Offshoring of goods and services

Week 8 | Offshoring of Goods and Services Reading: Chapter 7 1. Why do some firms shift parts of their production to other countries? 2. Who can gain when firms shift their production abroad? 3. Do countries gain overall when their firms offshore to other countries? ECON847 INTERNATIONAL TRADE 1 Introduction (1) • 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. – The term ‘offshoring’ sometimes refers to moving parts of operation to foreign subsidiaries (owned by the firm). E.g. Intel. – The term ‘foreign outsourcing’ sometimes refer to contracting out parts of operation to foreign firms (not owned by the firm). E.g. Mattel. – In this chapter, we will not worry about this distinction. ECON847 INTERNATIONAL TRADE 2 Introduction (2) • Offshoring is trade in intermediate goods. – Recall that Ricardian or HO model analyse trade in final goods. • Offshoring is a relatively new phenomenon in world trade. – The cost of transportation and communication have fallen substantially that it is now economical to combine resources of several countries to produce a good or a service. • Offshoring is similar to immigration in that firms are able to employ foreign workers, even though those workers do not have to leave their home countries. ECON847 INTERNATIONAL TRADE 3 Introduction (3) • This week, we examine in detail the phenomenon of offshoring. • First, we develop a model of offshoring. • Second, we analyse the effect of trade liberalisation on offshoring. – We also discuss how offshoring affects the demand for high-skilled and low-skilled labour and the wages. This is relevant to the current phenomenon of job polarisation (or increasing income inequality) in developed countries. • Third, we discuss gains from offshoring. – Similar to trade of final goods, offshoring creates overall gains but there are both winners and losers. • Lastly, we do some more related analyses of offshoring. ECON847 INTERNATIONAL TRADE 4 A Model of Offshoring: Value Chain (1) • First, we identify all activities involved in producing and marketing a good or a service. • This whole set of activities is called the value chain for the product, with each activity adding more value to the combined product. ECON847 INTERNATIONAL TRADE 5 A Model of Offshoring: Value Chain (2) • We line up the activities by the ratio of high-skilled/lowskilled labour used. • All these activities need not be done in one country. Which activities will be transferred to foreign countries? • We build a model below to answer this question. ECON847 INTERNATIONAL TRADE 6 A Model of Offshoring: Assumption (1) • Wages are lower in Foreign than in Home. But because lowskilled workers in Foreign earn very low wages, the relative wage of low-skilled labour to high-skilled labour is lower in Foreign that it is in Home. 𝑊𝐿∗ <𝑊𝐿 and 𝑊𝐻∗ <𝑊𝐻 𝑊𝐿∗ Τ𝑊𝐻∗ < 𝑊𝐿 /𝑊𝐻 – That is, the relative wage of high-skilled labour to low-skilled labour is higher in Home. ECON847 INTERNATIONAL TRADE 7 A Model of Offshoring: Assumption (2) • The costs of capital (e.g. costs of building a factory) and trade (e.g. communication, transportation, tariffs, etc.) apply uniformly across all the activities in the value chain. – This is of course simplification. They would vary across activities and countries in reality. – Higher capital and trade costs in Foreign can prevent a Home firm from offshoring. In making the decision, a firm will balance the savings from lower wages against the extra costs of capital and trade. ECON847 INTERNATIONAL TRADE 8 A Model of Offshoring: Slicing the Value Chain • Considering our assumption that 𝑊𝐿∗ Τ𝑊𝐻∗ < 𝑊𝐿 /𝑊𝐻 and the uniform extra costs of capital and trade across activities, it is sensible for a firm to send abroad the activities that are the least skilled-labour intensive and keep in Home the activities that are the most skilled-labour intensive. – For example, all activities to the left of A can be done in Foreign, and the rest in Home. – This transfer of activities is referred to as ‘slicing the value chain’. ECON847 INTERNATIONAL TRADE 9 A Model of Offshoring: Relative Demand for and Supply of Labour • The relative demand and supply model shows us how the relative wage of high-skilled labour to low-skilled labour (WH /WL), and their relative employment (H/L). ECON847 INTERNATIONAL TRADE 10 Fall in Foreign Costs and Offshoring (1) • We use the model built above and analyse the effect of changes in capital and trade costs on offshoring. • Suppose that capital and trade costs in Foreign fall (i.e. lower trade barriers), which makes it easier for Home firms to offshore to Foreign. – For example, countries may sign FTAs and lower tariffs; countries may eliminate regulations against FDI. ECON847 INTERNATIONAL TRADE 11 Fall in Foreign Costs and Offshoring (2) • It becomes more desirable for Home firms to shift more activities in the value chain from Home to Foreign (Slicing line from A to B). • The newly transferred activities are more skill-intensive than those formerly done in Foreign (left of A), but less skillintensive than those now done at Home (right of B). ECON847 INTERNATIONAL TRADE 12 Fall in Foreign Costs and Offshoring (3) • In Home, the relative demand for skilled labour increases. • The relative wage rises (A to B). ECON847 INTERNATIONAL TRADE 13 Fall in Foreign Costs and Offshoring (4) • In Foreign, the relative demand for skilled labour also increases. • The relative wage also rises (A* to B*). ECON847 INTERNATIONAL TRADE 14 Fall in Foreign Costs and Offshoring (5) • A fall in capital and trade costs in Foreign leads Home firms to transfer more activities to Foreign. • As activities in the middle of the value chain are shifted from Home to Foreign, they raise the relative demand for skilled labour in both countries. – It is because these activities are the least skill-intensive of those formerly done in Home, but the most skill-intensive of tasks done in Foreign. • Both countries experience an increase in the relative wage of skilled labour due to increased offshoring. ECON847 INTERNATIONAL TRADE 15 The Case of US and Mexico (1) • Our model predicts an increase in the relative wage of skilled workers in both the country doing the offshoring and the country receiving the new activities. • Indeed, 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. • We can use data from the manufacturing sector on “production” (unskilled) and “nonproduction” (skilled) workers. Why? ECON847 INTERNATIONAL TRADE 16 The Case of US and Mexico (2) • The following shows the relative wage and employment of nonproduction/product ion workers in the US manufacturing. • What do you observe? ECON847 INTERNATIONAL TRADE 17 The Case of US and Mexico (3) • The following is the scatter plot of the previous two datasets during the 1980s. – We will explore other periods during the workshop next week. • Both the relative wage and the relative employment of nonproduction, or skilled, workers rose during the 1980s, indicating that the relative demand curve must have shifted to the right. ECON847 INTERNATIONAL TRADE 18 The Case of US and Mexico (4) • One explanation for the shift in relative demand toward skilled workers is offshoring. • Another possible explanation is skill-biased technological change, the shift in relative demand toward skilled workers because of the use of high-tech equipment. • However, these two factors explain only about 50% of the rise in the relative wage of nonproduction workers during 1980s. • One other factor that may account for the shift is that production workers were laid off during the recession from 1980 to 1982, after which period firms found other ways to do the activities that these production workers used to do. ECON847 INTERNATIONAL TRADE 19 The Case of US and Mexico (5) • The following shows the relative wage of nonproduction/ production workers in the Mexican manufacturing. • Note that Mexico started lowering tariffs and became more open to FDI since 1985, and offshoring from the US to Mexico rose from 1984 to 1996 (data not shown here). • Is this consistent with the prediction of our model? ECON847 INTERNATIONAL TRADE 20 Gains from Offshoring • Offshoring generates both winners and losers. • Offshoring reduces production costs which, in a competitive market, reduces prices hence benefits consumers. • We have shown that offshoring can shift the relative demand for labour, and raise the relative wage for skilled workers. This implies that in both countries, high-skilled labour gains and low-skilled labour loses in relative terms. – It does not mean that low- (high-) skilled labour loses (gains) in absolute terms. • In the previous chapters, the Ricardian and Heckscher–Ohlin models predict that trade generate more gains than losses. Is this true for offshoring as well? ECON847 INTERNATIONAL TRADE 21 A Simplified Model of Offshoring: Setup • To answer the question, we simplify the model we built earlier. • Suppose there are only two activities: 1) component production, and 2) research and development (R&D). • Assumption 1: Each activity uses both skilled and unskilled labour. But component production is unskilled-labour intensive, and R&D is skilled-labour intensive. • Assumption 2: The costs of capital and trade are equal in both activities. • Then we want to compare the no-trade situation to another with trade through offshoring to determined if there are overall gains from trade. ECON847 INTERNATIONAL TRADE 22 A Simplified Model of Offshoring: No Trade (1) • The PPF shows the combinations of components and R&D that can be undertaken by a firm with a given amount of labour (skilled and unskilled) and capital. • An isoquant represents the combinations of components and R&D that produce the same amount of the final good. • In the absence of offshoring, the firm produces at A, using quantities of Qc of components and QR of R&D to produce the amount of Y0 of the final good. ECON847 INTERNATIONAL TRADE 23 A Simplified Model of Offshoring: No Trade (2) • The slope of the line tangent to the isoquant at A measures the value that the firm puts on components relative to R&D, or their relative price (PC/PR)A. • Note that Y1 is the amount of final good that the firm cannot produce as it lies outside its PPF of the firm. ECON847 INTERNATIONAL TRADE 24 A Simplified Model of Offshoring: Trade (1) • Suppose now the firm can import and export its production activities through offshoring. • The quantity of the final good is no longer constrained by the PPF. • Assume that the world relative price of components to R&D is cheaper than Home’s no trade relative price. – That is, it is relatively more expensive to operate component production at Home than in the rest of the world. – With a lower relative wage of unskilled labour in Foreign, component production will be cheaper in Foreign. ECON847 INTERNATIONAL TRADE 25 A Simplified Model of Offshoring: Trade (2) • In the presence of offshoring, the firm will do more R&D and less component production, at B. • The Home firm exports R&D activities and imports components at the world relative price of components, (PC/PR)W1, which is lower than its own (PC/PR)A . • The difference between Y0 and Y1 represents the gains to the Home firm from offshoring. ECON847 INTERNATIONAL TRADE 26 Gains from Offshoring (2) • The increase of final goods produced (Y1 –Y0) is a measure of the gains from offshoring to the Home firm from outsourcing. • As more of the final good is produced with the same overall amount of skilled and unskilled labour available in Home, the Home firm is more productive. • Both its production costs and the price of the final product falls (given a competitive market). This benefits consumers. • 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 overall gains from offshoring. ECON847 INTERNATIONAL TRADE 27 More Analyses on Offshoring (1) • What happens to offshoring when the world relative price of two activities changes? • Recall that a country’s terms of trade (TOT) equal the price of the country’s exports divided by the price of its imports. • Home is exporting R&D and importing components. Home’s TOT are (PR/PC)W1 . • A rise in TOT indicates that a country is either 1) getting a higher price for its exports, or 2) paying a lower price for its imports. Both benefits the country (ceteris paribus). – Conversely, a fall in TOT harms a country as it pays more for its imports and gets less for its exports. ECON847 INTERNATIONAL TRADE 28 More Analyses on Offshoring (2) • Suppose there is a fall in the relative price of component production. – e.g. Foreign companies improve productivity in components. • This rises Home’s TOT to (PR/PC)W2, flattening the world price line. • Home firm performs more R&D and less component production (B to B’). • Home firm produces more output given the same resources (C to C’). ECON847 INTERNATIONAL TRADE 29 More Analyses on Offshoring (3) • Suppose there is a fall in the relative price of R&D services. – e.g. Foreign companies gain productivity of performing R&D in which Home formerly had an advantage. • This lowers Home’s TOT to (PR/PC)W3 , compared to (PR/PC)W1, steepening the world price line. • Home firm performs less R&D and more component production (B to B’’). • Home firm produces less output given the same resources (C to C’’) – But still higher than Y0. ECON847 INTERNATIONAL TRADE 30