7 Foreign Outsourcing of Goods and Services 1 A Model of Outsourcing 2 The Gains from Outsourcing 3 Outsourcing in Services 4 Conclusions

7Foreign Outsourcing of

Goods and Services

1 A Model of

Outsourcing2

The Gains from Outsourcing

3 Outsourcing in

Services4

Conclusions

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© 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor 2 of 118

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Chapter Outline

• Introduction• A Model of Outsourcing

Value Chain of Activities Relative Wage of Skilled Workers Costs of Capital and Trade Slicing the Value Chain Relative Demand for Skilled Labor

Changing the Costs of Trade Change in Home Labor Demand and Relative Wage Change in Foreign Labor Demand and Relative Wage

Change in Relative Wages in Mexico

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Chapter Outline

• The Gains from Outsourcing Simplified Outsourcing Model

Production in the Absence of Outsourcing

Equilibrium with Outsourcing

Gains from Outsourcing Within the Firm

Terms of Trade Fall in the Price of Components

Fall in the Price of R&D

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Chapter Outline

• Outsourcing in Services The Logic of Service Outsourcing

Ricardian Model

Outsourcing Model

The Future of US Comparative Advantage

• Conclusions

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Learning Objectives

• To understand what outsourcing is• To understand how outsourcing differs from

trade in final products• To understand how outsourcing affects the

demand for skilled and unskilled labor and their wages

• To understand the gains from outsourcing• To understand how outsourcing affects high

skilled versus low skilled workers

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Learning Objectives

• To understand the outsourcing of business services to foreign countries

• To understand the trends in business services outsourcing

• To understand the implications for wage and the gains from trade that come from business services outsourcing

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Introduction

• A vast array of products consist of materials, parts, components, and services that are produced in multiple countries

• 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

• Outsourcing is a type of trade that differs from what we have studied so far

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Introduction

• Outsourcing is the trade in intermediate inputs, which can sometimes cross borders several times before being incorporated into a final good

• Outsourcing is a relatively new phenomenon as the costs of transportation and communication have fallen so much that it is now economical to combine resources from many countries to produce a good or service

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Introduction

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

• We will look at how outsourcing compares to these models. In some ways it is similar and in some ways it is different

• Outsourcing results in lower prices, but changes the mix of jobs in the US

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

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Introduction

• The first goal of this chapter is to examine in detail the phenomenon of outsourcing and describe in what ways it differs from trade in final products How does outsourcing affect the demand for

skilled and unskilled labor and their wages?

• The second goal of the chapter is to discuss the gains from outsourcing

• The third goal is to examine the newest form of outsourcing, the outsourcing of business services to foreign countries

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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?

• Yes, there is more trade and the type of trade has changed

• If we organize trade into five categories we get: (i) foods, feeds, and beverages; (ii) industrial supplies and materials; (iii) capital goods; (iv) finished consumer goods; and (v) automobiles

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• We can see in Figure 7.1 that US trade has shifted away from agriculture and raw materials, toward manufactured goods Together these accounted for 90% of imports in

1925 and 1950, but less than 25% in 1990 The export share fell from about 80% to 35%

• These are not goods in which it is profitable to outsource

• More outsourcing is done in the categories of capital and consumer goods

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• The share of capital plus consumer goods has increased from 10% of imports and 15% of exports in 1925, to over 50% in 1990

• 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)

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SIDE BAR


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Outsourcing versus Offshoring

• The term “offshoring” is sometimes used to refer to a company moving some of its operations overseas, but retaining ownership of those operations Intel produces microchips in China and Costa

Rica using subsidiaries that it owns Intel has engaged in foreign direct investment

(FDI) to establish those offshore subsidiaries Mattel, on the other hand, arranges for the

production of the Barbie doll in several different countries

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SIDE BAR


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Outsourcing versus Offshoring

The difference is that Mattel does not actually own the firms in those countries

Mattel is engaging in outsourcing as it contracts with these firms, but has not done any FDI

• In this chapter we will not worry about the distinction between “offshoring” and “outsourcing”

• We will use outsourcing whenever the components of a good or service are produced in several countries, regardless of who owns the plants that provide the service or components

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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 less skilled activities and move to

more complex components and then onto the more skilled labor activities

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Figure 7.2

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• 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

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• 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

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2. Costs of Capital and Trade Although labor costs are lower in Foreign, the

firm must also take into account extra costs of doing business there 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

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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

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4. Relative Demand for Skilled Labor Figure 7.3 graphs the demand for labor in each

country 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.

We can do the same thing for Foreign

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(a) Home Country

Skilled/Unskilled Wage, WS/WL

Home Supply

Home Demand

Skilled/Unskilled Labor, S/L

A

(b) Foreign Country

Foreign Supply

Foreign Demand

A*

Skilled/Unskilled Labor, S*/L*

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

Figure 7.3

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• Relative Demand for Skilled Labor We can add a relative supply curve to the graph The relative supply curve is upward sloping

because a higher relative wage for skilled labor will cause more skilled individuals to enter the industry

The intersection of the relative demand and relative supply curves gives the equilibrium relative wage in this industry in each country

We can now study how the equilibrium changes as Home outsources more activities to Foreign

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Changing the Costs of Trade

• Suppose that the costs of capital or trade in Foreign fall E.g. NAFTA lowered tariffs charged on goods

crossing the US-Mexico border

• Lowering trade costs makes it easier for Home to outsource to Foreign

• What are the effects of these changes on labor demand and relative wages?

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• 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 in the value chain from Home to Foreign Figure 7.4 The dividing line in the value chain shifts right

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

The relative demand for skilled labor at Home will increase

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Figure 7.4

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• Change in Home Labor Demand and Relative Wage The Home demand curve will shift right, shown in

Figure 7.5 (a) 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

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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

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• Change in Foreign Labor Demand and Relative Wage For Foreign, the activities that are newly

outsourced there are more skill-intensive than those initially outsourced to them

The range of activities in Foreign are more skilled-labor intensive on average

Therefore the relative demand for skilled labor in Foreign will increase

The demand curve shifts to the right as seen in Figure 7.5 (b)

The relative wage of skilled labor increases in foreign

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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 so the relative demand for skilled labor increases

B*

The relative wage of skilled labor increases in Foreign

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• 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

So the relative demand for skilled labor rises in both countries along with the relative wage

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Change in Relative Wages in the United States

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

• We can use data from the manufacturing sector on “production” (unskilled) and “non-production” (skilled) workers

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• Relative Wage of Non-production Workers Figure 7.6 shows the average annual earnings of

non-production workers relative to production workers in US manufacturing from 1958 to 2001 Relative earnings were erratic from 1958 to 1967, and

fell from 1968 to 1983 due to increased supply of college graduates

In 1983 the relative wage increased steadily to 2000

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Figure 7.6

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• Relative Employment of Non-production Workers Figure 7.7 shows a steady increase in the ratio of

non-production to production workers employed in US manufacturing until the early 1990’s Firms were hiring fewer production, or unskilled, workers

relative to non-production workers In 1990’s there was a fall in the ratio of non-production to

production workers From 1980 to about 1990, the relative

employment of non-production workers continued to rise even with a rising relative wage of non-production workers

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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 One factor that can lead to an increase in the

relative demand for skilled labor is outsourcing The evidence from the manufacturing sector in the

US is strongly consistent with our model of outsourcing

Another possible explanation is the increased use of personal computers in the workplace during that time frame This would also cause an increase in the relative demand for

skilled labor as workers who knew how to use them would be needed

This is called skill-biased technological change

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• Explanations So how do we determine which factor is

responsible for the change in wages? There have been many studies attempting to

answer this question mostly focusing 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

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• Explanations One of these studies is found 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 US manufacturing industries from 1979–1990 (part A) This captures both the rising relative wage and the rising

relative employment of skilled workers

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

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• Explanations Outsourcing is measured as the intermediate

inputs imported by each industry High-technology equipment can be measured in

two ways As a fraction of the total capital equipment installed in

each industry As a fraction of new investment in capital that is devoted

to computers and other high-tech devices Table 7.1 reports results from both measures

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• Explanations Using the first measure, the first row of part A

shows that between 20 and 23% of the increase in the share of wage payments going to the non-production workers was explained by outsourcing, and between 8 and 12% was explained by the growing use of high-tech capital

Using the second measure, outsourcing explains only 13% of the increase and high-tech investment explains 37% of the increase

So both are important, but which is more important depends on the measure used

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• Explanations In part B we try to explain the increase in the

relative wage of non-production workers Using the first measure, we show that between 21

and 27% of the increase in the relative wage was explained by outsourcing, and between 29 and 32% explained by growing use of high-tech capital

Using the second measure, new investment can explain nearly all (99%) of the increase in relative wages with outsourcing only explaining 12%

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Table 7.1

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• In summary, we conclude that both outsourcing and high-tech equipment are important explanations for the increase in the relative wage of non-production/production labor in US manufacturing

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

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

• We have seen this for the US, 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 US Relative wages do move in the same direction in

both countries

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Figure 7.9

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• 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 Maquiladora sector are plants near Mexico’s

border with the US engaged in outsourcing

• For the maquiladora sector, we see there is a continuing rise in the relative wage of non-production 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

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• 1994 is the year that NAFTA was formed and tariffs between the US and Mexico were reduced starting in the same year

• With this the prices of those goods fell in Mexico, which can explain why the relative wage of non-production labor also fell in the non-maquiladora plants

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• In summary Changes in relative prices in the US and Mexico

match each other from 1964 to 1985 (relative wages falling) and from 1985 to 1994 (relative wages rising)

Outsourcing from the US to Mexico was rising from 1985 to 1994, so the rise in relative wages matches our prediction from the model of outsourcing

After 1994, the relative wages move in opposite directions in the maquiladora and non-maquiladora plants in Mexico due to the start of NAFTA

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

• Since the wage for unskilled workers is the reciprocal of that for skilled workers, that means that outsourcing will decrease the relative wage for unskilled workers

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

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• The goal of this section is to try and balance the potential losses faced by some groups (unskilled labor) with the gains enjoyed by others (skilled labor and consumers)

• In the previous chapters, the Ricardian and Heckscher-Ohlin models generate more gains than losses

• Is this true for outsourcing?

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A Simplified Outsourcing Model

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

• Each activity uses skilled and unskilled labor, but we assume components uses unskilled labor intensively and R&D uses skilled labor intensively

• The costs of capital are equal in both activities• We want to compare the no-trade situation to an

equilibrium with trade through outsourcing, to determine if there are overall gains from trade

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• Suppose that the first has a certain amount of skilled (S) and unskilled (L) labor to devote to components and R&D

• Labor is free to move between the two activities

• Given the total amount of skilled and unskilled labor, we graph a production possibilities frontier (PPF) for the firm between components and R&D activities—Figure 7.10 Points on the PPF show the mix of skilled and

unskilled labor used in the firm for each good Moving along the PPF shows opportunity cost

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

outsourcing The component production and R&D done at Home are

used to manufacture a final product at Home It cannot assemble any components in Foreign nor send

any of its R&D results abroad

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

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• Production in the Absence of Outsourcing Figure 7.10 shows production in the absence of

outsourcing. The quantity of the final good Y0 can be produced

using the quantity QC of components and the quantity QR of R&D shown at point A

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

Y1 cannot be produced without outsourcing because it lies outside the PPF

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• Through the no-trade equilibrium A in Figure 7.10, we draw a line with the slope of the isoquant at point A

• The slope of the isoquant measures the value, or price, that the firm puts on components relative to R&D

• We can think of these prices as reflecting the marginal costs of production of the two activities

• The slope of the price line through A is the price of components relative to the price of R&D, (PC/PR)A, in the absence of outsourcing

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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

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• 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 A higher level of production (isoquant) is possible by

trading intermediate activities

We will refer to the relative price of the two activities that the Home firm has available through outsourcing as their world relative price, (PC/PR)W1

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

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• Equilibrium with Outsourcing With a lower relative wage of unskilled labor in

Foreign, the components assembly will also be cheaper in Foreign

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

The Home equilibrium is shown in Figure 7.11 The world relative price is tangent to the PPF at

B, and is flatter than the no-trade relative price line at Home

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• Equilibrium with Outsourcing The flatter line reflects the lower world relative

price of components as compared to the no-trade relative price at Home

The Home firm undertakes more R&D and less component production, moving from point A to point B on the PPF

Starting at B, the Home firm exports R&D and imports components, moving along the relative price line to point C The isoquant is tangent to the world price line at a new

maximum amount of the good, Y1, that can now be produced

Home can produce more with outsourcing

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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

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• Gains from Outsourcing Within the Firm The increase of final goods produced (Y0 to 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

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• Gains from Outsourcing Within the Firm Our first conclusion therefore is: when comparing

a no-trade situation to the equilibrium with outsourcing, and assuming that the world relative price differs from that at Home, there are always gains from outsourcing

We now need to consider the impact on a country’s terms of trade

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Terms of Trade

• As before, the terms of trade equal the price of a country’s exports divided by the price of its imports 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—both benefit the country

• Conversely, a fall in the terms of trade harms a country, because it is paying more for its imports and getting less for its exports

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Terms of Trade

• Fall in the Price of Components Turning to Figure 7.12, let the Home country start

at the equilibrium with outsourcing shown by points B and C

Suppose there is a fall in the relative price of component production Maybe Foreign improves its productivity in components

This raises the terms of trade for Home The world price becomes flatter and production

shifts to B’. The firm ends up at point C’ Production of the final good is Y2 > Y1

Home enjoys greater gains due to outsourcing

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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’

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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 US once had the comparative advantage

For example, as Indian companies like Wipro (an information technology service company) 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

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Terms of Trade

• Fall in the Price of R&D Figure 7.13 again shows the no-trade equilibrium

at point A and Home production at B with outsourcing from figure 7.11

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”

Final output has fallen from Y1 to Y3

The fall in the price of R&D services leads to losses for the Home firm

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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

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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

Samuelson’s point is that the US could be worse off if China or India becomes more competitive in, and lowers the prices of, the products that the US itself is exporting

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Terms of Trade

• Fall in the Price of R&D Additionally, notice that the final output of Y3 is still

higher than Y0—the no-outsourcing output

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

Samuelson’s point is that a country is worse off when its terms of trade fall, even though it is still better off than in the absence of trade. When there is a fall in the terms of trade, some factors of production will lose and others will gain, but in this case the gains of the winners are not enough to compensate the losses of the losers

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US Terms of Trade and Service Exports

• We now want to examine the evidence for the US to test Samuelson’s theoretical argument

• Merchandise Prices Figure 7.14 shows the terms of trade for the US

for merchandise goods (excluding petroleum)—red line

The terms of trade for goods fell from 1987 to 1994, but has been rising since

We have been able to import intermediate inputs at lower prices over time

Increasing gains from trade in merchandise goods

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

difficult to measure their prices in trade They are more tailored to buyers and do not have

standardized prices, therefore we do not have an overall measure of their terms of 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 US airlines divided by the price that Americans pay on foreign airlines

Blue line in Figure 7.14

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Figure 7.14

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• Service Prices The terms of trade in air travel is quite volatile,

falling from 1995 to 2002, but rising since then From this one category, the terms of trade

improvement since 2002 indicates growing gains from trade for the US—the same result found for merchandise goods

There is no evidence to date that the falling terms of trade that Samuelson was concerned with has occurred for the US

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• Service Trade While standard prices are not available, the

amount of service exports and imports for the US are collected annually

This data is shown in Table 7.2 for 2005 The US runs a substantial surplus in services

trade, with exports of $260 billion and imports of $281 billion

The fact that exports exceed imports in many categories of Table 7.2 means that the US 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 US, 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 US 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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• It is difficult to predict what will happen in the future• However, notice that as the Indian surplus began

growing in Figure 7.15, the rise in the US surplus has slowed down

• It is at least possible that in a decade or two, India’s surplus in service exports could overtake that of the US

• Our next story highlights some of the factors determining where US companies decide to outsource their services functions

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Figure 7.15

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Soccer, Samba and Outsourcing?

• Brazil has had great success from the increases in global outsourcing

• Many companies are moving their computer work to firms in Brazil who manage corporate data

• Although Brazil is not as cheap as India, it is still much cheaper than the US

• India cannot keep pace with the large increases in demand for outsourcing so Brazil has been able to take advantage of the excess demand

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• One of Brazil’s big selling points is that it is only 1 to 3 hours ahead of New York depending on the time of year compared to the 11 to 12 hours for India

• Additionally, some cultural issues have caused problems working in Asia

• Because of Brazil’s out of control inflation, Brazil’s big banks had to create sophisticated computer systems and therefore the country has more programming talent available than regional rivals

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• Brazil still brings its own quirks to the game• Americans have their own views of what

Brazil is like: either as unsafe or as a party place

• US firms have to educate their employees on some of the uniqueness of doing business in Brazil

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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 US, 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

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• 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

• From 1992 to 2000, service outsourcing can explain between 11 and 13% of the total increase in productivity

• Additionally, the outsourcing of material inputs explains between 3 and 6% of the increase in productivity

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Table 7.3

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• The contribution of service and material imports can be compared to the contribution of high-tech equipment in manufacturing, which explains another 4 to 7% of the total increase in productivity

• 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

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Outsourcing in Services

• Outsourcing that occurred from the US in the 1980’s and 90’s 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 US or European countries retain their comparative advantage?

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• 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 US

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

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• 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

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• Outsourcing Model Our first assumption was that the relative wage of

unskilled workers was lower in Foreign than in Home. Given data, we can see that the relative wage of

unskilled labor is lower in India than the US

Our second assumption was that the extra costs of capital and 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

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• 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

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• Outsourcing Model 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

Therefore it makes sense for the US and Europe to engage in service outsourcing with India, where India has a comparative advantage

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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

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Outsourcing Microsoft Windows

• During the non-operating hours in those companies, 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

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• As China and India grow, we should expect that the industrialized countries will face increasing competition in world markets

• The final issue we address in this chapter is to identify the types of goods or services for which the US can be expected to retain its comparative advantage

• We will argue that not all production is suitable for outsourcing

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• One of the first service activities to be outsourced to India was the transcription of doctor’s notes from spoken to written

• Since then other types of medical services have been outsourced and a New York Times article identified the reading of X-rays as the next area to shift overseas

• However, there are only certain types of radiology jobs that could potentially be transferred

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• The reading of X-rays is difficult and takes years of training and practice to perfect

• In a few cases, such as mammograms, it is possible that the work can be outsourced

• Firms knows as “nighthawks” already provide some outsourcing services primarily during nighttime hours Headquartered in US but have radiologists at

offshore sites These services allow smaller hospitals that cannot

afford a fulltime night radiologist

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• In many cases, the services being outsourced are not directly competing for the daytime jobs, but instead are complements to these US jobs

• Radiology is under no imminent threat from outsourcing because the profession involves decisions that cannot be codified in written rules

• The recognition of patterns cannot be simply passed onto another person or firm—work cannot be outsourced

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• In every profession there will be jobs that cannot be duplicated by someone who is not onsite

• In many manufacturing industries, the US is likely to continue to maintain some activities like R&D and marketing at home, even if a portion is shifted abroad

• Finally we should recognize that outsourcing ultimately makes the US companies involved more profitable, and therefore able to withstand foreign competition

• This allows other activities to remain in the US

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Pomp and Circumspect

• Students are often told to follow what they love, but are also taught that their futures depend on their ability to make money

• This year, however, students will be entering a labor market where they may be more successful by doing things out of an intrinsic satisfaction Designing cool things, telling stories, helping

others

• The advice of “do what you love” is becoming more meaningful

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• We have already seen last century how machines replaced humans

• This century we are seeing software having the ability to not just augment but replace humans in linear, computer-like activities

• Software is now better and faster at doing many things that humans used to do such as adding figures, processing claims, searching data, etc.

• We see accountants and lawyers losing business to tax and legal software

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• So now humans have to focus on what’s harder for a computer to do: invent, empathize, create, etc.

• Additionally, certain types of work migrate overseas such as call centers, writing computer code, etc.

• Graduates will have to draw on abilities that are more difficult to outsource. The good part is that these are typically jobs that end up more engaging

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• Finally, with the standard of living in the US, we demand a much more differentiated set of products Firms can no longer just produce the same

product over and over They must create customized and intriguing

goods and services This means graduates entering the workforce

must be able to provide those services to companies which again are usually jobs that are more fun and fulfilling

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• As technology improves, basic skills are good, but are no longer enough

• Many of the skills that employees must also have, luckily, are also those that tend to be intrinsically more gratifying

• This does not mean that doing whatever you want will necessarily lead you to a large income, but the idea of doing what you love is carrying more weight

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Conclusions

• We have studied outsourcing, a type of trade that is becoming more important Some production is shifted to another country,

while some is kept at home

• In our model of outsourcing, since unskilled labor is relatively cheaper abroad, it makes sense for Home to outsource the less skill-intensive activities to the Foreign country while keeping the more skill-intensive activities at Home

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Conclusions

• From both Home and Foreign point of view, the ratio of skilled to unskilled labor in value chain activities goes up

• A major conclusion is that an increase in outsourcing will raise the relative demand (and hence the relative wage) for skilled labor in both countries

• In our simplified model, we found that a fall in the world price of unskilled labor intensive input will lead to gains to the Home firm from outsourcing

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Conclusions

• In contrast, a fall in the price of skilled labor intensive input would lead to losses to the Home firm, compared to the prior trade equilibrium

• Such a price change is a terms of trade loss for Home, leading to losses due to the lower relative price of exports

• Although Home gains overall from outsourcing, it is still the case that competition in the input being exported by Home will make it worse off

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Conclusions

• We concluded the chapter by exploring outsourcing in service activities

• The new type of outsourcing that is getting a lot of media attention consists of higher skilled jobs performed by college educated people in countries like India

• The fact that it is not only possible to shift these activities to India, but economical to do so, shows how new technologies make possible patterns of international trade that would have been unimaginable a decade ago

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Conclusions

• We presented evidence that service outsourcing provides productivity gains, and therefore gains from trade, to the US

• For service outsourcing, it is possible that skilled workers will see a potential reduction in their wages, just as unskilled labor saw that in the 1980’s

• We still see though that the US and other industrialized countries continue to have a comparative advantage in exporting business services

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Conclusions

• One likely prediction is that the activities in the US that cannot be codified in written rules and procedures, and that benefit from face-to-face contact as well as proximity to other highly-skilled individuals in related industries, will continue to have comparative advantages

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Key Points

1. The provision of a service or the production of various parts of a good in different countries for assembly into a final good in another location is called foreign outsourcing

2. We can apply the same ideas that we developed for trade in final goods among countries to the trade of intermediate outsourced activities

3. Our model predicts that the relative demand for skilled labor increase in both countries. This explains the observation that relative wages have been increasing in the US

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Key Points

4. There are gains from outsourcing since specialization allows firms in both countries to produce a higher level of final goods. The increase in output represents a productivity gain and gains from trade

5. We showed that outsourcing does compare with the Ricardian model. India has a comparative advantage in services and therefore exports them

6. Rising productivity in India could mean a fall in the price of R&D which leads to a trade loss in the terms of trade for the US. Though the US still gains compared to no outsourcing

Documents

7 Foreign Outsourcing of Goods and Services 1 A Model of Outsourcing 2 The Gains from Outsourcing 3 Outsourcing in Services 4 Conclusions