1. Performance Pay and Offshoring
Elias Dinopoulos Theofanis Tsoulouhas
University of Florida UC Merced

2. Performance Pay and Offshoring
Organization
Introduction
Elements of the Model
Findings
Conclusions
Performance Pay and Offshoring

3. Performance Pay and Offshoring
Introduction
Fragmentation of production and offshorability of tasks has increased in the past two decades.
Manufacturing components are being produced and business services are being provided from low-wage countries.
Earlier studies of offshoring use the Heckscher-Ohlin trade model focusing on high and low-skilled wages.
These studies assume perfectly competitive labor markets .
Wages equal the marginal product of labor.
Performance Pay and Offshoring

4. Performance Pay and Offshoring
Introduction
Our paper studies offshoring in high-wage North and low-wage South model.
We highlight the role of imperfectly competitive labor markets.
There is production uncertainty, unobserved effort, and moral hazard issues.
Labor compensation is based on absolute performance ( piece-rate) contracts.
Performance Pay and Offshoring

5. Performance Pay and Offshoring
Introduction
We view the production process as a continuum of tasks performed by workers.
Worker output depends on skill level, effort, and an idiosyncratic shock.
Firms reward worker effort via a piece-rate contract consisting of a base payment and a bonus.
We incorporate the production structure in North-South model .
Both regions produce the same homogeneous good under perfect competition.
Performance Pay and Offshoring

6. Performance Pay and Offshoring
Introduction
The production structure consists of two segments:
In the modern segment each firm produces a continuum of offshorable tasks using performance pay contracts.
Firms in the traditional segment lack expertise in modern management practices and workers exert minimum effort.
Production in the traditional segment is deterministic.
Performance Pay and Offshoring

7. Performance Pay and Offshoring
Introduction
Northern modern firms may offshore management practices and production technology to low-wage South.
Production of offshored tasks occurs under performance pay contracts.
Northern firms face heterogeneous offshoring costs.
We model offshoring costs as “iceberg” costs.
Performance Pay and Offshoring

8. Performance Pay and Offshoring
Introduction
The assumption of heterogeneous offshoring costs
leads to an interior solution for the extent of offshoring.
affects the bonus component of compensation, effort, and wage structure in the South.
amplifies the productivity effect of offshoring through endogenous effort.
Performance Pay and Offshoring

9. Performance Pay and Offshoring
Introduction
We treat firm size and worker outside option as endogenous variables affected by general equilibrium interactions.
Worker mobility leads to equalization of expected utility across all workers within a region.
There is one-to-one correspondence between the outside wage and worker welfare.
Performance Pay and Offshoring

10. Performance Pay and Offshoring
Production Structure
Production in the modern segment consists of a continuum of tasks.
A worker in the North produces output
A worker in the South produces output
Performance Pay and Offshoring

11. Performance Pay and Offshoring
Production Structure
Total output of a modern Northern firm is given by
Preferences are given by the following CARA utility function.
Performance Pay and Offshoring

12. Performance Pay and Offshoring
Preference Structure
Utility function of a Northern worker:
Piece-rate contract offered to a Northern worker
Performance Pay and Offshoring

13. Performance Pay and Offshoring
Backward Induction
The model is solved by backward induction:
First, each firm calculates the effort level maximizing expected utility.
Second, the firm calculates the profit maximizing optimal bonus factor .
Third, the firm chooses the optimal fraction of offshored tasks.
Fourth, in the long run, free entry drives expected global profits to zero.
Performance Pay and Offshoring

14. Base Payment and Labor Markets
The base payment is determined by the relevant participation constraint.
Each worker is indifferent between the traditional and modern segment in each region.
Labor markets clear and lead to full employment in each region.
Performance Pay and Offshoring

15. Performance Pay and Offshoring
Equilibrium Effort
Effort exerted by a Northern worker
Effort exerted by a Southern worker
Performance Pay and Offshoring

16. Short-run Equilibrium
Optimum range of offshored tasks
LHS corresponds to expected task profitability located in the North.
RHS corresponds to expected profitability of the marginal task located in the North.
Performance Pay and Offshoring

17. Quality Heterogeneity and International Trade

18. Performance Pay and Offshoring
Long-run Equilibrium
In the long-run, firms earn zero expected global profits.
The zero-profit condition and the two full employment conditions determine the long-run equilibrium.
Performance Pay and Offshoring

19. Quality Heterogeneity and International Trade

20. Performance Pay and Offshoring
Larger South
Proposition 2: An increase in the Southern labor force has the following effects
The fraction of offshored tasks increases.
Employment in the modern Northern segment expands.
Northern workers become better off.
Southern workers become worse off.
Performance Pay and Offshoring

21. International Migration
Proposition 3: An increase in immigration quotas has the following effects:
The fraction of offshored activities declines.
Employment in the Northern modern segment expands.
Northern workers become worse off.
Southern workers left behind become better off.
Southern immigrants become better off.
Performance Pay and Offshoring

22. Offshoring Costs and Effort
Proposition 4: A decline in offshoring costs has the following effects:
The fraction of offshored tasks increases.
Employment in the Northern modern segment expands.
Northern workers become better off.
Southern workers become better off.
Performance Pay and Offshoring

23. Performance Pay and Offshoring
Conclusions
In this paper we incorporate piece-rate compensation contracts in a general equilibrium model of offshoring.
We model offshoring as an international transfer of managerial practices and production techniques.
Heterogeneous offshoring costs and endogenous effort enhance the productivity effect of offshoring.
Performance Pay and Offshoring

24. Performance Pay and Offshoring
Conclusions
If globalization increases the fraction of offshored tasks, it then benefits Northern workers.
A reduction in offshoring costs or international migration benefits Southern workers.
Extensions:
Relative performance or non-linear contracts .
Heterogenous ability or skills.
Buy or make decision and incomplete contracts.
Performance Pay and Offshoring