domestic import-competing sector via tariff protection is smaller than the ratio of the impact of the export subsidy on the output of the import-competing good to its impact on the output of the EPZ. Young (1987) introduced imported intermediate inputs in the standard 2 x 2 model and considered the effects of reducing tariff on the use of imported intermediate inputs in the EPZ. The study showed that a reduction in tariff on intermediate inputs would attract resources from the domestic zone which can lead to a deterioration in the host country’s welfare. Young and Miyagiwa (1987) considered the welfare effects of the formation of EPZs in a setting which allows for the existence of urban unemployment a la Harris-Todaro [see Khan (1987) and the references therein]. They showed that the national income of the host country will increase as a result of a reduction of duty on imported intermediate inputs in the EPZ. Young (1992) also focused on a country suffering from urban unemployment and derived conditions for optimal wage and taxation policies pertaining to EPZs. ‘In a comment on Hamada’s model, Rodriguez (1976) considered the possibility of capital mobility between the duty free zone and the rest of the economy and showed that the economy will attain the same level of welfare as can be achieved under an overall free trade regime.
M.-u. Din, Export processing zones and backward linkages
371
One of the major objectives for forming EPZs in several LDCs is to spur domestic primary producing-activities through backward linkages created by the processing activities of EPZs. 3 The present paper examines the effect of EPZs on sectoral output levels, factor rewards and national income of the host country within the framework of a three-sector general equilibrium model which incorporates an intermediate goods-producing sector. Section 2 presents the model. Sections 3 and 4 respectively consider positive and normative aspects of changes in foreign capital inflow in the EPZs when the intermediate good is internationally traded and when it is a non-traded good. Section 5 offers some concluding remarks.
2. The model Consider a small developing economy which faces exogenous prices of final goods and has fixed amounts of labor and capital. There are two zones in the economy: the domestic zone and the EPZ. The domestic zone also produces a third produces two goods, X, and X,. The country commodity, X3. We shall assume that X3 is exclusively produced in the EPZ which is established by an inflow of foreign capital. To study the implications of backward linkages created by the EPZs, we explicitly introduce an intermediate good in our model. We assume that X, is a pure intermediate good which is used in the production of X, and X,. Production of X, requires labor and domestic capital while labor, domestic capital and intermediate good are used in the production of X,. Sector 3 utilizes labor and intermediate good as well as foreign capital, which is assumed to be exogenously given and sector specific. Domestic capital is mobile between the two sectors of the domestic zone while labor is mobile among all three sectors of the economy. To sharpen focus, we assume that the amount of intermediate good required to produce a unit of final output is fixed in each final goodsproducing sector.4 It is assumed that production functions are linearly homogeneous and exhibit diminishing returns to changes in factor proportions. Furthermore, it is assumed that all the three commodities are produced at a positive output price vector and that perfect competition prevails in the economy. Since all the markets are assumed to be perfectly competitive and there are constant returns to scale, the zero profit condition in each sector implies that 3There are several empirical and descriptive studies which have pointed out that formation of EPZs is one of the several policy measures designed to establish production facilities which rely heavily on domestically produced intermediate goods. See, for instance, Spinanger (1984) Balasubramanyam (1988) and Warr (1989). “This assumption is commonly made in studies which deal with intermediate goods in a general equilibrium setting. See, for instance, Batra and Casas (1973) and Jones and Spencer (1989).
M.-u. Din, Export processing zones and backward linkages
372
unit cost is equal expressed as:
to the
price
of the
output.
These
conditions
can
be
(1)
where return amount The capital
P2 =%2w+~K2~+CX,Pl,
(2)
P3=%3W+%3~3+CC3Pl,
(3)
pi (i= 1,2,3) is the price of the ith sector’s output, w is wage, r is to domestic capital, r3 is return to foreign capital and uij indicates the of ith input required per unit of jth output. full employment conditions for labor, domestic capital and foreign are:
%,X1
+%2X,
%1X,
+%,X,=x,
(5)
~3x3
=
(6)
+%.3x,
(4)
=T,
K,,
where 9 and % respectively denote endowments of labor and domestic capital and K, is foreign capital in the EPZ. Aggregate demand for the intermediate good, X,, can be written as X,=u,,X, Finally,
national
(7)
+43x3.
income,
y, is given by
y=wLz++z.
(8)
This completes the specification of our model.5 We conclude this section by noting that our analysis below crucially hinges on the relative factor intensities of the three sectors. Since a comparison of factor intensities involves three sectors as well as asymmetry in the number of factors employed across sectors, it is instructive to proceed by clearly defining the factor intensities to avoid any ambiguity. Definition
1. Sector 2 if and only if
1 is said to be labor
(capital)
intensive
relative
to sector
5Notice that if the intermediate good is internationally traded, then we have eight equations determining eight endogenous variables which comprise three factor rewards, three sectoral outputs, demand for the intermediate good and national income. However, if the intermediate good is non-traded, then the price of the intermediate good also becomes endogenous which can be determined by supplementing the above equations by an equilibrium condition for the intermediate good which ensures equality of supply and demand for the intermediate good. Hence, our model is completely determined in both cases.
M.-u. Din, Export processing zones and backward linkages
373
where Li and Ki respectively denote employment of labor and capital in the ith sector, oij is value share of ith factor in jth sector and Aij is proportion of ith factor employed in the jth sector. We now turn to analyse the issue of backward linkages created by the establishment of processing activities of EPZs in the host economy. In what follows, we will focus only on the changes in foreign capital inflow which accompany the emergence of EPZ in the economy. We will consider the cases when the intermediate good is internationally traded at exogenously given price and when it is a non-traded good whose price is endogenously determined by the domestic supply and demand conditions. These cases have diverse implications for domestic resource allocation, income distribution and national income of the host country. A detailed solution of the model is presented in the appendix. 3. Internationally traded intermediate good If the intermediate good is internationally traded along with the final goods, then the economy takes their world market prices as given due to the small country assumption. Therefore, an analysis of changes in foreign capital inflow is fairly simple. We begin by recording the following result.6 Proposition I. If the intermediate good is internationally traded, then an increase in foreign capital inflow in the EPZ leaves national income of the host country unchanged. Furthermore, an increase in foreign capital inflow will lead to an increase (decrease) in the output of intermediate good zf and only if the intermediate good is capital (labor) intensive relative to good 2. The intuition is simple. From eqs. (1)<3), we note that our model is decomposable in that domestic factor endowments and foreign capital play no role in the determination of factor prices. Since national income equals payments to domestic factors of production, changes in foreign capital inflow do not affect national income of the host country. On the other hand, at constant output prices, an increase in foreign capital inflow will attract labor from the domestic sectors of the economy. This reduction in the availability of labor in the domestic sectors will reduce the output of the labor-intensive sector and raise that of the capital-intensive sector through the Rybczynski 6Notice that the assumption of lixity of input coefficients for the intermediate good is not really required for the results reported in this section since techniques of production are fixed anyway by exogenously given output prices and price of intermediate good.
374
M.-u. Din, Export processing zones and backward linkages
effect. It is worth emphasizing here that these changes in the output of the intermediate goods-producing sector stem only from the resource movement effect induced by foreign capital inflow in the EPZs. In other words, domestic demand conditions in the market for intermediate goods play no role in providing the stimulus to the intermediate goods-producing sector. This is because at exogenously fixed price, any gap between the supply of and the demand for the intermediate good is fully absorbed by changes in its volume of trade. Therefore, there is no room for demand-induced expansion in the intermediate goods-producing sector in this scenario. 4. Non-traded intermediate good We now analyse the case when the intermediate good is non-traded. We will distinguish two cases depending upon relative factor intensity of the intermediate goods-producing sector. Below we investigate the effects of foreign capital inflow on the host country’s primary-producing activities, income distribution and national income. 4.1. Income distribution
effects
In this section we examine the role of foreign capital inflow in the determination of factor prices. First consider the case when the intermediate good is labor-intensive relative to good 2. The following result summarizes the effects of foreign capital inflow on domestic factor rewards. Proposition 2. Suppose sectors 2 and 3 use a non-traded intermediate good which is labor-intensive relative to good 2. Then an increase in foreign capital inflow in the EPZ will raise wages and lower returns to both domestic and foreign capital in the host country. The economic interpretation of the above result is as follows. Since the intermediate good is non-traded, p1 is endogenous in our model. An increase in foreign capital inflow into the EPZ raises demand for the intermediate good which in turn raises its price. This price increase attracts both labor and domestic capital to the intermediate goods-producing sector. Now the increased demand for labor not only comes from the intermediate goodsproducing sector but also from the export processing zone. Since the endowment of labor is tixed, labor must be released from the capitalintensive sector (X,) which is unable to release enough labor to match the increase in the demand for labor. Consequently, excess demand for labor emerges and, therefore, wages must rise to satisfy the full employment condition for labor. On the other hand, more domestic capital is released from sector 2 than can be absorbed in the labor-intensive intermediate goods-producing sector. This creates an excess supply of domestic capital
M.-u. Din, Export processing zones and backward linkages
375
which culminates in lower return to domestic capital. Furthermore, as both the wage rate and the price of intermediate good have risen. at constant output price of sector 3, return to foreign capital must fall to maintain positive production of good 3. Now we turn to analyse the case when the intermediate good is capitalintensive. Our objective here is to see how Proposition 2 gets modified in this case. But unlike the case of labor-intensive intermediate good, we can not proceed further without making an additional assumption about relative factor intensities of other sectors of the economy. Particularly, we need Assumption 1. Sector 3 uses a higher sector 2. More formally,
labor
to intermediate
good ratio than
We can now state Proposition 3. If the intermediate good is capital-intensive then Proposition 2 continues to hold under Assumption I.
relative to good 2,
Notice first of all that, at constant output prices and for a given price of intermediate good, an increase in foreign capital inflow attracts labor from the domestic zone which dampens production of the labor-intensive sector (X,) and raises that of the capital-intensive intermediate goods-producing sector (X,). Furthermore, the foreign capital inflow also leads to an increase in the demand for intermediate good by the EPZ. However, since production of X, has decreased, industry 2 is forced to reduce its demand for the intermediate good. To determine the net impact on aggregate demand for the intermediate good we note that, by Assumption 1, sector 2 is relatively intensive in the use of the intermediate good and hence a decline in its output releases more intermediate good than can be absorbed by the EPZ. Therefore, aggregate demand for the intermediate good is depressed. Expansion in the output of the intermediate goods-producing sector coupled with a fall in the demand for its output creates an excess supply of the intermediate good which exerts a downward pressure on its price. The decline in the price of capital-intensive intermediate good prompts a withdrawal of both labor and domestic capital from this sector. At constant factor prices, more domestic capital and less labor is released than can be absorbed in other sectors of the economy. Consequently, wages must rise and the return to domestic capital must fall to satisfy the full employment conditions for labor and domestic capital. As for return to foreign capital, notice that the configuration of higher wages and lower price of the
376
M.-u. Din, Export processing
zones and backward
linkages
intermediate good makes changes in return to foreign capital ambiguous. However, Assumption 1 is sufficient to determine that return to foreign capital falls to support a positive production level of good 3.
4.2. Foreign
capital and primary
production
In this section we consider the effects of changes in foreign capital inflow in the EPZs on the output of domestic primary-producing activities. We begin by considering the case when the intermediate good is labor-intensive. Recall that in the present setting, foreign capital affects factor rewards through endogenous adjustment of the price of the intermediate good. Therefore, foreign capital will influence the output of intermediate good in two ways. First, at constant output prices and for a given price of the intermediate good, an exogenous increase in foreign capital inflow in the EPZ attracts labor from the domestic sectors. This reduction in the availability of labor in the domestic zone depresses the output of the laborintensive intermediate goods-producing sector via the Rybcyznski effect. Second, since the price of X, increases as a result of capital inflow, output of X, increases through this price effect. Therefore, the net impact of a change in foreign capital depends on the relative magnitudes of the resource movement effect and the price effect. We can, however, identify a necessary and sufficient condition under which the output of intermediate good will increase as a result of higher investment in export processing zone. Consider the following result. Proposition increase
4. An increase in foreign capital inflow in the EPZ will lead to an in the production of labor-intensive intermediate good if and only if
where E, is the elasticity of supply of the intermediate good, Ed is the absolute value of aggregate elasticity of demand for the intermediate good, and Atj is the allocative share of ith input in jth sector.
The above proposition brings out a necessary and sufficient condition for the output of intermediate good to increase as a result of investment in EPZs’ processing activities. It is evident that the higher the own price elasticity of supply, the greater the likelihood that domestic primary production will be stimulated as a result of formation of EPZs. Similarly, a lower price elasticity of demand contributes towards offsetting the contractionary resource movement effect by amplifying the positive price effect. In fact, Proposition 4 provides precisely the condition under which the positive price
M.-u. Din, Export processing zones and backward linkages
377
effect outweighs the contractionary resource movement effect, thereby raising the output of the intermediate good. It is important to see how the above result is modified when the intermediate good is capital-intensive. First observe that, contrary to the case of labor-intensive intermediate good, the resource movement effect will be expansionary in this case. This is because, at constant output prices and a given price of intermediate good, an increase in foreign capital inflow withdraws labor from the domestic zone which leads to an increase in the output of the capital-intensive intermediate goods-producing sector through the Rybczynski effect. To pin down the other effect of foreign capital inflow which originates from the endogenous adjustment of the price of intermediate good, we have to invoke Assumption 1. As shown in the previous section, in the case of capital-intensive intermediate good, this assumption is sufficient to establish that an increase in foreign capital inflow leads to a decline in the price of intermediate good which depresses the output of the and intermediate goods-producing sector. So in this case, the necessary sufficient condition for the output of intermediate good to increase is modified as follows. Proposition 5. Suppose the intermediate good is capital-intensive relative to good 2 and Assumption I holds. Then an increase in foreign capital inflow in the EPZ will lead to an increase in the output of intermediate good if and only if
The above result indicates that an increase in foreign capital inflow in the EPZs will lead to an increase in the output of capital-intensive intermediate good if and only if the expansionary resource movement effect dominates the negative price effect. A lower elasticity of supply and a higher elasticity of demand for the intermediate good enhances this possibility by mitigating the negative price effect. Propositions 4 and 5 provide some insight into the effects of foreign capital inflow in the EPZs on host country’s primary-producing activities which are non-traded. Specifically, these results put into question the widely held notion that expansion in export processing zones will automatically stimulate the domestic intermediate goods-producing sector through increased demand for the intermediate good. It is evident that the effect of foreign capital inflow in the EPZs on the domestic primary goods-producing sector is far from definitive and this is true regardless of the relative factor intensity of the intermediate goods-producing sector. The ambiguous effect of a foreign capital inflow arises due to the fact that while an expansion in the
378
M.-u. Din, Export processing zones and backward linkages
EPZs may generate additional demand for the intermediate good, it also withdraws productive factors from the domestic zone which may lead to a contraction in the output of the intermediate goods-producing sector.7 The above results highlight the fact that there are several factors which ought to be taken into account if the objective of formation of EPZs is to stimulate the domestic economy through backward linkages. The price elasticities of supply and demand for the intermediate good as well as the allocative shares of productive factors in the three sectors become instrumental in determining both direction and magnitude of change in the domestic intermediate goodsproducing sector. 4.3. Foreign capital and national income The following result summarizes the effect of foreign EPZs on national income of the host country.
capital
inflow
in the
Proposition 6. If the intermediate good is non-traded, then an increase in foreign capital inflow will unambiguously raise national income, provided that the intermediate good is relatively labor-intensive. However, if the intermediate good is capital-intensive, then Assumption 1 is sufficient to guarantee an improvement in national income. The above result can be explained as follows. Recall that if the intermediate good is non-traded, the factor rewards are not independent of factor supplies. In the case of labor-intensive intermediate good, we have shown that an increase in foreign capital inflow exerts an upward pressure on the price of intermediate good which in turn raises wages and lowers returns to domestic capital. Furthermore, increased demand for labor by the EPZ also puts an upward pressure on wages. Consequently, labor gains more than what capital loses so national income rises. On the other hand, if the intermediate good is capital-intensive, we have shown that an increase in foreign capital inflow will lead to a decline in the price of intermediate good provided Assumption 1 holds. This decline in the price of capital-intensive intermediate good again raises wages and lowers returns to domestic capital. But labor’s gain more than compensates for the decline in capital’s income which leads to an improvement in overall national income. The above result clearly shows the possibility of an improvement in national income of the host country as a result of formation of EPZs by taking into account backward linkages through the use of domestically produced intermediate goods by the EPZ. This is in contrast to earlier studies which show that the movement of foreign capital in the EPZ will harm the host country. ‘1 am thankful
to an anonymous
referee for emphasizing
this point
M.-u. Din, Export processing zones and backward linkages
379
5. Concluding remarks This paper has undertaken an economic analysis of the role of foreign capital inflow in the EPZ in engendering backward linkages in the host country. We have laid out a simple three-sector model of a small developing economy which allows us to study both positive and normative aspects of foreign capital inflow in the EPZ in a broader perspective which takes into account interdependence between the EPZ and the domestic zone in the form of local purchases of domestically produced intermediate goods by the EPZs. We have shown that if the intermediate good is internationally traded, then an increase in foreign capital inflow in the EPZs triggers a resource movement effect which culminates in higher (lower) production of the intermediate good depending upon whether it is capital (labor) intensive. However, results are not as sharp if the intermediate good is non-traded. In this case, we have shown that foreign investment in EPZs’ processing activities may stimulate the domestic production of intermediate good depending upon the relative magnitudes of the price elasticities of supply and demand for the intermediate good. Furthermore, we have shown that if the intermediate good is internationally traded, then foreign capital inflow in the EPZs leaves national income of the host country unchanged. On the other hand, if the intermediate good is non-traded, then national income unambiguously increases provided the intermediate good is labor-intensive. This conclusion remains valid in the case of capital-intensive intermediate good under the additional assumption that sector 3 uses a higher labor to intermediate input ratio than sector 2. It is appropriate to conclude this paper by highlighting some of the limitations of our analysis. Firstly, our analysis is based on the assumption that technical coefficients for the intermediate good are fixed in both the final goods-producing sectors. A more interesting, and analytically challenging, case emerges when these coefficients are allowed to be variable. Generalization of the results to the case of variable coefficients constitutes an important area for future research. Secondly, we have focused our analysis on the case of a pure intermediate good. This assumption does not really matter in the case of an internationally traded intermediate good but becomes critical when it is non-traded. It is worthwhile to investigate how our analysis gets modified when the non-traded good is also available for domestic consumption. We leave this question for future work. 6. Appendix This appendix provides detailed derivations of the results reported in the text. We proceed by solving eqs. (l)-(3) for given pi. Totally differentiating eqs. (1)+3), holding p2 and p3 fixed, we obtain the following system:
M.-u. Din, Export processing
380
[I/;z:]
=[!2;
:,:
;,I
zones and backward
linkages
[;],
where a caret over a variable denotes percentage change, is the value share of the ith input in the jth sector: O,,=-
i.e. i = 8x1~ and Oij
OiUij
Pi ’ where wi is price of the ith factor. The above prices. These solutions can be written as
system can be solved for factor
~=101-‘P,B1>
(A.1)
i= -Iol-l/L,i)l,
(A.2) (A.3)
where )Ol=O K3 (0 Ll 0 K2defined below:
h=°K3(0L2
0 L2 0 Kl ) is determinant
of the system
and CLiare as
(A.51
+0,20Ll)>o~
(A.61
~r3=0,3(0L10K2-0L20K1)+0L3(0K2+0x20K1)~
The cost minimizing conditions along with the assumption that input coefficients for the intermediate good are fixed give the following relationships between changes in input coeffkients for labor and capital and factor prices: tiLi = - OKifJi(iv- i), aKi=otiOi(k-i), ti L3=
(A.7) i= 1,2,
(A.8) (A.9)
-°K3cr3(iv-i3),
(A.lO)
21,, =O,,a,(G-Pi,), where gi is the elasticity and is defined as oi=Tp
We assume
^ aKi
of substitution
between
labor
and capital
^ -aLi
w-i
i
(A. 11)
.
that labor
in sector
and capital
are substitutes
so that gi > 0.
381
M.-u. Din, Export processing zones and backward linkages
Totally
differentiating
the full employment
i,,$
+&2r22+/2L3r2s=9-{<iL1
&&
+&&
rz, =I?,
conditions +&&
=2-{&&
(4)<6), we obtain +%L3&*s},
(A.12) (A. 13)
+&&2},
(A. 14)
-l&j.
Setting $? = 2 = 0, substituting eqs. (A.l)-(A.3) in the expressions for changes in input coeffkients and using the resulting expressions in the above equations we obtain the following system:
[k!J;;~;;jI”]
where 71j are as defined
=[:;:
‘,I
;‘I
[i;],
below:
~L=kv+PL,)(~L1~K1~,
+3,L,B,,az)+(~~+~,3)~L3eK3~3,
(A. 15)
%=(PW+Pu,)(&I&1~.1
+&Z~L2~*)7
(A.16)
71K3
(A. 17)
=(CLw+P(r3)~L3~3~
Solving the above system, the sectoral output levels:
we obtain
the following
expressions
for changes
in
(A.18)
rz, =(-I~I~‘n,,~,,)rZ,+&,a,, r22=(1~1-1~Klj’L3)IZ3-i)l{l~(-1leJ-’(;IK1~L+;1L1~K+~KI~,3n,3)>,
(A.19) z3 =I?,
(A.20)
-lel-‘7CK3i)l,
is determinant of the above system, where )l(=iL,&-&lE.LZ elasticity of supply of the intermediate good which is defined as
and E, is the
(A.21)
~,=~~~~‘l~l~‘(i.,,~~+~,,~,+j.,,~,,n,,).
Next totally differentiating eq. (7) and using the assumption that input coeffkients for the intermediate good are fixed, changes in aggregate demand for the intermediate good can be expressed as &$z,
(A.22)
+ LX3& = rz,.
Substituting eqs. (A.19) and (A.20) in the above equation following solution for aggregate demand for the intermediate
we obtain good:
the
382
M.-u. Din, Export processing
rZd=((p&&& where E,, is the aggregate is given by
linkages
+Ax3)RJ_Ed@l, elasticity
Ed=13’1~tlel-‘{n,,(n
Differentiating we have
zones and backward
equilibrium
of demand
(A.23) for the intermediate
K1711,+~L171K+~K1~L371K3)+)~1~x371K3}.
(A.24)
condition
good,
for the market
for intermediate
(A.25)
rz, =rz,. On substituting
good and
the solutions
for 2,
and 2, we obtain (A.26)
F1= *&, where + is defined
as (A.27)
Proof
of Proposition
1.
The fact that national income remains unchanged follows from decomposability of the model. Setting il =0 in eq. (A.18) and noting that 1~\<( >)0 as intermediate good is relatively capita1 (labor) intensive immediately proves the second assertion. Proof
of Proposition
2
Substitution of eq. (A.26) in eq. (A.lHA.3) tive static results:
~=lOlW,
yields
the following
compara-
(A.28)
(A.29)
(A.30)
Observe that the expressions pL, and pL, are positive regardless of the relative factor intensity of the intermediate good. If the intermediate good is laborintensive, (81>O, [A(> 0 and ,u~~~0. It follows that rci > 0, E, > 0, ed > 0 and
M.-u. Din, Export
hence Ic/>O. Having eqs. (A.2&0.30). Proof of Proposition It is convenient as follows:
determined
processing
zones and backward
these signs,
the result
383
linkages
readily
follows
from
E*
and $
3 to proceed
by rewriting
the expressions
for pr3,
(A.32) (A.33)
Notice that zK > 0 regardless of the relative factor intensity of the intermediate good. If the intermediate good is capital-intensive, (AI~0, lf9(<0 and hence I%l(~l >O. Furthermore, under Assumption 1, pr3 >O and hence nK3 and zL are positive. Also, since 3,,,&-&,/1,, >O by Assumption 1, it follows that E, >O, ed>O and $ ~0. Having pinned down signs of these expressions, the result immediately follows from eqs. (A.28)-(A.30). Proof of Proposition Substituting
4
eq. (A.26) in eq. (A.18) and using eq. (A.27) we have (A.34)
Since 1~1,E, and cd are positive, %> &d
it follows that %,/I?,
>O iff
J”K& ~x2’&1&3
(A.35) +&3/4’
On substituting the expression condition reported in the text. Proof of Proposition It is convenient
for 121,we obtain
5 to rewrite eq. (A.34) as
the necessary
and sufficient
M.-u. Din, Export processing
384
In this case, under Assumption the right-hand side is positive.
Proof of Proposition Totally
zones and backward
linkages
1, E, > 0, E,,>O and the first bracketed term on Since 121~0, it follows that X,/Z?, >0 iff
6
differentiating
eq. (8) we have
(A.38) On substituting we obtain
eqs. (A.28) and (A.29) and using the definitions
=~(BI-18,,{w~(8,,+8,,8,,)-r~(B,,+8,,8,,)}.
of p,,, and pP
b4.39)
Now notice that w5! = xi”= r piXieLi and rs =cf= i piXiQKi. Upon substituting these values in the above expression and a little manipulation yields the following expression for change in national income of the host country:
Notice that if the intermediate good is labor-intensive, then the above expression is unambiguously positive. To determine its sign when the intermediate good is capital-intensive, we can rewrite the above equation as
(A.41)
=lCllel-1r3{eKl(e~3~x2-6)L2ex3)+6)L3~K*+eL1~K1}.
The above expression
is positive
under
Assumption
1.
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M.-u. Din, Export processing
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linkages
385
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