Outsourcing, Productivity, and Input Composition at the Plant Level Catherine J. Morrison Paul and Mahmut Ya ş ar World Congress, Washington D.C., May 2008

Make-or-Buy “It is the maxim of every prudent master of a family, never to attempt to make at home what it will cost him more to make than to buy.” Smith (1776, pp ) “… quite apart from the question of diminishing returns the costs of organizing certain transactions within the firm may be greater than the costs of carrying out the exchange transactions in the open market.” Coase (1937, pp. 7-8)

Productivity drivers Firms’ productivity depends on their potential to minimize production costs by substituting among a variety of inputs Studies used to focus on “value added” capital and labor inputs but now recognize substitution of processed (materials) for processing (capital and labor) inputs More generally, input choices include purchasing rather than producing goods and services (implies outsourcing or subcontracting) Affects the productivity & competitiveness of outsourcing firms

Outsourcing drivers Firms would be expected to use their own inputs for activities they have a comparative advantage for and outsource others Roodhooft and Warlop (1999) A firm’s comparative advantage depends on trade, price, and technical conditions E.g., import competition from lower wage countries encourages foreign outsourcing, reducing the wages of less skilled laborers Feenstra and Hanson (1999, 2003), Hanson et al. (2005) In reverse, lower wage countries may subcontract output Both specialized tasks and lower productivity/skill processes may be outsourced to other domestic or foreign firms

Our goal We explore how outsourcing or subcontracting is related to plant productivity and input composition/substitution from the perspective of a developing country We consider the productivity effects of: domestic outsourcing, through the share of inputs that are subcontracted receiving contracts, through the share of output that is subcontracted foreign outsourcing, through the share of imported intermediate inputs represented as production frontier shifts and twists from diff shares of subcontracted inputs/outputs or imported materials and find this aspect of input choice important to recognize

Literature Outsourcing/subcontracting has not been a focus of the production literature But some studies suggest (domestic or foreign) outsourcing results if producing inputs or services in-house is at least as costly as subcontracting them Involves two types of costs production costs: labor costs, scale economies, clustering of special skills or expertise, or production smoothing transactions costs: negotiating, monitoring, and enforcing contracts, or searching for outside suppliers Also may be benefits from foreign technology transfer through outsourcing importing: R&D embodied in materials/capital imports and learning from their use (input subcontracting through input imports) FDI/exports: increased demand for exports from host country suppliers (output subcontracting)

Data: output and inputs Plant data collected by the State of Statistics in Turkey for the Annual Surveys of Manufacturing Industries International Standard Industrial Classification, Apparel & Textiles Output (Y): total value of shipments plus changes in inventories of finished goods and work-in-progress Material (M): expenditures, allowing for changes in stocks Energy (E): value of fuel+electricity Y,M and E nominal values are divided by corresponding price deflators to get constant value quantities at 1987 prices Labor input (L T and L N ): technical and administrative workers, production workers Capital (K): perpetual inventory method using gross investment data Seven regions distinguished

Data: outsourcing and technology transfer Our domestic outsourcing variables are: subcontracted input (the share of a plant’s inputs subcontracted to supplier plants, in total inputs) subcontracted output (the share of output subcontracted by other plants, in total output) Klicaslan and Taymaz (2005) Our foreign outsourcing variable is: the share of imported materials in total materials use Our foreign technology transfer variables include: the share of exports in total sales the share of foreign firm ownership (FDI)

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10 Empirical framework First look at premia/correlations for P it = performance indicators (t=time and i=plant) labor productivity (LProd), wage, employment, skilled labor, and capital intensity O/S jit (j=SUB I, SUB O, IMP M ) D=regional (r) and time (t) dummies and EMP=size Estimate:

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12 Econometric Framework We assume that the plant production function Y = f(X,r,t) can be represented by a translog approximation: where X j ( j = K,L T,L N,E,M) is the jth input, the r m include the O/S, technology transfer, characteristics and dummy variables distinguishing the plants, and  is a error term Use Olley and Pakes (OP) method to estimate

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14 SUB I Results β SUBI is positive and significant (at 10%) positive first order productivity effect of SUB I β LT,SUBI is positive and significant (at 1%) a strong positive L T bias a higher share of subcontracted inputs implies greater administrative and technical (skilled) labor intensity β LN,SUBI is significantly negative (at 5%) more SUB I is associated with less use of unskilled labor SUB I substantively affects only the labor shares all other cross-effects are insignificant The positive SUB I output elasticity is driven entirely by the positive first-order and L T effects

15 Interpretation SUB I -L T complementarity and SUB I -L N substitutability implies that subcontracting inputs reduces in-house “production” of lower-productivity and -skill activities or processes or services e.g., those provided by unskilled production line workers or janitorial workers rather than services of skilled workers e.g., legal or accounting services Perhaps because input subcontracting requires administrative and technical expertise due to greater required supervision or support of contractors.

16 SUB O Results By contrast, more SUB O implies significantly less reliance on skilled labor (L T ) implies subcontract-receiving plants are more “low-tech” SUB O is also associated with lower M levels suggests more use of lower value primary rather than processed materials but a greater energy share perhaps required for the additional processing The lower M and L T levels for subcontract-receiving plants underlie the negative SUB O output elasticity.

17 IMP M Results More IMP M also implies lower (but not sig) domestic materials and skilled labor use The only sig IMP M bias is a positive E effect The dominant effect of IMP M is therefore from the first order coefficient  IMPM imports have little effect on input composition the primarily negative input biases are too small to counteract the strong positive overall effect

18 Tech Trans Results, Linkages of trade factors with O/S vary by mechanism no significant productive relationships between SUB I and EXP, FDI, IMP M no significant productive relationships between SUB I and EXP, FDI, IMP M but effects between SUB O and trade variables are sig with EXP is negative, and with FDI and IMP M positive IMP or FDI firms do not have as low productivity as other SUB O plants, but EXP firms actually have worse productivity conversely, the productive contributions of trade factors are smaller for EXP and larger for IMP or FDI plants with SUB O a higher EXP share is associated with a lower L N share supports that internationally best practice production requires more skilled and less unskilled workers