7 foreign outsourcing of goods and services 1 a model of outsourcing 2 the gains from outsourcing 3...

7FOREIGN OUTSOURCING

OF GOODS AND SERVICES

1 A Model of

Outsourcing2

The Gains from Outsourcing

3 Outsourcing in

Services4

Conclusions

© 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor 2 of 118

Introduction

• The provision of services or the production of various parts of a good in different countries that are then used or assembled into a final good in another location is called foreign outsourcing, or simply outsourcing.

• Trade in intermediate inputs, which can cross borders several times before being incorporated into a final good.

• It is a relatively new phenomenon which arose with the decline in the costs of transportation and communication


Introduction

• Is outsourcing different from the type of trade we studied in the Ricardian and Heckscher-Ohlin models?

• Outsourcing results in lower prices, but changes the mix of jobs in the U.S.

• In some ways outsourcing is similar to immigration as U.S. companies can employ foreign labor although those workers still live in their own countries.

APPLICATION


Is Trade Today Different From the Past?

• We discussed in previous chapters how trade has evolved over time, so is the type of trade done today different from that done in the past?

• Figure 7.1 shows that U.S. trade has shifted away from agriculture and raw materials, toward manufactured goods.

• The share of capital, consumer, and automotive goods has increased from 10% of imports and 20% of exports in 1925 to 65% in 2005.

• These goods are much more likely to have the production sent overseas through outsourcing.

• Given the changes in the share of trade in these products, we can see that the type of trade has changed greatly from the past.

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Figure 7.1 (a)

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Figure 7.1 (b)


A Model of Outsourcing

• To develop the model of outsourcing, we need to distinguish all the activities used to produce and market a good or service.

• Figure 7.2 (a) describes the activities in the order in which they are performed.

• However, for outsourcing, it is more useful to look at the activities according to the ratio of skilled to unskilled labor they use which is shown in figure 7.2 (b). We start with the less skilled activities and move to more complex

components and then onto the more skilled labor activities.



Figure 7.2



• Value Chain of Activities The whole set of activities we just described is

sometimes called the value chain for the products. Each activity adds more value to the combined product.

Some of the activities can be transferred to other countries when it is more economical.

By looking at activities in terms of their relative amount of skilled labor, we can predict which ones are likely to be transferred abroad.



• This prediction depends on several assumptions:

1. Relative Wage of Skilled Workers We assume that Foreign wages for unskilled and

skilled workers are less than those at Home. W*L < WL and W*S < WS

Additionally, we assume the relative wage of unskilled labor is lower in foreign than at home.

W*L / WL and W*S / WS

Remember that unskilled labor in developing countries typically receives especially low wages.



2. Costs of Capital and Trade Must take into account extra costs of doing business

in the foreign country. Higher prices to build a factory or for costs of production. Extra costs in communication or transportation.

In making a decision to outsource, the firm will balance the saving from lower wages against the extra costs of capital and trade.

We assume that these extra costs apply uniformly across all the activities in the value chain—a somewhat unrealistic assumption.



3. Slicing the Value Chain Based on our previous assumptions, it will make

sense for the firms to send the most unskilled-labor intensive activities abroad and keep the more-skilled labor intensive activities at Home.

In figure 7.2 that might be all activities to the left of the vertical line A.

This is referred to as slicing the value chain. Activities to the left of line A are sent abroad because

the cost savings from paying lower wages in Foreign are greatest for the less-skilled labor intensive activities.



4. Relative Supply and Demand for Skilled Labor For Home we graph the relative demand for

skilled labor at Home, S/L against the relative wage, WS/WL for activities to the right of line A.

The relative demand curve slopes downward because a higher relative wage for skilled labor would cause home firms to substitute toward less-skilled labor in some activities.

The relative supply curve is upward sloping because a higher relative wage for skilled labor will cause more skilled individuals to enter the industry.



Figure 7.3


Changing the Costs of Trade

• Change in Home Labor Demand and Relative Wage When costs of capital or trade decline in Foreign, there is an

incentive to shift more activities to Foreign. The activities shifted to Foreign are less skill-intensive than

the ones left at Home. The range of activities now done at Home are more skilled

labor intensive on average.

Figure 7.4



• Change in Home Labor Demand and Relative Wage

The Home relative demand curve will shift right.

Remember this graph shows the relative demand, not the absolute quantity of labor demanded. We would expect the absolute demand of skilled and unskilled

workers to decrease with increased outsourcing.

BUT, relative demand increases because the activities still done at Home are more skill-intensive than before.

The relative wage of skilled labor will increase due to outsourcing.



Home Supply

Home Demand

Skilled/Unskilled Labor, S/L

(a) Home Country

A

Skilled/Unskilled Wage, WS/WL

Figure 7.5

Relative demand increases because the jobs done at home are now more skill intensive than before.

The relative wage of skilled labor increases due to outsourcing.

B



Figure 7.5

Foreign Supply

Foreign Demand

(b) Foreign Country

A*

Skilled/Unskilled Labor, S*/L*

Skilled/Unskilled Wage, W*S/W*L

The activities outsourced to Foreign are more skill intensive.

On average, economic activity in Foreign is more skill intensive, so the relative demand for skilled labor increases

B*

The relative wage of skilled labor increases in Foreign



• From this model we can see that both countries experience an increase in the relative wage of skilled labor due to increased outsourcing.

As activities in the middle of the value chain are shifted from home to Foreign, they raise the relative demand for skilled labor in both countries because these activities are the least skill-intensive of those formerly done at Home but the most skill-intensive of those done in Foreign.

Compare this to the predictions from our previous models.

APPLICATION


Change in Relative Wages in the United States

• Since the early 1980s, the wages of skilled workers have risen relative to those of unskilled workers in the U.S. as well as other countries.

• Use data from the manufacturing sector on “production” (unskilled) and “non-production” (skilled) workers.

• Figure 7.6 shows the average annual earnings of non-production workers relative to production workers in U.S. manufacturing from 1958 to 2001.

• Figure 7.7 shows a steady increase in the ratio of non-production to production workers employed in U.S. manufacturing until the early 1990s.

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Figure 7.6

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Figure 7.7

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• Relative Employment of Non-production Workers

The only way both of these could increase is if there was an outward shift in the relative demand for non-production (skilled) workers during that time period. This would lead to a simultaneous increase in their relative

employment and in their wages.

We can see this in figure 7.8 where we plot the relative wage and employment of non-production workers from 1979 to 1990.

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Figure 7.8

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• Explanations The evidence from the manufacturing sector in the U.S. is

strongly consistent with our model of outsourcing Another possible explanation is called skill-biased

technological change. Increased use of computers.

Which factor has had a bigger impact on wage inequality?

Studies attempting to answer this question mostly focus on the measurements in terms of some underlying variables. The number of computers and other high-technology equipment used in

manufacturing industries. Imports of intermediate inputs into manufacturing industries.

APPLICATION



• One of these studies is summarized in Table 7.1.

• One goal of the study is to explain the increase in the share of total wage payments going to non-production labor in U.S. manufacturing industries from 1979–1990 (part A).

• The second goal is to analyze the increase in relative wage of non-production labor in particular over the same period (part B).

• Outsourcing is measured as the intermediate inputs imported by each industry.

• High-technology equipment is measured as either the share of the capital stock or capital flows.

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Table 7.1

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• Both outsourcing and high-tech equipment are important explanations for the increase in the relative wage of non-production/production labor in U.S. manufacturing.

• However, it is difficult to judge which is more important because the results depend on how we measure the high-tech equipment.


Change in Relative Wages in Mexico

• Our model of outsourcing predicts that the relative wage of skilled labor will rise in both countries.

• We have seen this for the U.S., but what about for Mexico?

• Figure 7.9 shows the relative wage of non-production labor in Mexico from 1964–1994. Data comes from the census of industries in Mexico

which occurs infrequently. We can see the data seem to follow the same trends that

we saw in the U.S.



Figure 7.9



• After 1994, the change in the relative wage of non-production workers in Mexico depends on whether we look at the maquiladora sector or the non-maquiladora plants. The maquiladora sector represents plants near Mexico’s border

with the U.S. engaged in outsourcing.

• For the maquiladora sector, we see real monthly income rising faster than wages for production workers, meaning a continuing rise in the relative wage of non-production (skilled) workers.

• For the non-maquiladora plants in the rest of Mexico, the evidence is that the relative wage of non-production workers fell after 1994.


The Gains from Outsourcing

• We have shown that outsourcing can shift the relative demand for labor, and raise the wage for skilled workers; decreasing the relative wage for unskilled workers

• However, outsourcing reduces production costs which, in a competitive market, reduces prices so outsourcing benefits consumers.

• Do the overall gains outweigh the losses?


A Simplified Outsourcing Model

• Suppose there are only two activities: components production and research and development (R&D).

• Assume components is unskilled labor intensive.

• The costs of capital are equal in both activities.

• Compare the no-trade situation to an equilibrium with trade through outsourcing.

• The two kinds of labor are free to move between the two activities.

• Graph a production possibilities frontier (PPF) for the firm between components and R&D activities—figure 7.10.



• Production in the Absence of Outsourcing Suppose that the firm, initially, cannot engage in

outsourcing.

An isoquant is used to determine how much of the final good is produced. Similar to a consumer’s indifference curve except, instead of

utility, it illustrates production of the firm. A curve along which the output of the firm is constant despite

changing combinations of inputs.

This isoquant is tangent to the PPF showing this is the highest amount of product that can be produced with current amounts of components and R&D.



A

R&D

Components

QR

QC

Y0

Y1

Figure 7.10

Home firm PPF

No-trade Home firm equilibrium

Home firm isoquants

Relative price of components = (PC/PR)A



• Equilibrium with Outsourcing Now suppose the firm can import and export its

production activities through outsourcing. The quantity of the final good is no longer constrained by the

Home PPF. Output rises to Y1.

Assume the world relative price of components is cheaper than Home’s no-trade relative price.

With a lower relative wage of unskilled labor in Foreign, components assembly will also be cheaper in Foreign.

Home will want to outsource components, which are cheaper abroad, while Home firms will be exporting R&D, which is cheaper at Home.



Figure 7.11

A

R&D

Components

Y0

Y1

No-trade Home firm equilibrium

C

Gains from Outsourcing

B

World relative price of components = (PC/PR)W1

Home firm imports of components

Home firm exports of R&D

Before outsourcing, Home starts at A, the no-trade equilibrium. They can only use what they have

When the firm outsources, they now face the world relative price of components at B and use a new mix of inputs based on the new world price

This means the firm will export R&D and import Components. The increase in production from Y0 to Y1 are the gains from outsourcing

(PC/PR)A

Given the firms production abilities from the isoquants, we can see the firm can now produce Y1 at C using corresponding levels of R&D and Components

No-trade relative price of components = (PC/PR)A



• Gains from Outsourcing Within the Firm The increase of final goods produced (Y0 – Y1) is a

measure of the gains from trade to the Home firm from outsourcing.

Because more of the final good is produced with the same overall amount of skilled and unskilled labor available in Home, the Home company is more productive. Its costs of production fall. Price if the final product falls.

The gains for this company are therefore spread to consumers as well.


Terms of Trade

• We now need to consider the impact on a country’s terms of trade. (PEX/PIM)

Home terms of trade are (PR/PC)W1 since Home is exporting R&D and importing components.

• A rise in the terms of trade indicates that a country is getting a higher price for its exports, or paying a lower price for its imports.

• Fall in the Price of Components Suppose there is a fall in the relative price of

component production. Maybe Foreign improves its productivity in components.


Terms of Trade

Figure 7.12

R&D

Components

Y1

C


A

B


C’



B’

Home gains from trade when relative price of components falls

Y2

Relative price of components falls leading to a new relative world price (PC/PR)W2

The firm now exports less R&D and imports more components

Home gains from increased production

This leads to new use of inputs at B’, new production at Y2, and new use of inputs at C’


Terms of Trade

• Fall in the Price of R&D

Samuelson was referring to this when he stated that outsourcing might allow developing countries to gain a comparative advantage in those activities where the U.S. once had the comparative advantage.

For example, as Indian companies like Wipro engage in more R&D, they compete directly with American companies exporting the same services. Competition can lower the world price of R&D services.

A fall in the world relative price of R&D will lead to a steeper price line (PR falls).

Home shifts production to point B′′, and by exporting R&D and importing components, moves to point C′′.


Terms of Trade

Figure 7.13

R&D

Components

Y0

Y1

(PC/PR)A

(PC/PR)W1



After the costs of R&D fall, the world relative price gets steeper at (PC/PR)W3

A

B

World Relative Price of Components(PC/PR)W3

The country shifts production reducing R&D and increasing Components, moving from B to B”

C

Y3

B”

C”

Terms of trade loss leads to reduced production to Y3, and reduced exports and imports


Terms of Trade

• Fall in the Price of R&D

Remember Home is exporting R&D and importing components in the initial outsourcing equilibrium: terms of trade are PR/PC.

When the price of R&D falls, Home terms of trade have worsened and Home is worse off compared to initial outsourcing equilibrium.

There are still Home gains from outsourcing at C′′ as compared to the no-trade equilibrium at A.

APPLICATION


US Terms of Trade and Service Exports

• We now want to examine the evidence for the U.S. to test Samuelson’s theoretical argument.

• Merchandise Prices Figure 7.14 shows the terms of trade for the U.S. for merchandise

goods (excluding petroleum).

• Service Prices For trade in services such as R&D, it is very difficult to measure their

prices in trade. However, we can collect good data on air travel Terms of trade in air travel equals the price that foreigners pay for

travel on U.S. airlines divided by the price that Americans pay on foreign airlines (shown in figure 7.14).

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Figure 7.14

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• Service Prices There is no evidence to date that the falling terms of

trade that Samuelson was concerned with has occurred for the U.S.

• Service Trade While standard prices are not available, the amounts of

service exports and imports for the U.S. are collected annually. The data is shown in Table 7.2 for 2005.

The fact that exports exceed imports in many categories of Table 7.2 means that the U.S. has a comparative advantage in traded services.

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Table 7.2

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• The surpluses in “other business services” for the U.S., UK, and India since 1982 are graphed in figure 7.15.

• This area has been growing steadily since about 1985, and shows a very similar pattern to the trade surplus from the UK, its chief competitor.

• India’s surplus only began growing a decade later

• The U.S. and UK have continued to increase their surpluses in other business services even as India and other developing countries have become world competitors.

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Figure 7.15

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Impact of Outsourcing on US Productivity

• Before we focused on the impact of outsourcing on the relative wage of skilled labor, but we have not looked at the positive impact of outsourcing on productivity.

• We will measure the outsourcing of material inputs and of service inputs.

• In the U.S., the amount of imported service inputs is small but growing.

• Measured as a share of total inputs purchased, imported services were 0.2% in 1992 and grew to 0.3% in 2000.

APPLICATION



• Table 7.3 shows the impact of service outsourcing, materials outsourcing, and high-technology equipment on manufacturing productivity measured by estimating value-added per worker.

Table 7.3

APPLICATION



• We see that these three factors explain between 18% and 26% of the increase in value-added per worker.

• We conclude that service outsourcing together with the increased use of high-tech equipment can explain as much as one percentage point of productivity growth per year.


Outsourcing in Services

• Outsourcing that occurred from the U.S. in the 1980s and 1990s was often in manufacturing activities

• Today the focus is on the outsourcing of services, especially to India.

• Two questions often raised are: Does it contradict our ideas about international trade,

such as the principle of comparative advantage? In what goods or services will the U.S. or European

countries retain their comparative advantage?



• The Logic of Service Outsourcing Ricardian Model

In the Ricardian model, comparative advantage is determined by the difference in productivities across countries.

Countries with low overall productivity have lower wages. In service activities, however, Indian workers are probably

equally productive with their counterparts in developed countries.

If we measure the productivity of call centers relative to the productivity of manufacturing industries, this ratio is much higher in India than in the U.S.

According to the Ricardian model, India has a comparative advantage in service activities because its opportunity cost is relatively low.



• Outsourcing Model

In the outsourcing model we presented earlier, we used the value chain to show that Home would produce the most skill-intensive activities and Foreign would produce the least skill-intensive activities.

That assumption is contradicted by the outsourcing of business services to India. Activities such as writing computer code and other R&D

activities done in India are very skill intensive.

We will examine our previous assumptions one at a time.



• Outsourcing Model

Our first assumption was that wages in general and the relative wage of unskilled workers were lower in Foreign than in Home. Given data, we can see that the relative wage of unskilled labor

is indeed lower in India than the U.S.

Our second assumption was that the extra costs of capital and of trade in Foreign were spread uniformly over all the activities in the value chain. When a Home firm decides which activities to outsource, it will

base that decision only on labor cost savings Because Foreign has lower relative wages, it will make sense to

outsource unskilled labor-intensive activities.



• Outsourcing Model The second assumption does not hold in India. The actual costs of outsourcing relatively unskilled manufacturing

activities to India are much greater than the costs of outsourcing skilled service activities. Manufacturing requires transporting component parts to India which

has a poor transportation infrastructure. Outsourcing skilled service activities requires no transportation of parts

Service activities do not rely as much on transportation but instead require reliable and cheap communication. The communication infrastructure is very good in India and they have a

large number of well-educated individuals who speak English.

This makes sense for the U.S. and Europe to engage in service outsourcing with India, where India has a comparative advantage.

SIDE BAR


Outsourcing Microsoft Windows

• Microsoft Corp., in Seattle, WA, does not load their own upgrades of the Windows software onto its own computers.

• Wipro, an Indian high tech firm, manages Microsoft’s computers in the nighttime hours in Seattle, which is daytime in India.

• This is called “infrastructure outsourcing” and the remote management of computer resources is just one example of service outsourcing.

SIDE BAR


Outsourcing Microsoft Windows

• During the non-operating hours, Wipro remotely accesses their computers, performs routine maintenance, trouble-shoots for viruses, repairs corrupt files, and checks for other problems.

• The computers at Microsoft are better than when the employees left the night before, which makes those employees more productive in their own computer work.

7 foreign outsourcing of goods and services 1 a model of outsourcing 2 the gains from outsourcing 3...

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