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