Effects of Outsourcing in the Ricardian Model

Andr és Rodríguez-Clare PSU

Basic Assumptions

• Two goods: computers and shoes • Two countries: US and India • One factor: labor • Productivity (MPL) in shoes is 1 in both countries • Productivity in computers is A > 1 in US and 1 in India

Equilibrium without Outsourcing

• US specializes in computers and India in shoes • Relative price of computers (price in terms of shoes), p, must be between 1/A and 1 • The wage (in terms of shoes) in India is 1 • The wage in the US is pA (w = VMPL in computers) • Note that since p > 1/A then pA > 1, which implies that the wage in US > than in India

Introducing Outsourcing

• Computers are produced from two “activities”, 1 and 2 (e.g. production and customer support) • US’s superior productivity in computers comes 1 and not 2 – For concreteness, assume that productivity in activity 2 is the same in US and India • There is an incentive for US producers to outsource activity 2 to India – cost savings • This becomes possible thanks to the IT revolution – lower communication costs

Effect of Outsourcing

• As US firms start outsourcing, they can effectively use Indian labor to produce more computers • The increased supply of computers leads to a fall in the international price p • This leads to a decline in the US wage, pA • If communication barriers fall significantly, then can have pA fall to 1, at which point wages are equalized across US and India!

Overall effects: two views

• • The positive view: Offshoring entails more trade. Since trade is good, then offshoring is good.

Mankiw: “more things are tradable than were tradable in the past, and that’s a good thing.”

Overall effects: two views

The negative view: • Fragmentation erodes the effect of location on wages, to the detriment of rich country workers.

• Hira and Hira: “Offshoring affects American workers by undermining their primary competitive advantage over foreign workers: their physical presence in the U.S.”

Overall effects: A simple model

• Both are right!

• Consider U.S. It has strong productivity advantage in some industries (why?), but many tasks within these industries could be equally performed abroad.

• Fragmentation allows U.S. firms to offshore these tasks to lower wage countries and lower costs – Productivity gains related to the gains from trade as more things become tradable.

Overall effects: A simple model

• But this allows U.S. to expand supply, leading to a deterioration of its TOT.

• Two opposite effects: productivity effect (+) and TOT effect (-).

• In the limit, as fragmentation becomes complete, TOT effect necessarily dominates and wages become equal.

Overall effects: a simple model

Wages US wage India’s wage Point of wage equalization Superfluous fragmentation Fragmentation

Overall effects in the long run

• The previous model assumed that workers released from their tasks by offshoring become employed in

production

• Instead, it could be that labor released from simple tasks allows more labor (not necessarily the same) to go into

research

Overall effects in the long run

• We have to endogeneize the determinants of productivity differences across countries.

• U.S. (rich countries) are better at doing research, and this leads to productivity advantage in many areas • Model considers allocation of workers between research and production. Offshoring affects this allocation.

Overall effects in the long run

• There is a new positive effect for U.S.: the research effect.

• For poor countries this effect is negative: by devoting more labor to simple tasks for rich countries, they reduce R&D.

– Unless “curvature,” ignore from now on • It is shown that now effect is always positive in U.S., whereas in India the positive TOT effect is exactly balanced by the negative R&D effect – Overall effect is positive thanks to a world efficiency effect • Key insight: offshoring allows U.S. to focus on its real comparative advantage, R&D

Offshoring vs Immigration

• Economic effects of immigration in this model: – Short run: immigration increases labor pool and this deteriorates TOT, with no productivity effect because immigrants are paid US wages  effect is always negative – Long run: the R&D effect offsets the TOT effect, so only effect is a “world efficiency effect,” positive in both countries • The key difference is that with offshoring, U.S. firms pay Indian wages

Overall effects: conclusion

• Short run effects can be negative for rich countries, but long run effects should always be positive. – Attitude towards offshoring would then depend on how short run costs are weighted relative to long run gains.

• For poor countries, long-run effects are positive, but less so than in the short run