Economics Chapter 7 Homework Home Firm Although The Newly Outsourced Activities

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7 Offshoring of Goods and Services

Notes to Instructor

Chapter Summary

Up to this point, we have focused on the trade of final goods and services—consumer

goods. But, a significant amount of trade involves intermediate goods and services or

inputs that are used to build end products for sale to consumers. None of the models

covered up until now have addressed this type of trade. It will be the focus of this

chapter.

We will concentrate on offshoring, although this type of trade in intermediate goods can

also involve outsourcing. Offshoring is defined as “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.” Offshoring implies that the firm retains

The chapter examines whether offshoring or the shift toward skill-biased technological

equipment explains the increase in the demand for high-skilled labor in the United States.

There is a discussion of the potential loss of U.S. comparative advantage to countries

Comments

Offshoring is a deeply debated and political topic. Therefore, it is likely that your

students have some ideas about the impact of offshoring on their futures. After reminding

them of what they have learned thus far about the potential gains from international trade,

ask your students whether they support policies to limit offshoring. To motivate the topic,

Lecture Notes

Introduction

Offshoring materials, parts, components, and services necessary to produce the simplest

to the most sophisticated products is common. Technically, offshoring is defined as “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.” Offshoring differs

S I D E B A R

“Foreign Outsourcing” Versus “Offshoring”

Offshoring is defined as Foreign production of goods in plants owned by the Home firm.

As an example, Intel produces microchips in subsidiaries in China and Costa Rica. By

contrast, outsourcing occurs when a Home firm subcontracts the production of its product

1 A Model of Offshoring

We begin by building a model of offshoring by ranking skill intensity across the activities

or processes (called the value chain) involved in producing a good. Panel (a) of Figure 7-

1 presents the production process in chronologic order, namely, from research and

development to marketing and after-sales service. By contrast, panel (b) gives the rank of

the activities based on the ratio of high-skilled to low-skilled labor required in the

process, with assembly as the least skilled-intensive part of the production to research and

development the most skilled-intensive.

Value Chain of Activities

Figure 7-1 illustrates the value chain for the product because each subsequent activity

adds additional marginal value to the previous activity in order to produce the final good.

Assumption 1: The relative wage of low-skilled labor to high-skilled labor is lower in

Foreign than at Home.

Letting WL (WH) denote the wage of low-skilled (high-skilled) labor at Home, whereas

WL*(WH*) represents those in Foreign, we make the assumption that compared with

Home, wages in Foreign are less (WL* < WL and WH* < WH) and the relative wage of low–

skilled labor is lower (WL*/WH* < WL/WH).

Assumption 2: Costs of capital and trade apply uniformly across all activities in the

value chain. In deciding whether to offshore certain activities in its production process, a

firm must weigh the savings in labor cost achieved by shifting to the lower-wage Foreign

country against the additional costs associated with doing business abroad. These

additional “trade costs” include physical capital of a foreign plant or factory,

transportation and communication, and Foreign-imposed tariffs. So to simplify the firm’s

decision process, we assume its decision to offshore is based only on the savings in labor

costs and, regardless of the source, all costs of capital and trade apply uniformly across

all activities in the value chain.

Assuming that capital and trade apply uniformly across the value chain may be

unrealistic because costs of communication and transportation can vary significantly in

developing countries. Consider China and India, where infrastructure like roads has

improved much more slowly than telecommunication networks. This means that the

models.

Slicing the Value Chain Given our assumptions, the firm will maintain the more skill–

intensive activities at Home and shift the least skill–intensive activities abroad. Referring

to panel (b) of Figure 7-1, the firm is slicing the value chain by shifting all activities to

Relative Demand for Skilled Labor Across the Value Chain Adding the demand for

high-skilled and low-skilled labor in the activities to the right of line A in Figure7-1(b),

we obtain Home’s relative demand for high-skilled labor, as illustrated in Figure 7-2(a),

where the horizontal axis is the relative demand for skilled labor, H/L, and the vertical

axis gives the relative wage of high-skilled labor, WH/WL. The downward-sloping relative

Our next task is to study how the equilibria move as Home begins to offshore processes

to Foreign.

Changing in Foreign Costs and in Offshoring With our assumptions thus far, we see

that Home will send abroad to Foreign its least skilled–intensive activities, namely, those

to the left of line A, in Figure 7-1(b). Suppose further that the cost of offshoring decreases

Effect on Home Relative Labor Demand and Relative Wage Due to the decline in

trade costs, the Home firm will be motivated to shift more activities or processes in the

value chain to Foreign. In other words, Home will move the next least skilled–intensive

production processes abroad, as illustrated by the area between lines A and B in Figure 7-

3. These activities, although more skilled-intensive than those sent to Foreign before the

Note that Figure 7-4 does not identify absolute quantity of labor demanded. In fact, both

high- and low-skilled labor employment fall when offshoring occurs. This figure shows

Effect on Foreign Relative Labor Demand and Relative Wage Similarly, the average

range of activities in Foreign is now more skilled labor intensive as well due to the

additional offshoring done by the Home firm. Although the newly outsourced activities

(between lines A and B) are less skilled intensive, as compared with those maintained at

It is recommended that you go through the example provided in the textbook to help

students understand how all of this is possible. Consider a physics student who is

This model concludes by predicting:

As activities in the middle of the value chain are shifted by offshoring from Home to

Foreign, they raise the relative demand for skilled labor in both countries because these

2 Explaining Changes in Wages and Employment

The wage differential between high-skilled and low-skilled workers in developed

countries such as the United States, Australia, Canada, Japan, Sweden, and the United

Kingdom, as well as less–developed countries such as Chile, Hong Kong, and Mexico,

has increased since the early 1980s. So, at first glance the data appear to be consistent

with our model. But, let’s take a closer look at the data for Mexico and the United States.

What has the change in wages and employment been due to offshoring for these two

countries?

Changes in the Relative Wage of Non-Productive Workers in the United States A

comparison of the wage movements in the manufacturing industries allows us to more

accurately attribute each factor explaining the widening wage differential experienced in

the United States.

From Figure 7-5, we see that the average annual earnings of nonproduction workers

relative to production workers in U.S. manufacturing did not follow any particular trend

between 1958 and 1967. But, from 1968 to 1982, the relative wage of nonproduction

workers exhibited a downward trend. This decline is attributed to an increase in the

Changes in Relative Employment of Non-Production Workers Figure 7-6 shows the

relative employment of nonproduction to production workers in U.S. manufacturing from

The increase in the relative supply of college-educated workers in nonproduction from

1962 to 1982 coincides with both the decline in the relative wage (Figure 7-5) and

expansion in relative employment (Figure 7-6) of nonproduction workers.

Explanations The increase in the relative demand for high-skilled workers due to

offshoring is only one possible explanation for the rising wage gap between high-skilled

and low-skilled workers in the United States and other countries. The increase in the

relative demand for high-skilled workers can also partly be explained by the shift toward

computers and other high-tech equipment, or skill–biased technological change.

Both of these two reasons could explain an increase in the relative demand for skilled

workers in the United States. Offshoring as well as skill–based technological change

could result in a rightward shift in demand for skilled workers, as shown in Figure 7-4(a).

Given the observation of an increase in relative demand, how do we determine which is

the actual cause?

The approach taken is twofold. First, to determine whether skill-based technological

change is the culprit, researchers analyzed the changes in the quantity of high-tech

equipment used in manufacturing. And second, to determine if offshoring is the cause,

Changes in the Relative Wage of Nonproductive Workers in Mexico As predicted by

the offshoring model described in the preceding section, the relative wage of

Mexico initiated trade liberalization policies following its debt crisis in 1982, reducing

trade barriers and encouraging Foreign Direct Investment (FDI). In addition, Mexico

Thus, it is important to point out that the fall in wages from 64 to 84 and the rise in wages

from 84 to 96 is exactly what occurred in the United States, suggesting that our model is

Job Polarization in the United States The data from 1990 to 2014 tell a different story.

While the data from 64 to 84 support the model of offshoring, the evidence becomes

much more complex during the 1990s and beyond. Although throughout the 1990s, the

Average Wages in Occupations Figure 7-10 informs us that the data during the period

1979‒89 match our theory quite well. High-skilled occupations with higher average

wages increased over this decade.

But, in 1989‒99 as well as 1999‒2007, we find that the employment share for those

occupations receiving the lowest average wage rose, while the employment share of those

This pattern describes what economists call job polarization. Job polarization describes

an economy where the share of employment for jobs receiving the lowest pay increases,

the share of jobs for middle income falls, and the employment share of jobs for the

Taking Account of New Job Characteristics We need a more robust model that

addresses the detailed characteristics of the actual work engaged by labor. Specifically,

we will categorize job characteristics into four categories based on the type of work

performed:

1. Routine, manual

2. Nonroutine manual

3. Routine, cognitive

4. Nonroutine, cognitive

Routine jobs are characterized by well-defined rules and procedures. These types of jobs

are more easily replaced by computers and high-tech equipment. Routine jobs can be

both manual (production: assembly line) and cognitive (nonproduction: bookkeepers,

Figure 7-11 shows the growth in the four types of employment for the periods 1983‒93,

1990‒99, 2000‒07, and 2007‒14.

The data are much easier to understand if we first label the categories according to low-,

Production = manual

• Nonroutine = earning low–level wages

• Routine = earning mid–level wages

The greatest employment growth occurred in nonroutine occupations earning high- and

This trend is more pronounced in the early 2000s, where there is little to no growth at all

in routine jobs earning mid-level wages. But, both types of nonroutine jobs experienced

employment growth that is in the low– and high-level wage categories. Interestingly, the

data reveal that throughout the decades, higher-paying jobs experienced the highest

employment growth.

Now let’s look at where the lowest employment growth occurred. During the 1980s, both

types of manual jobs—routine and nonroutine—experienced the lowest employment

growth. This occurred among the low– and mid-level wage groups. In the 1990s,