OUTSOURCING OF GOODS PRODUCTION AND SERVICES

1 A Model of Outsourcing 2 The Gains from Outsourcing 3 Outsourcing in Services 4 Conclusions

1 Introduction
Outsourcing: The provision of services/products/components/parts from different countries that are used/assembled into a final good in another location. Offshoring (Offshore Outsourcing)is often used for trade in intermediate inputs, often implying that the domestic firm retrains ownership in the operation that produces the part abroad. Outsourcing is often used when U.S. firms employ workers located in foreign countries to provide services in the US 71% of American voters believe that outsourcing jobs overseas hurt the economy while another 62% believed that the U.S. government should impose some legislative action against companies that transfer domestic jobs overseas. (Zogby International poll, August 2004)

1 Introduction 1) First, we develop a model of offshoring to see how offshoring affects the activities of the firm. - analyze the impact of offshoring on the demand and relative wage of workers at home and abroad. - examine the gains from offshoring, how it affects relative prices and the terms of trade, and ultimately how it affects both firms and workers.

1 A Model of Offshoring

Value Chain of Activities

FIGURE 7-1

The Value Chain of a product implies that it would be indeed unusual to expect all components to be produced in the same country (given Ricardo or HO) Panel (a) lists activities for a given product and the order in which they occur.

1 A Model of Offshoring

Value Chain of Activities

FIGURE 7-1

The Value Chain of a product implies that it would be indeed unusual to expect all components to be produced in the same country (given Ricardo or HO) Panel (a) lists some activities for a given product and the order in which they occur. The value chain in panel (b) lists these same activities in order of the amount of high-skilled/low-skilled labor used in each.

1 A Model of Offshoring

Model Assumptions PART I Foreign wages are lower than those at Home W *L < WL and W *H < WH.

Skill premium in the Home country is higher, so that the relative wage of high-skilled labor is lower in Foreign W *L/W *H < WL/WH.

1 A Model of Offshoring
Relative Demand and Supply for Skilled Labor
FIGURE 7-2

Relative Demand and Supply for Skilled/Unskilled Labor In panel (a), we show the relative demand In panel (b), we show the relative demand and supply for skilled labor at Home, H/L, and supply for skilled labor in Foreign, depending on the relative wage, WH/WL. H*/L*, depending on the relative wage, W*H/W*L. The equilibrium relative wage at Home is determined at A. The Foreign equilibrium is at point A*.

1 A Model of Offshoring

Model Assumptions PART II

Costs of Capital and Trade To ship intermediate goods across countries is costly, so our offshoring model introduces transportation / setup / information costs In making the decision to offshore, a firm must balance the savings from lower wages against the extra costs of capital and trade.

1 A Model of Offshoring

Slicing the Value Chain: Where to Produce What

FIGURE 7-3

Offshoring on the Value Chain Home firm will find it profitable to offshore goods below A, since Foreign has a low skilled labor advantage. Skill-intensive activities are done at Home The threshold is determined by the marginal benefit (lower production cost) and the marginal cost (transport/trade/information cost) of outsourcing

1 A Model of Offshoring

Reoptimizing the Value Chain when Trade Costs Change

Example1: Trade Costs Fall in the Foreign
FIGURE 7-3

Offshoring on the Value Chain As the trade costs fall in the Foreign country, a Home firm will find it profitable to offshore more activities. Offshoring shifts the dividing line between Home and Foreign production from A to B. The activities between A and B, which formerly were done at Home, are now done in Foreign. These activities are more skill-intensive than the activities formerly done in Foreign (to the left of A) (but still less skill-intensive than the activities done at Home (to the right of B)).

1 A Model of Offshoring
Lower trade costs in foreign thus DECREASES the demand for unskilled Labor at home, which INCREASES the relative wage of skilled workers in Home
FIGURE 7-4 (a)

Change in the Relative Demand for High-skilled/Low-skilled Labor With greater offshoring from Home to Foreign, some of the activities requiring less skill that were formerly done at Home are now done abroad. It follows that the relative demand for skilled labor at Home increases, and the relative wage rises from point A to point B.

1 A Model of Offshoring
Lower trade costs in foreign increase the demand for Foreign skilled labor. This increases the Relative Wage of skilled workers in Foreign
FIGURE 7-4 (b)

Change in the Relative Demand for High-skilled/Low-skilled Labor (continued) The relative demand for skilled labor in Foreign also increases because the activities shifted to Foreign are more skill intensive than those formerly done there. It follows that the relative wage for skilled labor in Foreign also rises, from point A* to point B*.

1 A Model of Offshoring
Effect of Decreased Trade Costs: Summary

Both countries experience an increase in the relative wage of skilled labor due to increased outsourcing. 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 skill-intensive activities from home move to Foreign to become the most skill intensive activities there The relative demand for skilled labor rises in both countries along with the relative wage.

APPLICATION Change in Relative Wages in the United States

Relative Wage of Nonproduction Workers
FIGURE 7-5

Relative Wage of Nonproduction/Production Workers, U.S. Manufacturing This diagram shows the average wage of nonproduction workers divided by the average wage of production workers in U.S. manufacturing. This ratio of wages moved erratically during the 1960s and 1970s, though showing some downward trend. This trend reversed itself during the 1980s and 1990s, when the relative wage of nonproduction workers increased until 2000. This trend means that the relative wage of production, or low-skilled, workers fell during the 1980s and 1990s. In more recent years the relative wage has become quite volatile, falling substantially in 2002 and 2004, then rising in 2005 and 2006.

APPLICATION Change in Relative Wages in the United States

Relative Employment of Nonproduction Workers
FIGURE 7-6

Relative Employment of Nonproduction/Production Workers, U.S. Manufacturing This diagram shows the employment of nonproduction workers in U.S. manufacturing divided by the employment of production workers. There was a steady increase in the ratio of nonproduction to production workers employed in U.S. manufacturing until the early 1990s. That trend indicates that firms were hiring fewer production workers relative to nonproduction workers. During the 1990s, there was a fall in the ratio of nonproduction to production workers, and then a rise again after 2000.

APPLICATION Change in Relative Wages in the United States

Explanations

-Outsourcing -More high tech inputs in production (computers) - skill-biased technological change. -How do we distinguish between the two?

APPLICATION

Outsourcing measured as the intermediate inputs imported by each industry.

High-technology equipment measured as % of high tech capital in total capital. % of new capital investment that is devoted to computers and other high-tech devices.

APPLICATION
Increase in the Relative Wage of Nonproduction Labor in U.S. Manufacturing, 19791990 Estimated effects of (i) offshoring and (ii) high-technology equipment on the wages of nonproduction (or skilled) workers.

between 20 and 23% of the increase in the share of wage payments going to the non-production workers was explained by outsourcing. So it was outsourcing, not the existing high tech capital that increases relative wages in the Us high-tech investment explains 37% of the increase in the share of wage payments going to skilled workers. Of course it could be that outsourcing has changed the way US firms invest.

APPLICATION

APPLICATION Change in Developing Countries

Adrian Wood. Openness and Wage Inequality in Developing Countries: The Latin American Challenge to East Asian Conventional Wisdom https://hec.unil.ch/docs/files/40/285/openness_and_wage_inequality_in_developing_countries.pdf

2 The Gains from Offshoring

The model predicted changes in the relative wage, so we have again winners and losers from offshoring. Can we identify if winners can compensate losers, or in other words if there are net gains from trade? we must balance potential losses faced by unskilled labor with the gains enjoyed by skilled labor and consumers.
In the previous chapters, the Ricardian and HeckscherOhlin models generate more gains than losses. Is this true for outsourcing?

2 The Gains from Offshoring A Simplified Outsourcing Model

Assumptions: two activities: components production research and development (R&D). Each activity uses skilled and unskilled labor components is unskilled labor intensive R&D is skilled labor intensive. Free flow of capital equalizes the returns across both activities. The world relative price of components is cheaper than Homes no-trade relative price. Compare no-trade equilibrium with trade-and-outsourcing, to determine gains from trade.

A Simplified Outsourcing Model

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 consumers 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 Simplified Outsourcing Model Figure 7.10

R&D Home firm PPF No Trade price of components = (PC/PR)A No-trade Isoquant No-trade Home firm equilibrium QR A

Y0 QC Components

A Simplified Outsourcing Model

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 Homes 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.
Home firm PPF Relative price of components = (PC/PR)A

No-trade Home firm equilibrium QR A

Y1 Y0 QC Components Home firm isoquants

Figure 7.11
R&D

A Simplified Outsourcing Model

World relative price of components = (PC/PR)W1 This the firms firm will Giventhe firm outsources, When means theproduction Before outsourcing, export from the world abilitiesR&D the importHome theystarts faceand isoquants, now at Components. The can now we canpriceA, the no-trade at relative see thecomponents of firm equilibrium. They can only produce in new mix of BincreaseYa at C using inputs and use 1 production use what from on the they have corresponding levels of R&D based Y0 to Y1 are world price new the gains from outsourcing and Components

(PC/PR)A

B Home firm exports of R&D A

No-trade Home firm equilibrium

C Y1
Gains from Outsourcing

Y0

Components Home firm imports of components

A Simplified Outsourcing Model

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 of the final product falls (if the industry is competitive) and consumer surplus increases - Producer profits rise (if the industry is monopolistic)

Paul Samuelson (2004) questioned whether outsourcing is beneficial to Countries like the US if the terms of trade turn against the US.
The terms of trade are defined as (PEXports/PIMports) 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.
There are two possible cases: - A 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. - A Fall in the Price of R&D because the developing country becomes better at R&D

Favorable Terms of Trade

R&D World relative price of components = (PC/PR)W2 World relative price of components = (PC/PR)W1 B Home firm exports of R&D B This leads to new use of Relative price of Home The atgains from inputsfirm now exports less B, falls leading componentsnew production increasedimports more R&D and at Y2new relative world to a , and new use of inputs production components at C (PC/PR)W2 price

C
A

Y2 C
Home gains from trade when relative Y1 price of components falls

Components Home firm imports of components

Unfavorable Terms of Trade

Fall in the Price of R&D
Samuelson was referring to this case 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
(PC/PR)W1 R&D World Relative Price of Components(PC/PR)W3 (PC/PR)A The country shifts production reducing R&D and increasing Components, moving from B to B Terms of trade loss leads to reduced production to Y3, and reduced exports C and imports After the costs of R&D fall, the world relative price gets steeper at (PC/PR)W3

B
Home firm exports of R&D

B
A

Y1
Y3 Y0

Components Home firm imports of components

Even with unfavorable Terms of Trade, gains from trade persist, they are just smaller 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.

US Terms of Trade and Service Exports Figure 7.15

3 The Politics and Future of Offshoring

HEADLINES
How to Destroy American Jobs
Deep in the president's budget released Monday-in Table S-8 on page 161-appear a set of proposals headed "Reform U.S. International Tax System." If these proposals are enacted, U.S.-based multinational firms will face $122.2 billion in tax increases over the next decade. "Leveling the Playing Field: Curbing Tax Havens and Removing Tax Incentives for Shifting Jobs Overseas."

This is simply wrong. These tax increases would not create American jobs, they would destroy them.

3 The Politics and Future of Offshoring

HEADLINES
How to Destroy American Jobs
When parent firms based in the U.S. hire workers in their foreign affiliates, the skills and occupations of these workers are often complementary; they aren't substitutes. For example, as Wal-Mart has opened stores abroad, it has created hundreds of U.S. jobs for workers to coordinate the distribution of goods world-wide. 1988-2007, employment in affiliates rose by 5.3 mil (11.7 mil- 6.4 mil) Over that same period, employment in U.S. parent companies increased by nearly as much-4.3 million-to 22 million from 17.7 million. Indeed, research repeatedly shows that foreign-affiliate expansion tends to expand U.S. parent activity

3 The Politics and Future of Offshoring

HEADLINES
Boeing Outsourcing: Too much of a good thing.

3 The Politics and Future of Offshoring

Boeing Outsourcing: Too much of a good thing. HEADLINES

3 The Politics and Future of Offshoring

Which part of a Boeing is still built by Boeing? HEADLINES

http://www.huffingtonpost.com/2011/01/20/a-wing-and-a-prayer-outso_n_811498.html

3 The Politics and Future of Offshoring

HEADLINES
Boeing Outsourcing: Too much of a good thing.
As Boeing dramatically increased outsourcing around the globe, aircraft parts no longer fit together and caused costly delays on the production line. The 787 a 30% foreign-made content more any other Boeing plane (vs 5% in the 747). Boeing's goal is to convert its storied aircraft factory near Seattle to a mere assembly plant, bolting together modules designed and produced elsewhere. The drawbacks of this approach emerged early. Some of the pieces manufactured by far-flung suppliers didn't fit together. Some subcontractors couldn't meet their output quotas, creating huge production logjams when critical parts weren't available in the necessary sequence. Boeing even farmed out the design, which subcontractors then farmed out again Rather than follow its old model of providing parts subcontractors with detailed blueprints created at home, Boeing gave suppliers less detailed specifications and required them to create their own blueprints. Some then farmed out their engineering to their own subcontractors At least one major supplier didn't even have an engineering department when it won its contract no surprise components dont fit together.

Chapter 7: Offshoring of Goods and Services

Copyright 2011 Worth Publishers International Economics Feenstra/Taylor, 2/e.

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3 The Politics and Future of Offshoring

HEADLINES
Outsourcing

3 The Politics and Future of Offshoring

HEADLINES: Baldwin
Outsourcing and Insourcing

Mary Amiti and Shang-Jin Wei (2005) show that Like trade in goods, trade in services is a two-way street. Most countries receive outsourcing of services from other countries as well as outsource to other countries.

Summary
Outsourcing is a special case of intermediate goods/service trade We can integrate outsourcing easily into our existing trade models (PPF, World Price Line) to highlight gains from trade
Move of production structure towards comparative advantage Import intermediate good at lower price, Produce more output that is sold at a higher world price to generate greater income

We can again identify winners and losers. Outsourcing allows firms to slice the value chain and produce cheap components abroad and focus on R&D at home.