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7 FOREIGN OUTSOURCING OF GOODS AND SERVICES 1 A Model of Outsourcing 2 The Gains from Outsourcing 3 Outsourcing in Services 4 Conclusions.

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Presentation on theme: "7 FOREIGN OUTSOURCING OF GOODS AND SERVICES 1 A Model of Outsourcing 2 The Gains from Outsourcing 3 Outsourcing in Services 4 Conclusions."— Presentation transcript:

1 7 FOREIGN OUTSOURCING OF GOODS AND SERVICES 1 A Model of Outsourcing 2 The Gains from Outsourcing 3 Outsourcing in Services 4 Conclusions

2 2 of 118 © 2008 Worth Publishers International Economics Feenstra/Taylor Introduction 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. Trade in intermediate inputs, which can cross borders several times before being incorporated into a final good. It is a relatively new phenomenon which arose with the decline in the costs of transportation and communication

3 3 of 118 © 2008 Worth Publishers International Economics Feenstra/Taylor Introduction Is outsourcing different from the type of trade we studied in the Ricardian and Heckscher-Ohlin models? Outsourcing results in lower prices, but changes the mix of jobs in the U.S. In some ways outsourcing is similar to immigration as U.S. companies can employ foreign labor although those workers still live in their own countries.

4 APPLICATION 4 of 118 © 2008 Worth Publishers International Economics Feenstra/Taylor 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? Figure 7.1 shows that U.S. trade has shifted away from agriculture and raw materials, toward manufactured goods. The share of capital, consumer, and automotive goods has increased from 10% of imports and 20% of exports in 1925 to 65% in 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.

5 APPLICATION 5 of 118 © 2008 Worth Publishers International Economics Feenstra/Taylor Is Trade Today Different From the Past? Figure 7.1 (a)

6 APPLICATION 6 of 118 © 2008 Worth Publishers International Economics Feenstra/Taylor Is Trade Today Different From the Past? Figure 7.1 (b)

7 7 of 118 © 2008 Worth Publishers International Economics Feenstra/Taylor 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 the less skilled activities and move to more complex components and then onto the more skilled labor activities.

8 8 of 118 © 2008 Worth Publishers International Economics Feenstra/Taylor A Model of Outsourcing Figure 7.2

9 9 of 118 © 2008 Worth Publishers International Economics Feenstra/Taylor A Model of Outsourcing 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.

10 10 of 118 © 2008 Worth Publishers International Economics Feenstra/Taylor A Model of Outsourcing 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 < W L and W* S < W S Additionally, we assume the relative wage of unskilled labor is lower in foreign than at home. W* L / W L and W* S / W S Remember that unskilled labor in developing countries typically receives especially low wages.

11 11 of 118 © 2008 Worth Publishers International Economics Feenstra/Taylor A Model of Outsourcing 2.Costs of Capital and Trade Must take into account extra costs of doing business in the foreign country. 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 chaina somewhat unrealistic assumption.

12 12 of 118 © 2008 Worth Publishers International Economics Feenstra/Taylor A Model of Outsourcing 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.

13 13 of 118 © 2008 Worth Publishers International Economics Feenstra/Taylor A Model of Outsourcing 4.Relative Supply and Demand for Skilled Labor For Home we graph the relative demand for skilled labor at Home, S/L against the relative wage, W S /W L 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. The relative supply curve is upward sloping because a higher relative wage for skilled labor will cause more skilled individuals to enter the industry.

14 14 of 118 © 2008 Worth Publishers International Economics Feenstra/Taylor A Model of Outsourcing Figure 7.3

15 15 of 118 © 2008 Worth Publishers International Economics Feenstra/Taylor Changing the Costs of Trade 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 to Foreign. 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. Figure 7.4

16 16 of 118 © 2008 Worth Publishers International Economics Feenstra/Taylor Changing the Costs of Trade Change in Home Labor Demand and Relative Wage The Home relative demand curve will shift right. 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.

17 17 of 118 © 2008 Worth Publishers International Economics Feenstra/Taylor Changing the Costs of Trade Home Supply Home Demand Skilled/Unskilled Labor, S/L (a) Home Country A Skilled/Unskilled Wage, W S /W L 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

18 18 of 118 © 2008 Worth Publishers International Economics Feenstra/Taylor Changing the Costs of Trade 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. On average, economic activity in Foreign is more skill intensive, so the relative demand for skilled labor increases B* The relative wage of skilled labor increases in Foreign

19 19 of 118 © 2008 Worth Publishers International Economics Feenstra/Taylor Changing the Costs of Trade 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. Compare this to the predictions from our previous models.

20 APPLICATION 20 of 118 © 2008 Worth Publishers International Economics Feenstra/Taylor Change in Relative Wages in the United States Since the early 1980s, the wages of skilled workers have risen relative to those of unskilled workers in the U.S. as well as other countries. Use data from the manufacturing sector on production (unskilled) and non-production (skilled) workers. Figure 7.6 shows the average annual earnings of non- production workers relative to production workers in U.S. manufacturing from 1958 to Figure 7.7 shows a steady increase in the ratio of non- production to production workers employed in U.S. manufacturing until the early 1990s.

21 APPLICATION 21 of 118 © 2008 Worth Publishers International Economics Feenstra/Taylor Change in Relative Wages in the United States Figure 7.6

22 APPLICATION 22 of 118 © 2008 Worth Publishers International Economics Feenstra/Taylor Change in Relative Wages in the United States Figure 7.7

23 APPLICATION 23 of 118 © 2008 Worth Publishers International Economics Feenstra/Taylor Change in Relative Wages in the United States 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.

24 APPLICATION 24 of 118 © 2008 Worth Publishers International Economics Feenstra/Taylor Change in Relative Wages in the United States Figure 7.8

25 APPLICATION 25 of 118 © 2008 Worth Publishers International Economics Feenstra/Taylor Change in Relative Wages in the United States Explanations The evidence from the manufacturing sector in the U.S. is strongly consistent with our model of outsourcing Another possible explanation is called skill-biased technological change. Increased use of computers. Which factor has had a bigger impact on wage inequality? Studies attempting to answer this question mostly focus 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.

26 APPLICATION 26 of 118 © 2008 Worth Publishers International Economics Feenstra/Taylor Change in Relative Wages in the United States One of these studies is summarized 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 U.S. manufacturing industries from 1979–1990 (part A). The second goal is to analyze the increase in relative wage of non-production labor in particular over the same period (part B). Outsourcing is measured as the intermediate inputs imported by each industry. High-technology equipment is measured as either the share of the capital stock or capital flows.

27 APPLICATION 27 of 118 © 2008 Worth Publishers International Economics Feenstra/Taylor Change in Relative Wages in the United States Table 7.1

28 APPLICATION 28 of 118 © 2008 Worth Publishers International Economics Feenstra/Taylor Change in Relative Wages in the United States Both outsourcing and high-tech equipment are important explanations for the increase in the relative wage of non-production/production labor in U.S. manufacturing. However, it is difficult to judge which is more important because the results depend on how we measure the high-tech equipment.

29 29 of 118 © 2008 Worth Publishers International Economics Feenstra/Taylor Change in Relative Wages in Mexico Our model of outsourcing predicts that the relative wage of skilled labor will rise in both countries. We have seen this for the U.S., 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 U.S.

30 30 of 118 © 2008 Worth Publishers International Economics Feenstra/Taylor Change in Relative Wages in Mexico Figure 7.9

31 31 of 118 © 2008 Worth Publishers International Economics Feenstra/Taylor Change in Relative Wages in Mexico 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. The maquiladora sector represents plants near Mexicos border with the U.S. engaged in outsourcing. For the maquiladora sector, we see real monthly income rising faster than wages for production workers, meaning a continuing rise in the relative wage of non-production (skilled) 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.

32 32 of 118 © 2008 Worth Publishers International Economics Feenstra/Taylor The Gains from Outsourcing We have shown that outsourcing can shift the relative demand for labor, and raise the wage for skilled workers; decreasing the relative wage for unskilled workers However, outsourcing reduces production costs which, in a competitive market, reduces prices so outsourcing benefits consumers. Do the overall gains outweigh the losses?

33 33 of 118 © 2008 Worth Publishers International Economics Feenstra/Taylor A Simplified Outsourcing Model Suppose there are only two activities: components production and research and development (R&D). Assume components is unskilled labor intensive. The costs of capital are equal in both activities. Compare the no-trade situation to an equilibrium with trade through outsourcing. The two kinds of labor are free to move between the two activities. Graph a production possibilities frontier (PPF) for the firm between components and R&D activitiesfigure 7.10.

34 34 of 118 © 2008 Worth Publishers International Economics Feenstra/Taylor A Simplified Outsourcing Model Production in the Absence of Outsourcing Suppose that the firm, initially, cannot engage in outsourcing. An isoquant is used to determine how much of the final good is produced. Similar to a consumers indifference curve except, instead of utility, it illustrates production of the firm. A curve along which the output of the firm is constant despite changing combinations of inputs. This isoquant is tangent to the PPF showing this is the highest amount of product that can be produced with current amounts of components and R&D.

35 35 of 118 © 2008 Worth Publishers International Economics Feenstra/Taylor A Simplified Outsourcing Model A R&D Components QRQR QCQC Y0Y0 Y1Y1 Figure 7.10 Home firm PPF No-trade Home firm equilibrium Home firm isoquants Relative price of components = (P C /P R ) A

36 36 of 118 © 2008 Worth Publishers International Economics Feenstra/Taylor A Simplified Outsourcing Model Equilibrium with Outsourcing Now suppose the firm can import and export its production activities through outsourcing. The quantity of the final good is no longer constrained by the Home PPF. Output rises to Y 1. Assume the world relative price of components is cheaper than Homes no-trade relative price. With a lower relative wage of unskilled labor in Foreign, components assembly will also be cheaper in Foreign. Home will want to outsource components, which are cheaper abroad, while Home firms will be exporting R&D, which is cheaper at Home.

37 37 of 118 © 2008 Worth Publishers International Economics Feenstra/Taylor A Simplified Outsourcing Model Figure 7.11 A R&D Components Y0Y0 Y1Y1 No-trade Home firm equilibrium C Gains from Outsourcing B World relative price of components = (P C /P R ) 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 Y 0 to Y 1 are the gains from outsourcing (P C /P R ) A Given the firms production abilities from the isoquants, we can see the firm can now produce Y 1 at C using corresponding levels of R&D and Components No-trade relative price of components = (P C /P R ) A

38 38 of 118 © 2008 Worth Publishers International Economics Feenstra/Taylor A Simplified Outsourcing Model Gains from Outsourcing Within the Firm The increase of final goods produced (Y 0 – Y 1 ) 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.

39 39 of 118 © 2008 Worth Publishers International Economics Feenstra/Taylor Terms of Trade We now need to consider the impact on a countrys terms of trade. (P EX /P IM ) Home terms of trade are (P R /P C ) 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. 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.

40 40 of 118 © 2008 Worth Publishers International Economics Feenstra/Taylor Terms of Trade Figure 7.12 R&D Components Y1Y1 C World relative price of components = (P C /P R ) W1 A B World relative price of components = (P C /P R ) W2 C Home firm exports of R&D Home firm imports of components B Home gains from trade when relative price of components falls Y2Y2 Relative price of components falls leading to a new relative world price (P C /P R ) 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 Y 2, and new use of inputs at C

41 41 of 118 © 2008 Worth Publishers International Economics Feenstra/Taylor 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 U.S. once had the comparative advantage. For example, as Indian companies like Wipro engage in more R&D, they compete directly with American companies exporting the same services. Competition can lower the world price of R&D services. A fall in the world relative price of R&D will lead to a steeper price line (P R falls). Home shifts production to point B, and by exporting R&D and importing components, moves to point C.

42 42 of 118 © 2008 Worth Publishers International Economics Feenstra/Taylor Terms of Trade Figure 7.13 R&D Components Y0Y0 Y1Y1 (P C /P R ) A (P C /P R ) W1 Home firm imports of components Home firm exports of R&D After the costs of R&D fall, the world relative price gets steeper at (P C /P R )W 3 A B World Relative Price of Components(P C /P R ) W3 The country shifts production reducing R&D and increasing Components, moving from B to B C Y3Y3 B C Terms of trade loss leads to reduced production to Y 3, and reduced exports and imports

43 43 of 118 © 2008 Worth Publishers International Economics Feenstra/Taylor 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 P R /P C. When the price of R&D falls, Home terms of trade have worsened and Home is worse off compared to initial outsourcing equilibrium. There are still Home gains from outsourcing at C as compared to the no-trade equilibrium at A.

44 APPLICATION 44 of 118 © 2008 Worth Publishers International Economics Feenstra/Taylor US Terms of Trade and Service Exports We now want to examine the evidence for the U.S. to test Samuelsons theoretical argument. Merchandise Prices Figure 7.14 shows the terms of trade for the U.S. for merchandise goods (excluding petroleum). Service Prices For trade in services such as R&D, it is very difficult to measure their prices in 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 U.S. airlines divided by the price that Americans pay on foreign airlines (shown in figure 7.14).

45 APPLICATION 45 of 118 © 2008 Worth Publishers International Economics Feenstra/Taylor US Terms of Trade and Service Exports Figure 7.14

46 APPLICATION 46 of 118 © 2008 Worth Publishers International Economics Feenstra/Taylor US Terms of Trade and Service Exports Service Prices There is no evidence to date that the falling terms of trade that Samuelson was concerned with has occurred for the U.S. Service Trade While standard prices are not available, the amounts of service exports and imports for the U.S. are collected annually. The data is shown in Table 7.2 for The fact that exports exceed imports in many categories of Table 7.2 means that the U.S. has a comparative advantage in traded services.

47 APPLICATION 47 of 118 © 2008 Worth Publishers International Economics Feenstra/Taylor US Terms of Trade and Service Exports Table 7.2

48 APPLICATION 48 of 118 © 2008 Worth Publishers International Economics Feenstra/Taylor US Terms of Trade and Service Exports The surpluses in other business services for the U.S., UK, and India since 1982 are graphed in figure 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. Indias surplus only began growing a decade later The U.S. and UK have continued to increase their surpluses in other business services even as India and other developing countries have become world competitors.

49 APPLICATION 49 of 118 © 2008 Worth Publishers International Economics Feenstra/Taylor US Terms of Trade and Service Exports Figure 7.15

50 APPLICATION 50 of 118 © 2008 Worth Publishers International Economics Feenstra/Taylor 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 U.S., 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.

51 APPLICATION 51 of 118 © 2008 Worth Publishers International Economics Feenstra/Taylor Impact of Outsourcing on US Productivity 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. Table 7.3

52 APPLICATION 52 of 118 © 2008 Worth Publishers International Economics Feenstra/Taylor Impact of Outsourcing on US 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.

53 53 of 118 © 2008 Worth Publishers International Economics Feenstra/Taylor Outsourcing in Services Outsourcing that occurred from the U.S. in the 1980s and 1990s 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 U.S. or European countries retain their comparative advantage?

54 54 of 118 © 2008 Worth Publishers International Economics Feenstra/Taylor Outsourcing in Services 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 U.S. According to the Ricardian model, India has a comparative advantage in service activities because its opportunity cost is relatively low.

55 55 of 118 © 2008 Worth Publishers International Economics Feenstra/Taylor Outsourcing in Services 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.

56 56 of 118 © 2008 Worth Publishers International Economics Feenstra/Taylor Outsourcing in Services Outsourcing Model Our first assumption was that wages in general and the relative wage of unskilled workers were lower in Foreign than in Home. Given data, we can see that the relative wage of unskilled labor is indeed lower in India than the U.S. Our second assumption was that the extra costs of capital and of 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.

57 57 of 118 © 2008 Worth Publishers International Economics Feenstra/Taylor Outsourcing in Services 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 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. This makes sense for the U.S. and Europe to engage in service outsourcing with India, where India has a comparative advantage.

58 SIDE BAR 58 of 118 © 2008 Worth Publishers International Economics Feenstra/Taylor 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 Microsofts 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.

59 SIDE BAR 59 of 118 © 2008 Worth Publishers International Economics Feenstra/Taylor Outsourcing Microsoft Windows During the non-operating hours, 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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