2 The Gains from Offshoring

We have shown that offshoring can shift the relative demand for labor and therefore raise the relative wage for skilled workers. Because the relative wage for low-skilled workers is the reciprocal of the high-skilled relative wage, it falls in both countries. High-skilled labor gains and low-skilled labor loses in relative terms. On the other hand, the ability of firms to relocate some production activities abroad means that their costs are reduced. In a competitive market, lower costs mean lower prices, so offshoring benefits consumers. Our goal in this section is to try to balance the potential losses faced by some groups (low-skilled labor) with the gains enjoyed by others (high-skilled labor and consumers). Our argument in previous chapters on the Ricardian and Heckscher-Ohlin models has been that international trade generates more gains than losses. Now we have to ask whether the same is true for offshoring.

One answer to this question comes from a surprising source. The Nobel laureate Paul Samuelson has been among the foremost proponents of global free trade, but in 2004 he had the following to say about the gains from foreign outsourcing:10

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:

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?

Simplified Offshoring Model

To understand Samuelson’s comments, we can use a simplified version of the offshoring model we have developed in this chapter. Instead of having many activities involved in the production of a good, suppose that there are only two activities: components production and research and development (R&D). Each of these activities uses high-skilled and low-skilled labor, but we assume that components production uses low-skilled labor intensively and that R&D uses skilled labor intensively. As in our earlier model, we assume that the costs of capital are equal in the two activities and do not discuss this factor. Our goal will be to compare a no-trade situation with an equilibrium with trade through offshoring, to determine whether there are overall gains from trade.

Suppose that the firm has a certain amount of high-skilled (H) and low-skilled (L) labor to devote to components and R&D. It is free to move these workers between the two activities. For example, scientists could be used in the research lab or could instead be used to determine the best method to produce components; similarly, workers who are assembling components can instead assist with the construction of full-scale models in the research lab. Given the amount of high-skilled and low-skilled labor used in total, we can graph a production possibilities frontier (PPF) for the firm between components and R&D activities, as shown in Figure 7-9. This PPF looks just like the production possibilities frontier for a country, except that now we apply it to a single firm. Points on the PPF, such as A, correspond to differing amounts of high-skilled and low-skilled labor used in the components and R&D activities. Moving left from point A to another point on the PPF, for example, would involve shifting some high-skilled and low-skilled labor from the production of components into the research lab.

Production in the Absence of Offshoring

Now that we have the PPF for the firm, we can analyze an equilibrium for the firm, just as we have previously done for an entire economy. Suppose initially that the firm cannot engage in offshoring of its activities. This assumption means that the component production and R&D done at Home are used to manufacture a final product at Home: it cannot assemble any components in Foreign, and likewise, it cannot send any of its R&D results abroad to be used in a Foreign plant.

The two production activities are used to produce a final good. To determine how much of the final good is produced, we can use isoquants. An isoquant is similar to a consumer’s indifference curve, except that instead of utility, it illustrates the production of the firm; it is a curve along which the output of the firm is constant despite changing combinations of inputs. Two of these isoquants are labeled as Y₀ and Y₁ in Figure 7-9. The quantity of the final good Y₀ can be produced using the quantity Q_C of components and the quantity Q_R of R&D, shown at point A in the figure. Notice that the isoquant Y₀ is tangent to the PPF at point A, which indicates that this isoquant is the highest amount of the final good that can be produced using any combination of components and R&D on the PPF. The quantity of the final good Y₁ cannot be produced in the absence of offshoring because it lies outside the PPF. Thus, point A is the amount of components and R&D that the firm chooses in the absence of offshoring or what we will call the “no-trade” or “autarky” equilibrium for short.

Through the no-trade equilibrium A in Figure 7-9, we draw a line with the slope of the isoquant at point A. The slope of the isoquant measures the value, or price, that the firm puts on components relative to R&D. We can think of these prices as internal to the firm, reflecting the marginal costs of production of the two activities. An automobile company, for example, would be able to compute the extra labor and other inputs needed to produce some components of a car and that would be its internal price of components P_C. Similarly, it could compute the marginal cost of developing one more prototype of a new vehicle, which is the internal price of R&D or P_R. The slope of the price line through point A is the price of components relative to the price of R&D, (P_C/P_R)^A, in the absence of offshoring.11

Equilibrium with Offshoring Now suppose that the firm can import and export its production activities through offshoring. For example, some of the components could be done in a Foreign plant and then imported by the Home firm. Alternatively, some R&D done at Home can be exported to a Foreign plant and used there. In either case, the quantity of the final good is no longer constrained by the Home PPF. Just as in the Ricardian and Heckscher-Ohlin models, in which a higher level of utility (indifference curve) can be obtained if countries specialize and trade with each other, here a higher level of production (isoquant) is possible by trading intermediate activities.

We refer to the relative price of the two activities that the Home firm has available through offshoring as the world relative price or (P_C/P_R)^W1. Let us assume that the world relative price of components is cheaper than Home’s no-trade relative price, (P_C/P_R)^W1 < (P_C/P_R)^A. That assumption means the Home firm can import components at a lower relative price than it can produce them itself. The assumption that (P_C/P_R)^W1 < (P_C/P_R)^A is similar to the assumption we made in the previous section, that the relative wage of low-skilled labor is lower in Foreign, W^*_L/W^*_H <W_L/W_H. With a lower relative wage of low-skilled labor in Foreign, the components assembly will also be cheaper in Foreign. It follows that Home will want to offshore components, which are cheaper abroad, while the Home firm will be exporting R&D (i.e., offshoring it to Foreign firms), which is cheaper at Home.

The Home equilibrium with offshoring is illustrated in Figure 7-10. The world relative price of components is tangent to the PPF at point B. Notice that the world relative price line is flatter than the no-trade relative price line at Home. The flattening of the price line reflects the lower world relative price of components as compared with the no-trade relative price at Home. As a result of this fall in the relative price of components, the Home firm undertakes more R&D and less component production, moving from point A to point B on its PPF.

Starting at point B on its PPF, the Home firm now exports R&D and imports components, moving along the relative price line to point C. Therefore, through offshoring the firm is able to move off of its PPF to point C. At that point, the isoquant labeled Y₁ is tangent to the world price line, indicating that the maximum amount of the final good Y₁ is being produced. Notice that this production of the final good exceeds the amount Y₀ that the Home produced in the absence of offshoring.

Gains from Offshoring Within the Firm The increase in the amount of the final good produced—from Y₀ to Y₁—is a measure of the gains from trade to the Home firm through offshoring. Using the same total amount of high-skilled and low-skilled labor at Home as before, the company is able to produce more of the final good through its ability to offshore components and R&D. Because more of the final good is produced with the same overall amount of high-skilled and low-skilled labor available in Home, the Home company is more productive. Its costs of production fall, and we expect that the price of its final product also falls. The gains for this company are therefore spread to consumers, too.

For these reasons, we agree with the quote about offshoring at the beginning of the chapter: “When a good or service is produced more cheaply abroad, it makes more 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 offshoring. That is our first conclusion: when comparing a no-trade situation to the equilibrium with offshoring, and assuming that the world relative price differs from that at Home, there are always gains from offshoring.

To see how this conclusion is related to the earlier quotation from Samuelson, we need to introduce one more feature into our discussion. Rather than just comparing the no-trade situation with the offshoring equilibrium, we need to also consider the impact of offshoring on a country’s terms of trade.

Terms of Trade

As explained in Chapters 2 and 3, the terms of trade equal the price of a country’s exports divided by the price of its imports. In the example we are discussing, the Home terms of trade are (P_R/P_C)^W1, because Home is exporting R&D and importing components. A rise in the terms of trade indicates that a country is obtaining a higher price for its exports, or paying a lower price for its imports, both of which benefit the country. Conversely, a fall in the terms of trade harms a country because it is paying more for its imports or selling its exports for less.

In his paper, Samuelson contrasts two cases. In the first, the Foreign country improves its productivity in the good that it exports (components), thereby lowering the price of components; in the second, the Foreign country improves its productivity in the good that Home exports (R&D services), thereby lowering that price. These two cases lead to very different implications for the terms of trade and Home gains, so we consider each in turn.

Fall in the Price of Components Turning to Figure 7-11, let the Home country start at the equilibrium with offshoring shown by points B and C. From that situation, suppose there is a fall in the relative price of component production. That price might fall, for instance, if the Foreign country improves its productivity in components, thereby lowering the price paid by Home for this service. Because components are being imported by Home, a fall in their price is a rise in the Home terms of trade, to (P_R/P_C)^W2. Let us trace how this change in the terms of trade will affect the Home equilibrium.

Because of the fall in the relative price of components, the world price line shown in Figure 7-11 becomes flatter. Production will shift to point B′, and by exporting R&D and importing components along the world price line, the firm ends up at point C′. Production of the final good at point C′ is Y₂, which exceeds the production Y₁ in the initial equilibrium with offshoring.12 Thus, the Home firm enjoys greater gains from offshoring when the price of components falls. This is the first case considered by Samuelson, and it reinforces our conclusions that offshoring leads to overall gains.

Fall in the Price of R&D We also need to consider the second case identified by Samuelson, and that is when there is a fall in the price of R&D services rather than components. This is what Samuelson has in mind when he argues that offshoring might allow developing countries, such as India, to gain a comparative advantage in those activities in which the United States formerly had comparative advantage. As Indian companies like Wipro (an information technology services company headquartered in Bangalore) engage in more R&D activities, they are directly competing with American companies exporting the same services. So this competition can lower the world price of R&D services.

In Figure 7-12, we reproduce Figure 7-10, including the Home no-trade equilibrium at point A and the Home production point B with offshoring. Starting at point B, a fall in the world relative price of R&D will lead to a steeper price line (because the slope of the price line is the world relative price of components, which increases when P_R falls). At the new price (P_C/P_R)^W3, 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 Y₁ to Y₃. Therefore, the fall in the price of R&D services leads to losses for the Home firm. To explain where the losses are coming from, notice that Home is exporting R&D and importing components in the initial offshoring equilibrium (points B and C), so its terms of trade are the price of R&D divided by the price of components (P_R/P_C). With the fall in the price of R&D, the Home terms of trade have worsened, and Home is worse off compared with its initial offshoring equilibrium. Samuelson’s point is that the United States could be worse off if China or India becomes more competitive in, and lowers the prices of, the products that the United States itself is exporting, such as R&D services. This is theoretically correct. Although it may be surprising to think of the United States being in this position, the idea that a country will suffer when its terms of trade fall is familiar to us from developing-country examples (such as the Prebisch-Singer hypothesis) in earlier chapters.

Furthermore, notice that final output of Y₃ is still higher than Y₀, the no-offshoring output. Therefore, there are still Home gains from offshoring at C″ as compared with the no-trade equilibrium at A. It follows that Home can never be worse off with trade as compared with no trade. Samuelson’s point is that a country is worse off when its terms of trade fall, even though it is still better off than in the absence of trade. With the fall in the terms of trade, some factors of production will lose and others will gain, but in this case the gains of the winners are not enough to compensate the losses of the losers. Our simple model of offshoring illustrates Samuelson’s point.

The offshoring that occurred from the United States in the 1980s and the 1990s often concerned manufacturing activities. But today, the focus is frequently one of the newer forms of offshoring, the offshoring of business services to foreign countries. Business services are activities such as accounting, auditing, human resources, order processing, telemarketing, and after-sales service, like getting help with your computer. Firms in the United States are increasingly transferring these activities to India, where the wages of educated workers are much lower than in the United States. This is the sort of competition that Samuelson had in mind when he spoke of China and India improving their productivity and comparative advantage in activities that the United States already exports. The next application discusses the magnitude of service exports and also the changes in their prices.