International Business Chapter 7 But Make This Assumption Help Simplify Our Models Slicing The Value Chain

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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

overseas. This chapter will not draw the subtle distinction between the two and instead

will simply focus on offshoring.

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,

the video “Outsourcing: White Collar Exodus” provides an in-depth look at the growing

use of service outsourcing, particularly focusing on call centers in India.

This chapter uses the concept of production possibilities frontiers (PPFs) in examining

the model of outsourcing to analyze the net welfare gains of offshoring. Students should

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

from traditional models of international trade (Ricardian and Heckscher‒Ohlin) in that it

involves the trade of intermediate inputs rather than final goods. Unlike final goods,

intermediate inputs may cross numerous borders before being integrated into a product

that is sold either to the domestic or foreign market. The popularity of offshoring is

largely due to the cost reduction of international services, such as transportation and

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

to Foreign vendors. One example is Mattel, where the final product is made to the firm’s

outsourcing, this chapter will not make the distinction over ownership of the foreign plant

and will use the term offshoring whenever components of a good or service are produced

in multiple countries.

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

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.

We will use the value chain to determine which activities a firm is most likely to

outsource to maintain competition. We use this model to make predictions on which

activities are likely to be transferred abroad. Our prediction is based on two important

assumptions identified below.

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

We consider this a fairly realistic assumption since developing nations often pay very low

wages to low-skilled workers. For example, in developing countries a low-skilled worker

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

the left of the vertical line A to Foreign and those to the right of A will remain at Home.

Because we assume that capital and trade costs are applied uniformly across the value

chain, we can argue that optimizing on wage savings is the main determinant in

identifying which processes to offshore.

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

of line A in Figure 7-1(b). The relative demand for skilled labor in Foreign, H*/L*, against

the relative wage, WH*/WL*, is presented in panel (b) of Figure 7-2. By adding a relative

supply curve to each respective diagram, we are able to determine the equilibrium

relative wage given by points A and A* at Home and Foreign, respectively.

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

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

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

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,

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.

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

1958 to 2014. Employment of nonproduction to production workers is analogous to H/L

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.

Notice that contrary to conventional thinking, the increase in the relative wage of

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

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

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

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

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

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.

occupations earning the highest average wage experienced a significant increase in the

1990s and then flattened in the 2000s.

One more look at a different data set may help to answer why such a scenario is

repeatedly occurring.

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

Notice that these four characteristics—for manual versus cognitive tasks—refer to

production and nonproduction jobs, respectively. Manual jobs may require exertion,

physical activity, and mechanical ability, whereas cognitive jobs rely on face-to–face

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

mid-, and high-level wages. Low-level wage workers are categorized as manual and

Production = manual

• Nonroutine = earning low–level wages

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

low-level wages. During the 1980s, nonroutine cognitive jobs—the higher-paying jobs—

experienced the highest employment growth. During the 1990s, the highest employment

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,