Offshoring of Goods and Services
Chapter 7
Laurent Risler
ECON-371
International Economics: Trade
Fall 2022
Portions © 2021 by Worth Publishers
International Economics, 5th edition, Feenstra/Taylor, used with
permission. Other portions from the professor or other sources.
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© 2021 Worth Publishers
International Economics, 5e | Feenstra/Taylor
Introduction
• Over the last few decades, a new trend has emerged: the
large and rapidly increasing trade in intermediate inputs
(parts and materials used to produce final goods).
• The production process is increasingly fragmented: stages of
the production process are often located in various countries.
• Trade in intermediate inputs has become a substantial share
of world trade. Intermediate inputs make up more than half of
the goods imported by OECD economies and close to three-
quarters of the imports of large emerging economies, such
as China and Brazil (Ali and Dadush, 2011).
© 2021 Worth Publishers International Economics, 5e | Feenstra/Taylor3
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International Economics, 5e | Feenstra/Taylor
Introduction
• Why do firms “slice up” the production process?
o Dramatic fall in transportation costs;
o Dramatic fall in communication costs;
o Lower trade barriers;
o Higher labor costs and stricter regulations in advanced
economies have also contributed to the outsourcing of
unskilled labor-intensive activities in developing and
emerging countries (Cappariello and Zizza, 2007).
• This phenomenon raises new policy questions and thus
calls for a renewed theoretical approach: offshoring
models.
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International Economics, 5e | Feenstra/Taylor
Introduction
• 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 is called foreign outsourcing (a firm
outsources part of the its operations to foreign firms that they do not
own) or offshoring (a firm moves some of its operations overseas
via foreign direct investment, meaning it retains ownership of these
operations).
• Offshoring is trade in intermediate inputs.
• In this chapter, we will not worry about the distinction between
“offshoring” and “foreign outsourcing” and will use the term
“offshoring” whenever the components of a good or service are
produced in several countries, regardless of who owns the plants
that provide the components or services.
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International Economics, 5e | Feenstra/Taylor
Introduction
• The main goal of this chapter is to examine in detail the
phenomenon of offshoring and describe the ways in which it
differs from trade in final products.
– We discuss how offshoring affects the demand for high-skilled
and low-skilled labor and the wages paid to those workers.
– We examine whether changes in relative wages is the result of
offshoring or whether there are other explanations for it.
– We also describe the new phenomenon of job polarization,
which occurs when employment grows in occupations that pay
the highest wages and in those that pay the lowest wages, but
declines in occupations that pay md-level wages.
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International Economics, 5e | Feenstra/Taylor
A Model of Offshoring
The Value Chain of a Product
Most products have many different activities involved in its
manufacture.
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International Economics, 5e | Feenstra/Taylor
Gains from Offshoring
• Amati and Wei (2005) highlight the gains from offshoring
material inputs and services for US manufacturing firms.
• The offshoring of service activities (e.g., back-office
operations) can explain 11% to 13% of the total
increase in productivity.
• The offshoring of material inputs can explain 3% to 6%
of the total increase in productivity.
• Combining these effects, between 15% and 20% of
overall productivity gains in the US manufacturing
sector can be attributed to offshoring.
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Changes in Wages and Employment
Changes in the Relative Wage of Nonproduction
Workers in the United States
• Our offshoring model predicts that the relative wage of
skilled workers will rise in both the country doing the
offshoring and the country receiving the new activities.
• Indeed, since the early 1980s, the wages of skilled
workers have risen relative to those of unskilled workers
in the United States as well as other countries.
• We can use data from the manufacturing sector on
“production” (unskilled) and “nonproduction” (skilled)
workers.
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International Economics, 5e | Feenstra/Taylor
Productivity, Real Wages, and Incomes in
Mexico: The Rising Skill Premium
Labor Productivity and Wages in Mexico Panel
(a) shows labor productivity for workers in the
maquiladora Mexican manufacturing plants and
for workers in non-maquiladora plants in the rest
of Mexico.
Panel (b) shows wages and monthly income for
workers in maquiladora and non-maquiladora
plants. Productivity and real monthly income grew
faster in the maquiladora plants because of
increased trade with the United States.
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International Economics, 5e | Feenstra/Taylor
Changes in Wages and Employment
Relative Wage of Nonproduction Workers in the Mexican
Manufacturing Sector
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International Economics, 5e | Feenstra/Taylor
Changes in Wages and Employment
Relative Wage of Nonproduction Workers in the US Manufacturing
Sector
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International Economics, 5e | Feenstra/Taylor
Changes in Wages and Employment
Relative Employment of Nonproduction/Production Workers in the
US Manufacturing Sector
This diagram shows the employment of nonproduction workers in U.S. manufacturing divided by the
employment of production workers. There was a steady increase in the relative employment of
nonproduction workers employed in U.S. manufacturing until the early 1990s. That trend indicates that
firms were hiring fewer production workers relative to nonproduction workers. There was a fall until
1998, after which relative employment rose again erratically.
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Job Polarization
• The phenomenon of job polarization (or job bipolarization)
occurs when the employment shares of jobs with the lowest
wages and jobs with the highest wages increase, while the
employment share of jobs with wages in the middle has
fallen.
• This characteristic of labor markets is generally observed in
advanced economies that suffered from waves of
deindustrialization. Industrial jobs in certain sectors exposed
to the competition of countries with lower production costs
were especially affected: textile, steel, automobile,
pharmaceuticals.
• This pattern can be (partly) explained by our offshoring
model.
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Job Polarization: Policy Issues
• This is a factor of social tensions: well compensated jobs in manufacturing
industries are replaced by low-paid jobs in the personal services sector.
This leads to a substantial increase in inequality. Workers at the low-end of
the spectrum feel a great deal of frustration because of their declining
social status.
• Another implication is the erosion of tax revenue. Tax administrations
derive a substantial share of revenue from industrial jobs, in particular
direct taxes (PIT, CIT) and social contributions. When these jobs
disappeared and were replaced with low-paid jobs the service sector, tax
collection fell substantially. In addition, there is substantial leakage at the
high-end of the income distribution. All in all, job polarization is generally
associated with lower tax revenue.
• In certain instances, policymakers opted to increase indirect taxes (VAT,
sales taxes, excise taxes) to offset the loss of revenue. As indirect taxes
are generally less progressive than direct taxes, tax systems have become
less equitable, which may have exacerbated social tensions.
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International Economics, 5e | Feenstra/Taylor
Conclusions
• Offshoring is the shifting of some production activities to another
country while other production activities are kept in Home.
• Rather than trading final goods, with offshoring each good can be
produced in stages in several countries and then assembled in a
final location.
• Each country engages in the activities for which its labor is
relatively less expensive.
• An increase in offshoring will raise the relative demand (and hence
relative wage) for skilled labor in both countries.
• Polarization of the job market means that there is employment
growth for high-paying and low-paying jobs, but less growth or even
declines in jobs with mid-level wages. There jobs can be automated
or outsourced.