Foreign capital, non-traded goods and welfare in a developing economy in the presence of externalities

- We develop a 3-sector GE model with a non-traded good that emanates externalities.
- Of two types of capital considered one type is specific to the non-traded sector.
- Foreign capital of the type that is used in all the sectors may improve welfare.
- Foreign capital of the specific type may affect social welfare adversely.
- We question the desirability of foreign capital inflows in the non-traded sector.

A three-sector, three-factor general equilibrium model is developed for a small open developing economy where an inflow of foreign capital generates externalities in the presence of a non-traded final commodity. There are two types of capital and the efficiency of labor depends positively on the consumption of the non-traded commodity. Effects of inflows of foreign capital on social welfare and human capital formation are examined. The analysis finds that while capital that is used in all the sectors may improve welfare, capital used specifically in the non-traded sector is likely to affect social welfare adversely. These results, which hold for a wide range of parameter values, can at least question the desirability of allowing entry of foreign capital in the non-traded final good sector that emanates externalities.