Are Trade and Factor Movement Complements or Substitutes? Depends on Trade Policy

Abstract

This paper uses a classic model to show that the trade-factor movement relationship depends not only on technology or endowment differences but varies with trade policy. Challenging Mundell’s (1957) result, based on Heckscher-Ohlin (H-O), that trade and factor movement are substitutes, Markusen (1983) assumed identical endowments and successively changed one of the H-O model’s other assumptions (e.g., identical technology), obtaining complementarity when factor movement is liberalized and trade is free. I generalize Markusen’s analysis by considering two additional policy scenarios: factor movement liberalization under trade barriers and trade liberalization under free factor movement. Changes in technology gap are also examined. The main findings are: i) Substitution (complementarity) prevails at high (low) protection rates; ii) The same result holds for a large increase (decrease) in protection when the protection rate is low (high) but not when it is high (low), in which case the relationship is ambiguous; and iii) A decrease in technology gap raises the range of protection rates where substitution prevails. Implications of the findings are provided.

Keywords: Substitution, complementarity, trade, factor movement

JEL Classification: F16, F21, F22