8 F-T CH7 Ouitsourcing

7/29/2019 8 F-T CH7 Ouitsourcing

1/43

OUTSOURCING OF GOODS PRODUCTION

AND SERVICES

1A Model ofOutsourcing

2The Gains from

Outsourcing3

Outsourcing inServices

4Conclusions


2/43

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 intermediateinputs, often implying that the domestic firm retrains ownership in theoperation that produces the part abroad.

Outsourcing is often used when U.S. firms employ workers located inforeign countries to provide services in the US

71% of American voters believe that outsourcing jobs overseas hurt theeconomy while another 62% believed that the U.S. government shouldimpose some legislative action against companies that transfer domestic jobsoverseas. (Zogby International poll, August 2004)

1 Introduction


3/43

1 Introduction

1) First, we develop a model of offshoring to see howoffshoring affects the activities of the firm.

- analyze the impact of offshoring on the demandand relative wage of workers at home and abroad.

- examine the gains from offshoring, how it

affects relative prices and the terms of trade, andultimately how it affects both firms and workers.


4/43

1 A Model of Offshoring

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.

Value Chain of Activities


5/43


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.

Value Chain of Activities


6/43


Model Assumptions PART I Foreign wages are lower than those at Home

W*L < WLand W*H< WH.

Skill premium in the Home country is higher, so that therelative wage of high-skilled labor is lower in Foreign

W*L/W*H< WL/WH.


7/43

Relative Demand and Supply for Skilled Labor

FIGURE 7-2

In panel (a), we show the relative demand

and supply for skilled labor at Home, H/L,

depending on the relative wage, WH/WL.

The equilibrium relative wage at Home is

determined at A.

In panel (b), we show the relative demand

and supply for skilled labor in Foreign,

H*/L*, depending on the relative wage,

W*H/W*L.

The Foreign equilibrium is at point A*.

Relative Demand and Supply for Skilled/Unskilled Labor



8/43


Model Assumptions PART II

Costs of Capital and TradeTo ship intermediate goods across countries is costly, soour offshoring model introduces transportation / setup /information costs

In making the decision to offshore, a firm must balancethe savings from lower wages against the extra costs ofcapital and trade.


9/43


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-intensiveactivities 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


10/43


Reoptimizing the Value Chain when Trade Costs Change

Example1: Trade Costs Fall in the ForeignFIGURE 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 ofA) (but still less skill-intensive than the activities done at

Home (to the right ofB)).


11/43


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.


12/43


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 laborin 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*.


13/43


Effect of Decreased Trade Costs: Summary

Both countries experience an increase in the relativewage of skilled labor due to increased outsourcing.

activities in the middle of the value chain are shiftedfrom Home to Foreign,

they raise the relative demand for skilled labor inboth countries

skill-intensive activities from home move toForeign to become the most skill intensiveactivities there

The relative demand for skilled labor rises in bothcountries along with the relative wage.


14/43

FIGURE 7-5

APPLICATION

Change in Relative Wages in the United States

Relative Wage of Nonproduction/Production Workers, U.S. Manufacturing This diagramshows 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.

Relative Wage of Nonproduction Workers


15/43

FIGURE 7-6

APPLICATION


Relative Employment of Nonproduction/Production Workers, U.S. Manufacturing Thisdiagram 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.

Relative Employment of Nonproduction Workers


16/43

APPLICATION


Explanations

-Outsourcing

-More high tech inputs in production (computers)

- skill-biased technological change.

-How do we distinguish between the two?


17/43

APPLICATION

Outsourcing

measured as the intermediate inputs imported byeach industry.

High-technology equipment

measured as

% of high tech capital in total capital.

% of new capital investment that is devoted tocomputers and other high-tech devices.


18/43

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 wasexplained by outsourcing. So it was outsourcing, not the existing high tech capital that increases relative wages inthe Us

high-tech investment explains 37% of the increase in the share of wage payments going to skilled workers. Ofcourse it could be that outsourcing has changed the way US firms invest.


19/43

APPLICATION


20/43

APPLICATION

Change in Developing Countries

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


21/43

2 The Gains from Offshoring

The model predicted changes in the relative wage, sowe have again winners and losers from offshoring.

Can we identify if winners can compensate losers, or inother words if there are net gains from trade?

we must balance potential losses faced by unskilledlabor with the gains enjoyed by skilled labor andconsumers.

In the previous chapters, the Ricardian and Heckscher-Ohlin models generate more gains than losses. Is thistrue for outsourcing?


22/43

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, todetermine gains from trade.


23/43


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, itillustrates 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 ofcomponents and R&D.


24/43


R&D

Figure 7.10

A

Components

QR

QC

Y0

Home firm PPF

No-trade Home firmequilibrium

No Trade price ofcomponents = (PC/PR)

A

No-trade Isoquant


25/43


Equilibrium with Outsourcing

Now suppose the firm can import and export its production activitiesthrough 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 Homesno-trade relative price.

With a lower relative wage of unskilled labor in Foreign, componentsassembly 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.

A

Components

QR

QC

Y0

Y1

Home firm PPF

No-trade Home firm

equilibrium

Home firm

isoquants

Relative price of

components = (PC/PR)A

A

Components

QR

QC

Y0

Y1

Home firm PPFHome firm PPF

No-trade Home firm

equilibrium

No-trade Home firm

equilibrium

Home firm

isoquants

Home firm

isoquants

Relative price of


Relative price of



26/43

A Simplified Outsourcing ModelFigure 7.11

A

R&D

Components

Y0

Y1

No-trade Home firmequilibrium

C

Gains fromOutsourcing

B

World relative price ofcomponents = (PC/PR)

W1

Home firm imports of components

Home firmexports ofR&D

Before outsourcing, Homestarts at A, the no-tradeequilibrium. They can onlyuse what they have

When the firm outsources,they now face the worldrelative price of components atB and use a new mix of inputsbased on the new world price

This means the firm willexport R&D and importComponents. Theincrease in productionfrom Y0 to Y1 are thegains from outsourcing

(PC/PR)A

Given the firms productionabilities from the isoquants,we can see the firm can nowproduce Y1 at C usingcorresponding levels of R&Dand Components


27/43


Gains from Outsourcing Within the Firm

The increase of final goods produced (Y0 Y1) is a measure ofthe gains from trade to the Home firm from outsourcing.

Because more of the final good is produced with the sameoverall amount of skilled and unskilled labor available inHome, 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)


28/43

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 pricefor 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 becomesbetter at R&D


29/43

Favorable Terms of Trade

R&D

Components

Y1

C


W1

A

B


W2

C


Home firm imports of components

B

Home gainsfrom tradewhen relativeprice of

componentsfalls

Y2

Relative price of

components falls leadingto a new relative worldprice (PC/PR)

W2

The firm now exports lessR&D and imports morecomponents

Home gains fromincreasedproduction

This leads to new use of

inputs at B, new productionat Y2, and new use of inputsat C


30/43

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, theycompete 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.


31/43

Terms of Trade

R&D

Components

Y0

Y1

(PC/PR)A

(PC/PR)W1

Home firm imports ofcomponents


After the costs of R&D fall,

the world relative pricegets steeper at (PC/PR)W

3

A

B

World Relative Price ofComponents(PC/PR)

W3

The country shifts productionreducing R&D and increasingComponents, moving from Bto B

C

Y3

B

C

Terms of trade loss leadsto reduced production toY3, and reduced exportsand imports


32/43

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 Cas compared to theno-trade equilibrium at A.


33/43

US Terms of Trade and Service ExportsFigure 7.15


34/43

3 The Politics and Future of Offshoring

How to Destroy American Jobs

HEADLINES

Deep in the president's budget released Monday-in Table S-8 on page161-appear a set of proposals headed "Reform U.S. International Tax

System." If these proposals are enacted, U.S.-based multinational firmswill face $122.2 billion in tax increases over the next decade.

"Leveling the Playing Field: Curbing Tax Havens and Removing TaxIncentives for Shifting Jobs Overseas."

This is simply wrong. These tax increases would not create

American jobs, they would destroy them.


35/43


How to Destroy American Jobs

HEADLINES

When parent firms based in the U.S. hire workers in their foreign affiliates, the skills andoccupations 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


36/43


HEADLINES

Boeing Outsourcing: Too much of a good thing.


37/43


HEADLINESBoeing Outsourcing: Too much of a good thing.

f Off


38/43


HEADLINESWhich part of a Boeing is still built by Boeing?

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

3 Th P liti d F t f Off h i
http://www.huffingtonpost.com/2011/01/20/a-wing-and-a-prayer-outso_n_811498.htmlhttp://www.huffingtonpost.com/2011/01/20/a-wing-and-a-prayer-outso_n_811498.htmlhttp://www.huffingtonpost.com/2011/01/20/a-wing-and-a-prayer-outso_n_811498.htmlhttp://www.huffingtonpost.com/2011/01/20/a-wing-and-a-prayer-outso_n_811498.htmlhttp://www.huffingtonpost.com/2011/01/20/a-wing-and-a-prayer-outso_n_811498.htmlhttp://www.huffingtonpost.com/2011/01/20/a-wing-and-a-prayer-outso_n_811498.htmlhttp://www.huffingtonpost.com/2011/01/20/a-wing-and-a-prayer-outso_n_811498.htmlhttp://www.huffingtonpost.com/2011/01/20/a-wing-and-a-prayer-outso_n_811498.htmlhttp://www.huffingtonpost.com/2011/01/20/a-wing-and-a-prayer-outso_n_811498.htmlhttp://www.huffingtonpost.com/2011/01/20/a-wing-and-a-prayer-outso_n_811498.htmlhttp://www.huffingtonpost.com/2011/01/20/a-wing-and-a-prayer-outso_n_811498.htmlhttp://www.huffingtonpost.com/2011/01/20/a-wing-and-a-prayer-outso_n_811498.html


39/43


HEADLINES

Boeing Outsourcing: Too much of a good thing.

As Boeing dramatically increased outsourcing around the globe, aircraft parts no longerfit 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 productionlogjams 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 detailedblueprints created at home, Boeing gave suppliers less detailed specifications andrequired them to create their own blueprints. Some then farmed out theirengineering to their own subcontractors At least one major supplier didn't even have an engineering department when itwon its contractno surprise components dont fit together.


40/43

40 of 52Copyright 2011 Worth Publishers International Economics Feenstra/Taylor, 2/e.

Chapter7:OffshoringofGo

odsandServices



41/43


Outsourcing

HEADLINES



42/43


Outsourcing and Insourcing

HEADLINES: Baldwin

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

well as outsource to other countries.
http://www.voxeu.org/index.php?q=node/2792http://www.voxeu.org/index.php?q=node/146http://www.voxeu.org/index.php?q=node/146http://www.voxeu.org/index.php?q=node/146http://www.voxeu.org/index.php?q=node/146http://www.voxeu.org/index.php?q=node/2792


43/43

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 allowsfirms to slice the value chain and produce cheap components

abroad and focus on R&D at home.

Documents

8 F-T CH7 Ouitsourcing