7
FOREIGN OUTSOURCING
OF GOODS AND SERVICES
1
A Model of
Outsourcing
2
The Gains from
Outsourcing
3
Outsourcing in
Services
4
Conclusions
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
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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.
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Is Trade Today Different From the Past?
APPLICATION
• 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 2005.
• 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.
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Is Trade Today Different From the Past?
APPLICATION
Figure 7.1 (a)
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Is Trade Today Different From the Past?
APPLICATION
Figure 7.1 (b)
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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.
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A Model of Outsourcing
Figure 7.2
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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.
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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 < WL and W*S < WS
 Additionally, we assume the relative wage of unskilled
labor is lower in foreign than at home.
 W*L / WL and W*S / WS
 Remember that unskilled labor in developing countries
typically receives especially low wages.
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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 chain—a
somewhat unrealistic assumption.
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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.
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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, WS/WL 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 lessskilled 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.
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A Model of Outsourcing
Figure 7.3
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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
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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.
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Changing the Costs of Trade
Figure 7.5
(a) Home Country
Skilled/Unskilled
Wage, WS/WL
Home
Supply
Relative demand increases
because the jobs done at
home are now more skill
intensive than before.
B
The relative wage of skilled
labor increases due to
outsourcing.
A
Home
Demand
Skilled/Unskilled
Labor, S/L
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Changing the Costs of Trade
Figure 7.5
(b) Foreign Country
Skilled/
Unskilled
Wage,
W*S/W*L
Foreign
Supply
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*
A*
Foreign
Demand
The relative wage of skilled
labor increases in Foreign
Skilled/Unskilled
Labor, S*/L*
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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.
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Change in Relative Wages in the United States
APPLICATION
• 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 nonproduction workers relative to production workers in U.S.
manufacturing from 1958 to 2001.
• Figure 7.7 shows a steady increase in the ratio of nonproduction to production workers employed in U.S.
manufacturing until the early 1990s.
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Change in Relative Wages in the United States
APPLICATION
Figure 7.6
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Change in Relative Wages in the United States
APPLICATION
Figure 7.7
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Change in Relative Wages in the United States
APPLICATION
• 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 nonproduction (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.
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Change in Relative Wages in the United States
APPLICATION
Figure 7.8
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Change in Relative Wages in the United States
APPLICATION
• 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.
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Change in Relative Wages in the United States
APPLICATION
• 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.
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Change in Relative Wages in the United States
APPLICATION
Table 7.1
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Change in Relative Wages in the United States
APPLICATION
• 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.
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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.
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Change in Relative Wages in Mexico
Figure 7.9
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Change in Relative Wages in Mexico
• After 1994, the change in the relative wage of nonproduction workers in Mexico depends on whether we look
at the maquiladora sector or the non-maquiladora plants.
 The maquiladora sector represents plants near Mexico’s 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.
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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?
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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 activities—figure 7.10.
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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 consumer’s 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.
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A Simplified Outsourcing Model
Figure 7.10
R&D
Home firm PPF
Relative price of
components = (PC/PR)A
No-trade Home firm
equilibrium
QR
A
Y1
Y0
QC
Home firm
isoquants
Components
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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 Y1.
 Assume the world relative price of components is
cheaper than Home’s 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.
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A Simplified Outsourcing Model
Figure 7.11
R&D
World relative price of
components = (PC/PR)W1 No-trade relative price of
(PC/PR)A
components = (PC/PR)A
B
This means
the
firm will
Given
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When
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Before
outsourcing,
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and
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Home firm
exports of
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A
C
Y1
Y0
Gains from
Outsourcing
Components
Home firm imports of components
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A Simplified Outsourcing Model
• Gains from Outsourcing Within the Firm
 The increase of final goods produced (Y0 – Y1) 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.
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Terms of Trade
• We now need to consider the impact on a country’s
terms of trade. (PEX/PIM)
 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 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.
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Terms of Trade
Figure 7.12
R&D
World relative price of
components = (PC/PR)W2
World relative price of
components = (PC/PR)W1
This
leads
to new
Relative
price
of use of
Home
gains
from
The firm
now
exports
less
inputs
at B’,
new
production
components
falls
leading
increased
and
imports
more
at
Y
, and
new
use
of inputs
toR&D
a 2new
relative
world
production
W2
components
at
C’ (PC/PR)
price
B’
Home firm
exports of
R&D
B
C’
Y2
A
C
Home gains
from trade
when relative
Y1 price of
components
falls
Components
Home firm imports of components
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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 (PR falls).
 Home shifts production to point B′′, and by exporting R&D and
importing components, moves to point C′′.
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Terms of Trade
Figure 7.13
R&D
(PC/PR)W1
World Relative Price of
Components(PC/PR)W3
After the costs of R&D fall,
the world relative price
gets steeper at (PC/PR)W3
(PC/PR)A
B
Home firm
exports of
R&D
B”
A
C”
The country shifts production
reducing R&D and increasing
Components, moving from B
to B”
Terms of trade loss leads
to reduced production to
Y3, and reduced exports
C and imports
Y1
Y3
Y0
Components
Home firm imports of
components
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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 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 C′′ as
compared to the no-trade equilibrium at A.
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US Terms of Trade and Service Exports
APPLICATION
• We now want to examine the evidence for the U.S. to test
Samuelson’s 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).
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US Terms of Trade and Service Exports
APPLICATION
Figure 7.14
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US Terms of Trade and Service Exports
APPLICATION
• 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 2005.
 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.
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US Terms of Trade and Service Exports
APPLICATION
Table 7.2
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US Terms of Trade and Service Exports
APPLICATION
• The surpluses in “other business services” for the U.S.,
UK, and India since 1982 are graphed in figure 7.15.
• 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.
• India’s 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.
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US Terms of Trade and Service Exports
APPLICATION
Figure 7.15
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Impact of Outsourcing on US Productivity
APPLICATION
• 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.
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Impact of Outsourcing on US Productivity
APPLICATION
• Table 7.3 shows the impact of service
outsourcing, materials outsourcing, and hightechnology equipment on manufacturing
productivity measured by estimating value-added
per worker.
Table 7.3
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Impact of Outsourcing on US Productivity
APPLICATION
• 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.
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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?
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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.
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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.
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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.
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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.
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Outsourcing Microsoft Windows
SIDE BAR
• 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
Microsoft’s 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.
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Outsourcing Microsoft Windows
SIDE BAR
• 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.
© 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor
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