Effects of Outsourcing in the Ricardian Model

Andrés 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

Fragmentation

Wages

US wage

India’s wage

Point of wage equalization

Superfluous 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