Foreign Outsourcing of Goods and Services PDF

WORLD ECONOMICS Chapter 7: Foreign outsourcing of goods and services Marc Arza 2023-2024 1of 57  Foreign outsourcing of goods and services Aims The objective of this chapter is to analyze the o...

WORLD ECONOMICS Chapter 7: Foreign outsourcing of goods and services Marc Arza 2023-2024 1of 57  Foreign outsourcing of goods and services Aims The objective of this chapter is to analyze the outsourcing process by comparing it with the theories of trade of final goods. The analysis will predict wages’ variation and the distribution between skilled and unskilled workers. We will also measure the gains from outsourcing. Finally, we present a more recent phenomenon as outsourcing of services. References Feenstra, Robert C. and Alan M. Taylor, International Trade, Economics, MacMillan, 2017, Fourth Edition. 2of 57  Foreign outsourcing of goods and services 1. Introduction 2. A Model of Outsourcing 3. Effect of Outsourcing on Relative Wages 4. Outsourcing of Services 3of 57  Foreign outsourcing of goods and services 1. Introduction 2. A Model of Outsourcing 3. Effect of Outsourcing on Relative Wages 4. Outsourcing of Services 4of 57  Foreign outsourcing of goods and services  In this chapter, we’ll try to explain a yet different type of trade: trade in intermediate goods or inputs.  Remember the Barbie doll? 5of 57  Foreign outsourcing of goods and services  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 outsourcing.  Services, and not only manufacturing, are also increasingly being outsourced.  Main idea: Firms save on production costs by importing parts or components (intermediate goods) that are produced abroad more cheaply.  Could be contracted out to other firms abroad (outsourcing) or produced in foreign subsidiaries of the firm (offshoring or the phenomenon of vertical multinationals).  Either way the effects are the same. 6of 57  Foreign outsourcing of goods and services  Outsourcing is different from other trading ways as Ricardo or Heckscher-Ohlin model?  It shares some similarities but it has also some specificities.  Outsourcing lowers prices and changes employment composition.  Is outsourcing different from immigration models?  In some ways yes because firms can hire foreign labor, but in this case the workers are still living in their countries of origin. 7of 57  Foreign outsourcing of goods and services  Is current trade different from that of some years ago?  The composition of trade has changed as share of agricultural products has decreased over time:  90% of imports in 1925 to less than 25% in 1990.  at the same period of time exports fell from 80% to 35%.  Which are the reasons of this change? These are goods (agricultural) where outsourcing is not profitable.  Instead, outsourcing has increased in capital goods and consumer goods.  What has changed about the weight of these goods in terms of imports and exports?  Imports have increased from 10% in 1925 to 50% in 1990.  Exports have increased from 15% in 1925 to 50% in 1990.  Therefore, the type of trade has changed. 8of 57 Foreign outsourcing of goods and services 9of 57 Foreign outsourcing of goods and services 10of 57  Foreign outsourcing of goods and services 1. Introduction 2. A Model of Outsourcing 3. Effect of Outsourcing on Relative Wages 4. Outsourcing of Services 11of 57  Foreign outsourcing of goods and services  To develop the model of outsourcing, we need to distinguish all the activities (the so-called value-chain) used to produce a good or service. 12of 57  Foreign outsourcing of goods and services Value chain Trade costs Example: Mexico Example: Job polarization  How value chain works?  Each activity adds more value to the final product.  Some of the activities can be transferred to other countries if production is cheaper there.  We can previously decide activities that are more likely to be produced abroad according to various assumptions. 13of 57  Foreign outsourcing of goods and services Value chain Trade costs Example: Mexico Example: Job polarization Assumption 1 Relative wage of skilled workers  Foreign wages for unskilled and skilled workers are less than those at Home: W*L < W L and W*S < W S  Relative wage of unskilled labor is lower in Foreign than at Home: W*L / W*S < W L / W S 14of 57  Foreign outsourcing of goods and services Value chain Trade costs Example: Mexico Example: Job polarization Assumption 2 Capital, transportation and trade cost  Besides labor, firms that do outsourcing face other costs in the foreign location (capital costs, transportation and trade costs). We’ll assume these extra costs apply uniformly across all the activities in the value chain and across all sectors. 15of 57  Foreign outsourcing of goods and services Value chain Trade costs Example: Mexico Example: Job polarization Assumption 3 Outsourcing  So based on the previous assumptions, if firms can do outsourcing, they will decide to outsource the most unskilled-labor intensive activities abroad and keep the skilled labor intensive activities at Home  So, firms segment the value chain. Outsourcing 16of 57  Foreign outsourcing of goods and services Value chain Trade costs Example: Mexico Example: Job polarization  Suppose the costs of trade in Foreign fall --for ex. because Home and Foreign sign a free trade agreement that eliminates tariffs between the two countries (e.g., NAFTA agreement between Mexico and U.S.).  Lower trade costs makes it easier for Home to outsource to Foreign. Thus Home firms have an incentive to shift more activities in the value chain to Foreign 17of 57  Foreign outsourcing of goods and services Value chain Trade costs Example: Mexico Example: Job polarization  The dividing line in the value chain shifts right.  The activities shifted to Foreign are less skill-intensive than the ones left at Home. Thus, the relative demand for skilled labor at Home will increase.  But by the same logic, the relative demand for skilled labor at Foreign will also increase!  So the relative demand for skilled labor rises in both countries along with the relative wage (see next figure). 18of 57  Foreign outsourcing of goods and services Value chain Trade costs Example: Mexico Example: Job polarization (a) Home Country Skilled/Unskilled Relative demand increases Wage, W S/WL because the jobs done at Home Supply home are now more skill intensive than before. B The relative wage of skilled A labor increases due to outsourcing. Home Demand Skilled/Unskilled Labor, S/L 19of 57  Foreign outsourcing of goods and services Value chain Trade costs Example: Mexico Example: Job polarization (b) Foreign Country Skilled/ The activities outsourced to Unskilled Foreign Wage, Foreign are more skill intensive Supply W*S/W*L so the relative demand for skilled labor increases B* The relative wage of skilled A* labor increases in Foreign Foreign Demand Skilled/Unskilled Labor, S*/L* 20of 57  Foreign outsourcing of goods and services Value chain Trade costs Example: Mexico Example: Job polarization  Consequences? Home Foreign Skill level Ratio S/L Ratio W S/W L 21of 57  Foreign outsourcing of goods and services Value chain Trade costs Example: Mexico Example: Job polarization  Since the early 1980s, the wages of skilled workers have risen relative to those of unskilled workers in the U.S., but also in the U.K and other industrialized countries.  At the same time, relative employment of skilled workers also increased.  How is this possible?  Can outsourcing be responsible for this? 22of 57  Foreign outsourcing of goods and services Value chain Trade costs Example: Mexico Example: Job polarization Wages of non-production (skilled) workers to production (unskilled) workers 23of 57  Foreign outsourcing of goods and services Value chain Trade costs Example: Mexico Example: Job polarization Relative employment of non-production to production workers 24of 57  Foreign outsourcing of goods and services Value chain Trade costs Example: Mexico Example: Job polarization The simultaneous increase in relative wages and relative employment of skilled workers is only possible by an outward shift of the relative demand curve 25of 57  Foreign outsourcing of goods and services Value chain Trade costs Example: Mexico Example: Job polarization  As seen, outsourcing can lead to an increase in the relative demand for skilled labor.  The evidence from the manufacturing sector in the U.S. is strongly consistent with our model of outsourcing –ie., the trade in intermediate inputs increased during that period.  However, another possible explanation is the increased use of personal computers in the workplace during that time. (This is called skill-biased technological change).  This would also cause an increase in the relative demand for skilled labor as workers who knew how to use them (skilled) would be needed.  There have been many empirical studies attempting to answer this question. However, it is difficult to judge which one (skill-biased technological change or outsourcing) is more important. 26of 57  Foreign outsourcing of goods and services Value chain Trade costs Example: Mexico Example: Job polarization  Our outsourcing model predicts an increase in relative wages of skilled workers in both countries.  The relative wage (S/L) of Mexico for the period 1964-1994 seems to follow the same trend as the U.S.. 27of 57  Foreign outsourcing of goods and services Value chain Trade costs Example: Mexico Example: Job polarization  1994: NAFTA was created and, therefore, tariffs between the U.S. and Mexico were reduced.  After 1994, change in relative wages has been industry specific.  For the maquilas, there was an increase in the relative wages of skilled labor.  The maquilas are manufacturing activities located near the U.S.- Mexico border closely related to outsourcing.  For the rest of the manufacturing sector in Mexico, the relative wage of skilled workers declined after 1994. 28of 57  Foreign outsourcing of goods and services Value chain Trade costs Example: Mexico Example: Job polarization Complicated patterns are observed recently in the US that cannot be explained by the offshoring model we have just learnt:  During the 1990s, the relative wage of nonproduction workers continued to rise, as it did during the 1980s, but their relative employment fell.  The pattern became erratic during 2000–05, when the relative wage sometimes fell and the relative employment rose.  During 2006–12 both the relative wage and employment rose again, and then relative employment fell in 2013–14. 29of 57  Foreign outsourcing of goods and services Value chain Trade costs Example: Mexico Example: Job polarization Relative Wage and Employment of Nonproduction Workers 1990–2014 This diagram shows the wage and employment of nonproduction workers relative to production workers in U.S. manufacturing. While relative wage of nonproduction workers rose in U.S. manufacturing from 1990–99 (red dots), their relative employment fell. The pattern became erratic during 2000–05 (green dots), when the relative wage sometimes fell and relative employment rose. From 2006– 12 (purple dots) the relative wage and relative employment once again increased at the same time, and then relative employment fell in 2013–14 (orange dots). 30of 57  Foreign outsourcing of goods and services Value chain Trade costs Example: Mexico Example: Job polarization Change in Employment Shares by Occupational Wage Percentile The horizontal axis organizes 326 U.S. occupations from the percentile of occupations paying the lowest averages wages (on the left) to the percentile paying the highest wages (on the right). For each of these wage percentiles, we plot the change in the employment share of workers in those occupations for the periods 1979–89, 1989–99, and 1999–2007. From 1989– 99 and 1999–2007, the occupations with the lowest wages and with the highest wages had increasing employment shares, and the occupations in the middle had falling employment 31of 57 shares.  Foreign outsourcing of goods and services Value chain Trade costs Example: Mexico Example: Job polarization The phenomenon in previous figure is job polarization, which occurs when the employment shares of jobs with the lowest wages and jobs with the highest wages increase, while the employment share of jobs with wages in the middle has fallen. The complicated pattern is consistent with the recent change that the nonroutine (manual or cognitive) experiences employment growth, while the routine jobs experiences less growth or even employment decline. 32of 57  Foreign outsourcing of goods and services Value chain Trade costs Example: Mexico Example: Job polarization Growth in Employment by Type of Occupation The horizontal axis arranges occupations into four groups: nonroutine manual jobs; routine manual jobs; routine cognitive jobs; and nonroutine cognitive jobs. For each of these groups, we plot the growth rate of employment over the periods 1983–2000 (red bars), 2001–07 (green bars), and 2008–14 (purple bars). 33of 57  Foreign outsourcing of goods and services 1. Introduction 2. A Model of Outsourcing 3. Effect of Outsourcing on Relative Wages 4. Outsourcing of Services 34of 57  Foreign outsourcing of goods and services  The process of outsourcing can shift the relative demand for labor and increase the wage of skilled workers.  Since the salary of unskilled workers is the reciprocal of the one of skilled workers, this implies that outsourcing will decrease the relative wages of unskilled workers.  However, outsourcing reduces production costs and, therefore, lowers the price in a competitive marketplace benefiting the consumers.  We will compare the losses of certain groups (unskilled workers) with gains of other groups (skilled workers and consumers). 35of 57  Foreign outsourcing of goods and services A simplified model of outsourcing Terms of Trade  Let’s start with the analysis when no outsourcing is done (no-trade equilibrium) and then see how countries can benefit from outsourcing (in the trade-equilibrium).  Assumptions:  there are only two activities that use skilled and unskilled labor:  Production of components: unskilled labor intensive  Research and development (R&D): skilled labor intensive  labor moves freely between the two activities.  capital costs are identical in the two activities.  We can show the PPF (production possibility frontier) for a firm of R&D and components.  The curve show the PPF mix of skilled and non-skilled labor used by a firm in the production of each good.  The displacement along the PPF shows the opportunity cost.  We compare the situation in autarky equilibrium with respect to trade through outsourcing... 36of 57  Foreign outsourcing of goods and services A simplified model of outsourcing Terms of Trade Figure 7.10: Home PPF in the absence of outsourcing R&D Home firm PPF Relative price of components = (PC/PR)A No-trade Home firm equilibrium QR A Y1 Home firm Y0 isoquants QC Components 37of 57  Foreign outsourcing of goods and services A simplified model of outsourcing Terms of Trade Figure 7.11: Equilibrium with outsourcing This means Given When thefirm the the firms firm will production outsources, R&D Before export abilities R&D fromoutsourcing, and the import Home isoquants, World relative price of they now starts face at A, the the world no-trade components = (PC/PR)W1 No-trade relative price of Components. we canprice relative see the of The firm can nowat components (PC/PR)A equilibrium. increase in They production can only Bconsume and use Ya at Cmix 1new using of inputs components = (PC/PR)A use from Y what to corresponding Y they are have the levels of R&D based on 0 the 1new world price gains and from outsourcing Components B Home firm No-trade Home firm exports of equilibrium R&D A C Y1 Gains from Outsourcing Y0 Components Home firm imports of components 38of 57  Foreign outsourcing of goods and services A simplified model of outsourcing Terms of Trade  Equilibrium with Outsourcing  The new equilibrium occurs at point B, where the world relative price is tangent to the PPF.  The Home firm undertakes more R&D and less component production, moving from point A to point B.  Also, starting at B, the Home firm exports R&D and imports components, moving along the relative price line to point C.  Notice that with the same amount of skilled and unskilled labor, thanks to outsourcing the Home firm can now produce more output! 39of 57  Foreign outsourcing of goods and services A simplified model of outsourcing Terms of Trade  Gains from Outsourcing Within the Firm  The increase of final goods produced (Y1 – Y0) is a measure of the gains from outsourcing to the Home firm → The Home firm is now more productive.  Equivalently, the firm’s costs of production must be lower: Home firm becomes more competitive and it can pass this drop in costs onto consumers in the form of lower prices.  … but what happens with terms of trade? 40of 57  Foreign outsourcing of goods and services A simplified model of outsourcing Terms of Trade Figure 7.12 World relative price of components = (PC/PR)W2 This leads Relative to new price of use of Home The firmgains now from exports less R&D inputs at B’, components new falls production leading increased World relative price of toR&D at Y a 2newand , and imports new relativeuse more of inputs world production components components = (PC/PR)W1 at C’ (PC/PR) price W2 B’ Home firm B exports of R&D C’ Y2 A C Home gains from trade when relative Y1 price of components falls Components 41of 57 Home firm imports of components  Foreign outsourcing of goods and services A simplified model of outsourcing Terms of Trade  Situation 1: Fall in the Price of Components  As Home imports components and exports R&D, a fall in the relative price of components implies an improvement on its terms of trade.  As we see in Figure 7.12, other things equal, Home is better off when its terms of trade improve. 42of 57  Foreign outsourcing of goods and services A simplified model of outsourcing Terms of Trade Figure 7.13 (PC/PR)W1 World Relative Price of After the costs of R&D fall, Components(PC/PR)W3 the world relative price R&D gets steeper at (PC/PR)W 3 The country shifts production (PC/PR)A reducing R&D and increasing Components, moving from B to B” B B” Terms of trade loss leads Home firm to reduced production to exports of Y3, and reduced exports R&D A C and imports C” Y1 Y3 Y0 Components Home firm imports of 43of 57 components  Foreign outsourcing of goods and services A simplified model of outsourcing Terms of Trade  Terms of Trade at the US and exports of services:  The exports are higher than imports in many categories (2013, $ millions), which implies that the U.S. has comparative advantage in services. 44of 57  Foreign outsourcing of goods and services A simplified model of outsourcing Terms of Trade  Terms of Trade at the US and exports of services:  The trade surplus in other business services, computer and information services and financial services has increased since the 1970s in the US and UK (In India two decades later).  US and UK surplus continued to increase even when the number of competitors has increased worldwide.  Future? It is possible that in a decade or two, India exceeds US... 45of 57  Foreign outsourcing of goods and services 1. Introduction 2. A Model of Outsourcing 3. Effect of Outsourcing on Relative Wages 4. Outsourcing of Services 46of 57  Foreign outsourcing of goods and services  In the 1980s and 1990s outsourcing used to occur in manufacturing.  However, today outsourcing in business services is increasingly important. Examples:  Accounting firms outsourced.  Customer service of flight companies, computer firms, etc. outsourced.  Technical assistance –computer debugging.  Some of these outsourcing done in less developed countries such as India, South Africa, etc.  Is this consistent with our model of outsourcing? 47of 57 Foreign outsourcing of goods and services 48of 57  Foreign outsourcing of goods and services  Revision: Outsourcing Model  Assumption 1: relative wage of unskilled workers is lower in a less developed country (such as India) than in a developed country (such as the U.S.) - OK.  Given data, we can see that the relative wage of unskilled labor is lower in India than say the U.S. 49of 57  Foreign outsourcing of goods and services  Revision: Outsourcing Model  Assumption 2: the extra costs of capital and of trade in the less developed countries spread uniformly over all the activities in the value chain and across all sectors – not OK.  The costs of outsourcing relatively unskilled manufacturing activities to India are much greater than the costs of outsourcing skilled service activities.  Communication infrastructure is very good in India and they have a large number of well-educated individuals who speak English, while physical infrastructure (roads, etc.) is not too good.  Thus, it makes sense for the U.S. and other developed countries to engage in service outsourcing with India → According to the Ricardian model, India has a comparative advantage in service activities. 50of 57 Foreign outsourcing of goods and services 51of 57  Foreign outsourcing of goods and services Key points (i) 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 or offshoring. We can apply the same ideas that we developed for trade in final goods among countries to the trade of intermediate offshored activities. For instance, if low-skilled labor is relatively inexpensive in the Foreign country, then the activities that are least skill-intensive will be offshored there, and Home will engage in the activities that are more skill-intensive. We can also predict what happens to relative wages of skilled labor when there is a change in trading costs and more offshoring. Our model predicts that the relative demand for skilled labor increases in both countries. This result helps to explain the observation that the relative wage of nonproduction/production workers increased both in the United States and in Mexico during the 1980s. 52of 57  Foreign outsourcing of goods and services Key points (ii) During the 1990s and into the 2000s, the changes in labor demand in the US / EU became more complex, due to the phenomenon of job polarization. Employment has increased for both low-paying and high- paying jobs, but fallen for jobs with mid-level wages. The explanation for these changes is that nonproduction jobs that are routine are more likely to be offshored or replaced by computers, and these jobs pay a mid-level of wages. There are gains from offshoring (the specialization of countries in different production activities allows firms in both countries to produce a higher level of final goods). That increase in output represents a productivity gain due to offshoring. But the extent of gain is reduced when Foreign exports more of the same good that Home is exporting. With service offshoring, it is possible that a country like India will have rising productivity in activities in which US / EU has comparative advantage, such as R&D. Rising productivity in India would lead to a fall in the price of R&D, which is a terms-of-trade loss for the US / EU. For that reason, US / EU could lose due to service offshoring, though it still gains as compared with a situation of no offshoring at all. 53of 57