Why do they JUST DO IT?

A theory of outsourcing and working conditions

Alejandro Donado∗

University of Heidelberg

Abstract

Nike and other brand companies have long been the target of widespread crit-

icism for outsourcing their manufacturing production to contract factories with

dismal working conditions. Despite the overwhelming amount of public interest,

there exists no theory for studying this topic. The current paper fills this gap. In

the model, the most productive firms in the North make high profits and outsource

their manufacturing production to contract factories in the South. Factories pay

wages that can compensate for poor working conditions, but these wages might not

cover for workers’basic needs. The paper studies an extension under which factory

workers are not appropriately compensated for inferior working conditions.

JEL: F16, J81, F23, F12, J31, F66, J83.

Keywords: Outsourcing, working conditions, compensating wage differentials, labor

standards, subcontracting, Nike, sweatshop.

∗University of Heidelberg, Department of Economics, Bergheimer Str. 58, 69115 Heidelberg, Germany.

(e-mail: alejandro.donado@awi.uni-heidelberg.de). I would like to thank Hartmut Egger, Thomas Eife,

and participants at several workshops and conferences for helpful comments and suggestions.

1 Introduction

In 1997, an audit report revealed poor working conditions at one of Nike’s contract

factories. The factory, located in Vietnam, employed around 10,000 workers and produced

400,000 pair of shoes per month. According to the report, factory workers were exposed

to excessive heat, noise, dust, and toxic fumes. Exposure to some carcinogens even

exceeded by 171 times Vietnamese legal standards. An estimate suggested that more than

77% of the workers were suffering from respiratory diseases. Some of the contributing

causes included inadequate ventilation systems, an understaffed medical room, insuffi cient

protective equipment, and lack of training for workers on occupational health and safety.

In addition, the report found that workers were required to work more hours than the

legal limit and were only paid $10 a week.1

This was neither the first nor the last time that Nike had been accused of outsourc-

ing production to contract factories operating under poor working conditions. But this

report was different. It was not one of the many documents from human rights or labor

groups that had been criticizing Nike’s practices for several years. This was a report

commissioned by Nike itself, and it was prepared by the prominent accounting firm Ernst

& Young. The report was meant to be for Nike’s internal use only, until it leaked to the

media on November 1997, attracting significant press coverage and further damaging the

company’s image (see Greenhouse 1997).

Nike’s business model consists in designing, developing, marketing, and selling the

products, but the actual manufacturing process is outsourced to independent contract

factories located in low-cost countries. In the fiscal year 2012-13, the company employed

1See Ernst & Young (1997). Despite the very serious findings, this report has been criticized for not

being comprehensive enough (see O’Rourke 1997).

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around 48,000 people directly and more than one million people indirectly at 789 contract

factories. Despite the criticisms, the business model has been very successful and has

transformed Nike from a small-scale importer of Japanese shoes to the world’s leader in

athletic footwear, apparel, and equipment. Nike’s gross profits have increased steadily

and surpassed the 12 billion mark in 2014.2

But Nike is by no means the only company that has been accused of benefiting from

exploitative working conditions in developing countries. Other targeted companies in-

clude many brand names such as Reebok, Gap, Mattel, Levi Strauss, Adidas, H&M,

Apple, etc.3 The typical accusations are that workers in the contract factories are forced

to work overtime, under poor working conditions, and for less than the living wage. These

accusations raise several questions. In particular, why do profitable brand companies like

Nike outsource their manufacturing production to contract factories operating under poor

working conditions? Why are working conditions poor in those factories? And why are

factory wages not high enough to cover for workers’basic needs?

The main contribution of this paper is to provide a positive theory of outsourcing and

working conditions that can be used to address these questions. The paper develops an

analytically tractable framework that embeds a compensating-wage-differentials model à

la Rosen (1974, 1987) into the global sourcing model of Antràs and Helpman (2004). The

model consists of two countries, the technologically advanced North and the South. Only

northern firms have the knowledge to design and develop differentiated manufacturing

products. These firms, however, outsource the actual manufacturing stage to contract

factories that can be located either in the North or in the South. Contract factories in

the South can undertake the manufacturing stage at lower costs than contract factories

2See more details in Locke (2003) and Nike (2014a, 2014b).3See, e.g., Moran (2002), Rosen (2002), Esbenshade (2004), Ross (2004), and Sluiter (2009).

2

in the North, but fixed and transportation costs associated with southern outsourcing are

higher. Only the most productive northern firms find it profitable to invest in the higher

fixed costs to benefit from the lower manufacturing costs at southern factories.

Manufacturing production is inherently dangerous. For this reason, good working

conditions are more expensive to provide in factories than in other workplaces in the

economy. In the model, workers’preferences depend not only on wages, but also (in-

directly) on the working conditions prevailing at their workplace. Thus, to be able to

attract workers, factories have to pay workers a wage premium that compensates them

when working conditions are inferior. Factories, however, only need to pay workers their

outside option plus the compensating wage premium. In the model, the factory workers’

outside option is related to the country’s labor productivity, and this productivity is as-

sumed to be higher in the North. Thus, workers’outside option is higher in the North,

and this explains why contract factories in the South can undertake the manufacturing

stage at lower costs.

The benchmark model’s main predictions are:

P1: The most productive northern firms make high profits and outsource their actual

manufacturing stage to contract factories in the South.

P2: The level of working conditions at factories depends on the costs of providing these

working conditions and on the country’s labor productivity.

P3: Workers in contract factories earn more than in alternative workplaces, but wages

are only higher because they compensate workers for inferior working conditions.

P4: Despite being higher, factory wages might not cover for workers’basic needs, but

the reason is that the country’s labor productivity is too low.

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P5: The only source of comparative advantage is the difference in labor productivities

between the two countries. Thus, a low-productivity country can attract more

outsourcing contracts since it can undertake the manufacturing stage at lower costs.

The benchmark model can be easily extended to study the consequences of other

frequent accusations that have been made to brand companies. One topic that has

attracted considerable attention is factory workers’lack of knowledge about occupational

risks and about their labor rights. This is a problem of asymmetric information on

the workers’side. This extension is important since it shows that workers’asymmetric

information can lead to poorer working conditions and lower factory wages. In particular,

factory workers might not be appropriately compensated for the risks they are taking

on the job. Also, under workers’ asymmetric information, factories can attract more

outsourcing contracts because they can undertake the manufacturing stage at lower costs.

A second important extension is noncompliance. Contract factories, especially in low-

cost countries, are often accused of noncompliance with local legal standards. As an

example of noncompliance, this paper studies the consequences when factories do not

comply with wage and safety standards that seek to alleviate the workers’asymmetric

information problem. The main result is that if compliance inspections are rare and

penalties low, factories can undertake the manufacturing stage at lower costs and are

thus able to attract more outsourcing.

Under asymmetric information and noncompliance, the predictions of the benchmark

model need to be replaced by:

P1’: The most productive northern firms make high profits and outsource their actual

manufacturing stage to contract factories in the South. However, asymmetric

information and noncompliance in the South lead to even higher profits

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and more outsourcing.

P2’: The level of working conditions at factories depends on the costs of providing these

working conditions, on the country’s labor productivity, and on the amount of

workers’asymmetric information.

P3’: Except for the (unlikely) perfect-misinformation case, workers in contract

factories earn more than in alternative workplaces, but wages are only higher be-

cause they compensate workers for inferior working conditions.

P4’: Despite being higher, factory wages might not cover for workers’basic needs. The

reasons are: low country’s labor productivity and a high level of workers’asym-

metric information.

P5’: There are three potential sources of comparative advantage: (i) differences in labor

productivity; (ii) differences in asymmetric information; (iii) differences

in noncompliance. Thus, a country with a low labor productivity, or in which

workers’asymmetric information is high, or in which factories noncom-

pliance with legal standards is more prevalent can attract more outsourcing

contracts since it can undertake the manufacturing stage at lower costs.

The reminder of the paper is organized as follows. The next section relates this work to

the existing literature. Section 3 introduces the benchmark model and applies this model

to understand Nike’s international labor practices. Section 4 extends the benchmark

model to account for asymmetric information and noncompliance. Section 5 concludes.

A detailed Online Appendix contains all derivations reported in the paper.

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2 Related literature

Despite the overwhelming amount of attention that working conditions at Nike contract

factories have attracted from activists, college students, labor unions, NGOs, govern-

ments, international organizations, journalists, and the general public (see, e.g., Spar

2002), there exists to this date no integrated theory that can be used to study the topic.

The current paper fills this gap. In doing so, the paper connects two strands of the

literature.

The first strand is fairly recent and studies the global sourcing strategies of firms

that differ in their productivities.4 Following the seminal contribution of Antràs and

Helpman (2004), this literature seeks to explain the organizational mode and location

choice of firms that are able to fragment their production process into smaller segments.

By incorporating contractual frictions between firms and their subsidiaries or suppliers,

the organizational mode and location choice emerge endogenously as an outcome of these

models. Firms with different productivity levels sort into different organizational forms.

In contrast to Antràs and Helpman (2004), the current paper assumes away contractual

frictions. The consequence of this simplification is that the organizational mode becomes

irrelevant and firms only have to focus on the location decision. On the other hand,

the current paper extends this literature by incorporating the role of working conditions.

This extension is crucial for studying the issues surrounding the accusations made to Nike

and other brand companies.

The second strand of the literature that this paper connects is a series of applications

of the compensating-wage-differentials theory.5 This theory goes back to Adam Smith’s

4See, e.g., Antràs and Helpman (2004), Grossman and Helpman (2004), Grossman, Helpman, and

Szeidl (2005), and Antràs and Helpman (2008).5See Rosen (1987) for a summary.

6

Wealth of Nations from 1776 but was first formalized by Rosen (1974). The basic idea

is that jobs have nonpecuniary attributes that can be unpleasant for workers. In order

to attract workers, firms have to pay them a premium (or a “compensating wage differ-

ential”) for accepting those unpleasant attributes. The current paper incorporates this

framework into the model to explain why factory workers in low-cost countries tend to

earn more than in alternative employment. The explanation is that their wages are higher

because workers are compensated for the poorer working conditions at factories.

Finally, this paper also contributes to the literature on labor standards and globaliza-

tion.6 One important concern in this literature is over the universality of labor standards.

In particular, should all countries in the world adhere to a set of minimum universal stan-

dards? One argument in favor is that countries with low labor standards can unfairly

attract more investments and that minimum standards are necessary to avoid unfair

competition. In contrast to this, some scholars have claimed that prematurely impos-

ing labor standards might be counterproductive for developing countries. After all, rich

countries introduced most labor standards after having attained a relatively high devel-

opment level (see, e.g., Hall and Leeson 2007). The framework presented in this paper

proposes a way to rationalize both views. On the one hand, the benchmark model pre-

dicts that the level of working conditions depends naturally on the development level of

a country. On the other hand, the extended version of the model shows that asymmetric

information on the workers’side and factories’noncompliance with minimum standards

can indeed be sources of comparative advantage that might serve the South in attracting

more outsourcing contracts at the expense of the North.7

6This literature is summarized in Brown (2000) and Basu et al. (2003). See also Elliott and Freeman

(2003) and Donado and Wälde (2015).7Although outside the scope of this paper, a few empirical studies have also investigated the impact

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5 Conclusion

For several years, Nike and other brand companies have been the target of widespread

criticism for outsourcing their manufacturing production to contract factories with dismal

working conditions. The main allegations are that factory workers are paid extremely

low wages, are required to work excessive overtime, and are often exposed to unsafe,

unhealthy, and abusive working conditions. According to critics, these working conditions

stand in stark contrast to the large profits usually reported by brand companies. The

current paper has introduced a theory of outsourcing and working conditions that is able

to rationalize these observations.

In the framework, the most productive northern firms make large profits and out-

source their manufacturing production to independent contract factories located in the

South. Compared to the North, wages and the level of working conditions in southern

factories can be relatively low. Southern workers, despite earning more at factories than

in alternative employment, might not be able to cover for their basic needs. The bench-

mark model predicts that only an improvement in the southern labor productivity can

lift workers out of poverty.

The model, although stylized in some dimensions, is tractable enough to accommo-

date several extensions. The current paper has shown how to incorporate asymmetric

information on the workers side and factories’noncompliance with legal standards. Under

these extensions, factory wages and the level of working conditions are lower than in the

benchmark case. This allows southern factories to undertake the manufacturing stage at

lower costs. As a consequence, more northern firms outsource production in the South,

and the firms that were already engaged in southern outsourcing are able to generate

even higher profits.

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The benchmark model and the two extensions studied in this paper should be seen as

a first step in our understanding of the interrelationship between outsourcing and working

conditions. The model might be fruitfully extended to capture other dimensions of the

debate on brand companies and their global labor practices. Other important issues

that require further research include the presence of immigrant and underage workers at

contract factories and the impact of codes of conduct on working conditions.

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