Foreign Outsourcing of Goods and Services - Notes | ECN 160A, Study notes of Economics

Download Foreign Outsourcing of Goods and Services - Notes | ECN 160A and more Study notes Economics in PDF only on Docsity! Lecture 6 (ch 6) One facet of increased services trade is the increased use of offshore outsourcing, in which a company relocates labor-intensive service-industry functions to another country. When a good or service is produced more cheaply abroad, it makes more sense to import it rather than to make or provide it domestically. Economic Report of the President, 2004 Foreign Outsourcing of Goods and Services The provision of a service 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 more simply Outsourcing. Outsourcing is trade in intermediate inputs , which can sometimes cross borders several times before being incorporated into a final good that can be sold domestically or abroad. Is outsourcing different from the type of trade examined in the Ricardian and Heckscher- Ohlin models? From one point of view, the answer is no: outsourcing allows a company to purchase inexpensive goods or services abroad, just as consumers can purchase lower- priced goods from abroad in the Ricardian and Heckscher-Ohlin models. This is what the above quote from the Economic Report of the President suggests: with outsourcing we import those goods and services that are cheaper to produce abroad. From another point of view, however, outsourcing is different. Companies now have the opportunity to send a portion of their activities to other countries. The jobs associated with that portion leave the United States, and by paying lower wages abroad, U.S. firms lower their costs and pass on these savings to consumers. Outsourcing results in lower prices, but changes the mix of jobs located in the U.S.: higher skilled workers in the U.S., engaged in activities like marketing and research, will be combined with less-skilled workers abroad, engaged in assembling products. In a sense, outsourcing is similar to immigration, in that U.S. firms are able to employ foreign workers, even though those workers do not have to leave their home countries. Three goals of this chapter: 1. See how outsourcing affects the demand for skilled and unskilled labor and their wages. 2. Discuss the gains from outsourcing. 3. Examine the newest form of outsourcing, the outsourcing of business services to foreign countries. This involves the movement overseas of skill-intensive activities rather than unskilled activities. Wage Patterns in the United States 1 Skilled and Unskilled workers: Two methods for classification: 1- Education: school dropout, high school graduates, 16 or more years of education 2- Type of work: production” and “nonproduction” workers  Production workers are involved in the manufacture and assembly of goods, whereas nonproduction workers are involved in supporting service activities.  Generally, nonproduction workers require more education, and so we will treat these workers as “skilled,” while the production workers are treated here as “unskilled” workers. Earnings patterns:  By Education: Real wages of full-time U.S. workers between1979 and 1995, Fell by 20% for high school dropouts Fell by 13%, for high school graduates (with no further education) Rise by 3% for workers with 16 or more years of education Rise by 14% for those with 18 or more years of education o So you can see that a “wage gap” developed between the earnings of the “unskilled” workers  By type of work: see Figure 6.2. o This diagram shows the average wage of non-production workers divided by the average wage of production workers (analogous to the ratio of skilled to unskilled wages, which we define later as WS/WL), in U.S. manufacturing. o The figure shows the relative wage of production, or unskilled, workers fell during the 1980s and 1990s. Figure 6.2: Relative Wage of Non-production/Production Workers, U.S. Manufacturing Why the relative wages of unskilled workers fell? two possibilities: 2 Figure 6.9: Change in the Relative Demand for Skilled/Unskilled Labor With greater outsourcing from Home to Foreign, some of the less-skilled activities 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. The relative demand for skilled labor in Foreign also increases, because the activities shifted to Foreign are more skill-intensive than those formerly done there. It follows that the relative wage for skilled labor in Foreign also rises, from point A* to point B*. Two Explanations: What factors can lead to an increase in the relative demand for skilled labor? 1- skill-biased technological change.  With the appearance of personal computers in the 1980’s employers started to substitute skilled for unskilled workers leading to an increase in demand for skilled workers 2- International Trade  The 1980s was also a time of increasing imports into the United States.  The HO model predicts that rising imports in one industry will lead to a fall in demand for all factors of production in that industry and that after some time these factors will be employed elsewhere in an economy.  In other words, HO predicts between-industry movements in factors of production, from those industries losing comparative advantage to others that are gaining comparative advantage.  But the shift in relative demand toward skilled labor shown in Figure 6.4 holds not only for all manufacturing industries in the U.S. but also within many manufacturing industries, and even within individual firms: firms have been substituting away from unskilled labor and toward skilled labor, even as skilled labor is becoming relatively more expensive.  There is no explanation in the Heckscher-Ohlin model (or the Ricardian model) for this kind of within-industry shift in labor demand. Outsourcing 5  There may be other reasons related to international trade that can explain this shift; outsourcing is one such reason.  The ability to “break apart” the production process, and do the unskilled-intensive activities abroad, is what outsourcing allows firms to do.  The ability to outsource is another explanation for the rising relative wage of skilled labor in the United States, and other countries.  Want to predict which activities are likely to be transferred abroad. A Model of Outsourcing Order of production: activities in the order in which they are performed Ranked by skill: activities in the order they are of the amount of skilled/unskilled labor used in each Figure 6.6: The Value-Chain of a Product Assumptions On wages: WL*< WL , WS*< WS, and WL */WS*< WL/WS, relative wage of unskilled labor is lower in Foreign that at Home On Capital and Trade costs Extra costs of capital and of trade apply uniformly across all the activities in the value chain, that is, these extra costs add, say, 10% to each and every component of operation in Foreign as compared to Home. 6 Extra cost of capital like higher prices to build a factory or higher prices for utilities such as electricity and fuel in foreign country Extra cost of trade like extra costs involved in transportation and communication which will be especially high if Foreign is still developing roads, ports and telephone capabilities; and the extra costs due to tariffs if Foreign imposes taxes on goods (such as component parts) when they come into the country. We will lump together the last two factors together into what we call “trade costs.” Which activities will be transferred?  Home firms send the most unskilled-labor intensive activities abroad and to keep the more skilled-labor intensive activities at Home.  In Figure 6.6, all activities to the left of the vertical line A might be done in Foreign.  We can refer to this transfer of activities as slicing the value chain. Relative Demand and Supply of Skilled Labor:  For home country add up the demand for skilled labor S and unskilled labor L for all the activities to the right of line AA for Home.  Taking the ratio of these, we graph the relative demand for skilled labor at Home, S/L against the relative wage, WS/WL.  This 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.  Similarly for Foreign country  In each country, we can add a relative supply curve to the diagram.  Relative supply curve is upward sloping because a higher relative wage for skilled labor will cause more skilled individuals to enter this industry - individuals will invest more in equipping themselves with the skills necessary to earn the higher relative wage.  A and A* are the equilibrium relative wage in this industry in each country, and the equilibrium relative employment of skilled/unskilled workers.  Starting at these points, we will next study how the equilibrium changes as Home outsources more activities to the Foreign country. Changing the Costs of Trade  Suppose now that the costs of capital or trade in Foreign fall. o e.g., NAFTA lowered tariffs charged on goods crossing the U.S.-Mexico border. => lower trade costs => makes e it easier for U.S. firms to outsource to Mexico. o Another example is India, which in 1991 eliminated many regulations that had been hindering both businesses and communications, and also allowed more foreign investment. These changes made India more attractive to foreign investors and firms interested in outsourcing.  With lower trade costs it is now desirable to shift more activities in the value- chain from Home to Foreign. 7 o compare no-trade situation to an equilibrium with trade through outsourcing, to determine whether or not there are overall gains from trade o Suppose that the firm has a certain amount of skilled (S) and unskilled (L) labor to devote to components and R&D. It is free to move these workers between the two activities. o Given the amount of skilled and unskilled labor used in total, we can graph a production possibility frontier (PPF) for the firm between components and R&D activities, as shown in Figure 6.11. o This PPF looks just like the production possibilities frontier for a country, except that now we apply it to a single firm. Figure 6.11: No-Trade Equilibrium at Home The PPF shows the combinations of components and R&D that can be undertaken by a firm with a given amount of labor and capital. In the absence of outsourcing the firm produces at A, with the quantities QC1 of components and QR1 of R&D. The amount Y1 of the final good is produced. The line tangent to the isoquant through point A measures the value that the firm puts on components relative to R&D, or their relative price, (PC/ PR)A. The amount Y2 of the final good cannot be produced in the absence of outsourcing, because it lies outside the PPF for the firm. Equilibrium with Outsourcing: Suppose: (PC/PR) W < (PC/PR) A The world relative price of QC is cheaper than Home’s no-trade relative price. => the Home firm can import components at a lower relative price than it can produce them itself. The assumption that (PC/PR) W < (PC/PR) A is similar to the assumption that the relative wage of unskilled labor is lower in Foreign, W*L/W*S < WL/WS. 10 With a lower relative wage of unskilled labor in Foreign, then components assembly will also be cheaper there. It follow that Home will want to outsource components, which is cheaper abroad, while Foreign firms will outsource the skilled-intensive activity, R&D, which is cheaper at Home. Then according to H-O model = => we expect that Home country to export QR (skilled-labor-intensive intermediate input) and import QC (unskilled labor-intensive intermediate input). Gains from Outsourcing Within the Firm:  Increase in Y from Y1 to Y2 – is a measure of the gains from trade to the Home firm through outsourcing.  same total amount of resources + outsourcing = => more final good  => higher productivity => lower production costs => lower price of Y  =>consumer gain  Thus: “When a good or service is produce more cheaply abroad, it makes sense to import it than to make or provide it domestically.”  In our example, component production is cheaper in Foreign than in Home, so Home imports components from Foreign.  There are overall gains from outsourcing. That is our first conclusion: 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.  To see how this conclusion we need to consider the impact of outsourcing on a country’s terms of trade. Figure 6.12: International Trade Equilibrium at Home 11 In the presence of outsourcing the firm will do more R&D and less component production, producing at point B. The Home firm then exports R&D and imports components, moving to point C. At point C the amount Y2 of the final good is produced. The difference between Y1 and Y2 represents the gains to the Home firm from outsourcing. If the price of components falls, then the Home firms will shift to B' and C', with even greater gains. Possibility of making a loss o The Nobel laureate Paul Samuelson: o Most noneconomists are fearful when an emerging China or India, helped by their still low real wages, outsourcing and miracle export-led developments, cause layoffs from good American jobs. This is a hot issue now, and in the coming decade, it will not go away. Prominent and competent mainstream economists enter in the debate to educate and correct warm-hearted protestors who are against globalization. Here is a fair paraphrase of the argumentation that has been used recently… Yes, good jobs may be lost here in the short run. But still total U.S. net national product must, by the economic laws of comparative advantage, be raised in the long run (and in China, too). The gains of the winners from free trade, properly measured, work out to exceed the losses of the losers… Correct economic law recognizes that some American groups can be hurt by dynamic free trade. But correct economic law vindicates the word “creative” destruction by its proof that the gains of the American winners are big enough to more than compensate the losers. Does this paraphrase by Samuelson sound familiar? You can find passages much like it in this chapter and earlier ones: saying that the gains from trade exceed the losses. But listen to what Samuelson says next: The last paragraph can be only an innuendo. For it is dead wrong about [the] necessary surplus of winnings over losings… So Samuelson seems to be saying that the winnings for those who gain from trade do not necessarily exceed the losses for those who lose. How can this be? His last statement seems to contradict much of what we have learned in this book. Or does it? Fall in the Price of R&D:  Starting at point B, a fall in relative world price of R&D (PC/PR)W ↓=> steeper price line (PR/PC)W.  At the new prices Home shifts production to point B', and by exporting R&D and importing components, moves to point C'.  Notice that final output has fallen from Y2 to Y3. Therefore, the fall in the price of R&D services leads to losses for the Home firm.  Samuelson’s point is that U.S. could be worse off if China or India becomes more competitive in, and lowers the prices of, the products that the U.S. itself is exporting. 12 6.4 Outsourcing in Services The outsourcing of skilled service activities seems to violate the prediction of our outsourcing model. Why does the model fail when skilled services are outsourced? The brief answer is that the assumptions we made in the outsourcing model are not satisfied when comparing the U.S. and India. Let us examine these assumptions one at a time. 1. Our first assumption was that Foreign wages are less than those at Home, and in addition, that the relative wage of unskilled labor is lower in Foreign that at Home. That assumption holds true for the U.S. and India. Certified public accountants earn $15,000 in India and $75,000 annually in the U.S., so the high-skill U.S. wage is five times higher. But the gap for less skilled workers is much greater. Indian wages for entry level call center employees in urban areas is $2,400 per year, whereas in the U.S. entry level call center employees earn at least $24,000 per year, a wage that is 10 times higher. 2. Our second assumption in the outsourcing model was that the extra costs of capital and of trade in Foreign were spread uniformly over all the activities on the value chain. But this second assumption does not hold in India. The costs of outsourcing relatively unskilled manufacturing activities to India are much greater than the costs of outsourcing skilled service activities. That is in part because manufacturing requires transporting component parts to India, which has a poor transportation infrastructure: ships are frequently delayed at ports and roads are clogged. Policy makers in India are well aware of these difficulties, which have limited their ability to engage in manufacturing outsourcing, as their neighbor China has done. Indeed, in an attempt to encourage other countries to outsource their manufacturing there, India is now proposing free trade zones (i.e. government subsidized areas not subject to regular customs restrictions) which encourage foreign firms to outsource with Indian manufacturing. We can view the creation of free trade zones as decreasing the trade costs associated with manufacturing outsourcing. These zones have been very successful in China at promoting manufacturing exports, particularly in the coastal regions which have better access to shipping routes. Service activities, on the other hand, do not rely as much on transportation but instead require reliable and cheap communication. The communication infrastructure is very good in India, where cell phone charges are less than in the U.S. and Europe. In addition, India has a large number of well-educated individuals who speak English, and is in a time zone that is 12 hours different from the Eastern time zone in the U.S., which can be an advantage for performing some service activities. All these aspects create a compelling logic for firms in the U.S. and Europe to engage in service outsourcing with India, where India has a comparative advantage. Until trade and capital costs across industries are similar as assumed by our outsourcing model, India will continue to have a comparative advantage in performing service activities, not manufacturing activities. Appendix What can explain increasing wage inequality in US? 15 Since the early 1980’s the wage of skilled relative to unskilled workers in U.S has increased. Is this because of Trade with NIC’s? Is this related to the growth of exports of manufacturing goods of NIC’s and a move toward FPE? There is skepticism based on 4 observations: 1- According to H-O a K-abundant country such as U.S is expected to export K- intensive goods. This would increase r and decrease w. If so then we should observe (R.K/GDP)↑ and (W.L/GDP)↓. But there has been no change in the distribution of income of K and L. 2- According to SS-Theorem, an increase in the price of skilled intensive good leads to an increase in the wage rate of skilled labor PS-INT↑ =>WS↑. But there is no clear evidence of a rise in the relative price of skilled intensive goods. 3- If increase in the price of skilled intensive good was the reason for an increase in the skilled-unskilled wage gap in U.S. then we should have observe the reverse in unskilled labor abundant countries such as China PS-INT↑ =>WS↓. That is with an increase in the price of unskilled intensive goods the skilled-unskilled wage gap in China should have decreased but this in fact has increased in NIC’s. 4- Trade of advanced countries with NIC’s is a small share of total spending in advanced countries. P C /P S SS (W L /W S )W (W L /W S ) (W L /W S )* (P C /P S ) (P C /P S )*(P C /P S )W 16 Non-traded goods and the Harrigan empirical observation Movement in wages over 1980s and 1990s are – not correlated with trade prices (PT) or outsourcing, – but rather with non-traded goods (PNT): – i.e. there is a sharp increase in the price of skilled intensive non-traded goods in the U.S.: WS↑ as PS-NT↑ – as well as a decrease in the price of unskilled-intensive non-traded goods. – WL↓ as PL-NT↓ - This finding poses a challenge to the idea that either trade or technology is responsible for the changes in wages. Price of NT Skilled-intensive goods ↑ Price of NT Unskilled-intensive goods ↓ = = > this cannot be because of trade or technology (because ∆W is correlated with PNT and not with PT) = = > something else is going on unrelated to international trade 17