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Offshoring of Goods and Services
This chapter develops a theoretical model that explains offshoring and predicts how it should affect the wages of skilled workers relative to unskilled. It explains why offshoring normally should yield overall gains from trade, but that it also has distributional effects.
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 than to make or provide it domestically.
Economic Report of the President, 2004
Increasing numbers of Americans…perceive offshoring…as an actual or potential threat to their jobs or to their wages even if they hold onto their jobs.
Jagdish Bhagwati and Alan S. Blinder, 2007, Offshoring of American Jobs
The American people deserve a tax code that…lowers incentives to move jobs overseas, and lowers tax rates for businesses and manufacturers that are creating jobs right here in the United States of America. That’s what tax reform can deliver.
President Barack Obama, State of the Union address, February 12, 2013
1. Definition and examples of offshoring.
2. Trade in intermediate inputs is a fairly recent phenomenon, caused by the fall in transportation and communication costs.
3. Is offshoring different from trade in The Ricardian model or HO? Two answers:
a. No. Offshoring merely allows a company to acquire cheaper goods from abroad, just as consumers do in The Ricardian model and HO.
b. Yes, since the company can send some of its production abroad. This affects the quantity and mix of employment. Offshoring is like migration, since it allows domestic firms to employ foreign workers.
4. Objectives of chapter
a. Examine offshoring in detail and explain how it differs from trade in goods. Can it explain the increase in wages of skilled workers relative to unskilled?
b. Discuss the gains from outsourcing: Overall gains, but also redistributive effects.
c. Analyze policy responses to offshoring
If you take the battery out of your cell phone to see where the phone was produced, you will likely see several countries listed inside. Motorola, for example, is a U.S. company that produces some of its cell phones in Singapore using batteries and a battery charger made in China. Nokia is a Finnish company that produces some of its American-sold cell phones in the United States using batteries made in Japan and software that was written in India. Apple produces its iPhone in facilities found in China, Taiwan, Thailand, Malaysia, Singapore, South Korea, the Czech Republic, Philippines, and the United States. A vast array of products, including simple toys like the Barbie doll and sophisticated items like airplanes and personal computers, consist of materials, parts, components, and services that are produced in numerous countries. The following excerpt from a New York Times article illustrates this observation:1
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General Electric in the United States and Snechma of France…jointly manufacture the jet engine for Boeing’s 737 and Airbus’s 320. G.E. makes the “hot section” at its plant in Cincinnati, while Snechma manufactures the giant fans in France. They ship these components to each other and each partner does the final assembly of the engines for its customers. In addition, G.E. makes smaller jet engines for the commuter planes that Bombardier makes in Canada and Embraer makes in Brazil. The engines are exported to those countries, but 24 percent of the value of the engines comes from components imported from Japan.
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, offshoring. We will not worry about the subtle distinction between these two terms in this chapter (see Side Bar: “Foreign Outsourcing” Versus “Offshoring”); we’ll use “offshoring” because it has become most commonly used by economists.2
Emphasize that offshoring is a consequence of falling trade costs.
Offshoring is a type of international trade that differs from the type of trade analyzed in the Ricardian and Heckscher-Ohlin models; the goods traded in those models were final goods. Offshoring 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. Offshoring is a relatively new phenomenon in world trade.3 The amount of world trade relative to the GDPs of countries was high even in the late nineteenth and early twentieth centuries. But it is unlikely that a good would have crossed borders multiple times at several stages of production because the costs of transportation and communication were too high. Today, however, these costs have fallen so much that it is now economical to combine the labor and capital resources of several countries to produce a good or service. Indeed, if you have ever called for help with your laptop, chances are that you have spoken with someone at a call center in India, which shows just how low the costs of communication have become!
The key insight
Is offshoring different from the type of trade examined in the Ricardian and Heckscher-Ohlin models? From one point of view, the answer is no. Offshoring 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 quote from the Economic Report of the President at the beginning of the chapter suggests: with offshoring we import those goods and services that are cheaper to produce abroad. From another point of view, however, offshoring is different. Companies now have the opportunity to send a portion of their activities to other countries. The jobs associated with those activities leave the United States, and by paying lower wages abroad, U.S. firms lower their costs and pass on these savings to consumers. Offshoring results in lower prices but changes the mix of jobs located in the United States. Higher-skilled workers in the United States, engaged in activities such as marketing and research, will be combined with less skilled workers abroad, engaged in assembling products. In a sense, offshoring 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.
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Offshoring occurs when a domestic company retains ownership of its operations, but moves them overseas. Foreign outsourcing occurs when the domestic firm allows its products to be produced abroad by foreign firms that it does not own.
In discussions of foreign outsourcing, we often hear the term “offshoring.” The quote from the Economic Report of the President at the beginning of the chapter combined these terms as “offshore outsourcing.” Is there a difference between “foreign outsourcing” and “offshoring”?
The term “offshoring” is sometimes used to refer to a company moving some of its operations overseas but retaining ownership of those operations. In other words, the company moves some operations offshore but does not move production outside of its own firm. Intel, for example, produces microchips in China and Costa Rica using subsidiaries that it owns. Intel has engaged in foreign direct investment (FDI) to establish these offshore subsidiaries.
Mattel, on the other hand, arranges for the production of the Barbie doll in several different countries. Unlike Intel, however, Mattel does not actually own the firms in those countries. Furthermore, Mattel lets these firms purchase their inputs (like the hair and cloth for the dolls) from whichever sources are most economical. Mattel is engaging in foreign outsourcing as it contracts with these firms abroad but has not done any FDI.
Dell is an intermediate case. Dell assembles its computers overseas in firms it does not own, so it is outsourcing rather than offshoring the assembly. However, Dell exercises careful control over the inputs (such as computer parts) that these overseas firms use. Dell outsources the assembly but monitors the overseas firms closely to ensure the high quality of the computers being assembled.
In this chapter, we will not worry about the distinction between “offshoring” and “foreign outsourcing”; we’ll use the term “offshoring” whenever the components of a good or service are produced in several countries, regardless of who owns the plants that provide the components or services.
The first goal of this chapter is to examine in detail the phenomenon of offshoring and describe in what ways it differs from trade in final products. We discuss how offshoring affects the demand for high-skilled and low-skilled labor and the wages paid to those workers. Since the early 1980s, there has been a significant change in the pattern of wage payments in the United States and other countries—the wages of skilled workers have been rising relative to those of less skilled workers. We examine whether this change in relative wages is the result of offshoring or whether there are other explanations for it.
A second goal of the chapter is to discuss the gains from offshoring. We argue that offshoring creates gains from trade, similar to those seen from the trade of final goods in the Ricardian or Heckscher-Ohlin models. But having overall gains from trade for a country does not necessarily mean that every person in the country gains. As the second quote at the beginning of the chapter shows, many workers are fearful that their jobs and wages are threatened by offshoring. We focus attention on how offshoring affects high-skilled versus low-skilled workers.
A third goal of the chapter is to examine the response to offshoring in the United States. The final quotation at the beginning of the chapter, from the 2013 State of the Union address by President Obama, indicates that he proposes to limit tax breaks to companies engaged in offshoring. Many economists would disagree with this proposal, and argue instead that offshoring has overall benefits. We examine these arguments and also discuss the newest trend of “inshoring” activities back into the United States.
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