Outsourcing Can Benefit Home Workers

''International outsourcing'' – in which multinational firms move parts of their production processes offshore to countries where wages are lower – can be a friend, rather than an enemy, to workers in the home country, according to new research by Professor Wilhelm Kohler, published in the March 2004 issue of the Economic Journal. It may lead to an increase in domestic wages for some workers and/or other jobs coming back home.

Firms in many high-wage countries are increasingly moving single tasks or stages of complex production processes to foreign locations where wages are lower. International outsourcing of this kind seems to increase vastly the exposure of domestic labour to international competition. And it seems to hit a raw nerve of policy, sometimes giving rise to protectionist sentiment and even restrictive policy reactions.

The underlying intuition seems fairly straightforward: if production processes get fragmented and particular jobs move offshore, then we should surely expect employment opportunities for that particular kind of domestic labour to be worsened, either in the form of lower wages or increased unemployment. This intuition is difficult to dismiss outright. Yet, it ignores two important effects:
· First, if particular stages of production are more cheaply produced abroad, then this should enable domestic firms, through a cost-savings effect, to pay higher rewards to some domestic factors.
· And second, domestic labour may meet additional demand from those production stages that are still produced at home, and it may also find alternative employment in other industries.

Kohler's research provides a theoretical analysis of these two effects, looking at a case where a multi-stage industry faces competitive pressure in the form of a falling world price for its final output, and where the option of outsourcing labour-intensive stages of production to some low-wage country is an integral part of coping with this pressure.

If there is a second domestic industry using the same type of labour and capital, and if that industry is more labour-intensive than the outsourcing industry, the outcome under perfect competition runs counter to the above intuition in either of two forms:
A: Domestic wages may rise, even though adjustment does involve more outsourcing.
B: Adjustment may in fact involve ''insourcing'' some of the stages that have previously been produced offshore, again with an attendant domestic wage increase.

Case A (B) arises if the production stage that is moved offshore (back home) is less (more) labour-intensive than the other industry. If the other industry is less labour-intensive than the outsourcing industry as a whole, then the adjustment again involves ''insourcing'', but with an attendant domestic wage cut.

The analysis thus identifies several instances where outsourcing as such turns out to be a ''friend'', rather than an ''enemy'', to domestic labour. Similar adjustments can be observed if outsourcing happens, not as a result of increased competitive pressure, but because of technological improvements, say in transport and communication.

The results of this analysis certainly suggest a view on outsourcing that is more favourable, or at least more cautious, than is commonly assumed in policy debates that largely assume, a priori, detrimental domestic labour market effects from offshore procurement of parts and services for domestic production.

But the general warning that economists often express in connection with ''gains-from-trade'' applies to outsourcing as well: such gains do not come without pains. More specifically, pains may arise in the form of income
redistribution involving a real income loss for some factor owners.

The analysis shows that this holds true even for the case where outsourcing as such is the result of easier transport and communication. While the economy as a whole will gain, some of its households will suffer a loss.

''International Outsourcing and Factor Prices with Multistage Production'' by Wilhelm Kohler is published in the March 2004 issue of the Economic Journal. Kohler is Professor of Economics at Johannes Kepler University Linz, Austria.