Week 7: Offshoring Flashcards
offshoring/ outsorcing
- the provision of a service, or the production of various parts of a good in a different country which are then used or assembled into a final good in another location
Assumption 1 of outsourcing
Assumption 2 of outsourcing
- Costs of capital and trade apply uniformly to all parts of the value chain
- outsourcing firms might incur extra costs, such as:
- higher expenses to build manufacturing/firm or higher prices for fuel, electricity etc
- higher trade cost (transportation/communication)
Value Chain
Starts with:
1. R&D
2. Component Production
3. Assembly
4. Marketing and sales (finish
- each activity adds more value to the production
Value chain performed in foreign
- Assembly
- component production
Value chain stages performed at home
- Marketing and sales
- R&D
value chain and outsourcing
The value chain is split into high-skilled and low-skilled activities
- Low-skilled activities performed abroad
- this follows on from assumptions 1 (on wages) and 2 (trade costs)
- firms gain most by outsourcing the lowest-skilled, labour-intensive activities
Outsourcing trade off
- Outsourced activities are cheaper since wages are cheaper
- outsourced activities are more expensive due to trade costs (plant investment, transportation, communications, tarriffs, taxes, etc
Home country labour
- Demand: if Wh/Wl increases then firms substitute away from the highly skilled labour towards low-skilled labour i.e. H/L goes down
If Wh/Wl goes up, workers invest more in acquiring skills. i.e. H/L goes up. - equilibrium relative wage given by point A
foreign Country labour
- foreign has more low skilled labour as WH/WL > WH/WL
if Trade costs fall
- The firm finds it more profitable to offshore more activities
- the optimal division between offshored and retained activities shifts from A to B
Fall in trade costs affect on home labour
- Home loses it’s lowest skill-intensive activities
- Home supply curve is constant as labour supply is fixed
- Relative demand of Highly skilled labour shifts to the right
- relative supply of highly skilled labour does not change
- equilibrium relative wage of highly skilled labour shifts upward from A to B
Fall in trade costs affect on foriegn labour
- The foreign supply curve is constant, as labour supply is fixed
- The Foreign demand curve shifts to the right due to the increase in low-skill-intensive activities driving up demand for low-skill labour, thus also driving up demand for high-skill labour
- for any relative wage WH/WL, firms like to hire more high-skill labour than low as they are more productive
- Equilibrium relative wage of high-skilled labour shifts upward from point A to point B
Fall in trade costs affect on both countries
- Outsourcing raises the relative wage of skilled labour in both countries.
- Mid-value chain tasks shift from Home to Foreign, increasing demand for skilled labour in both locations.
- These tasks are the least skill-intensive for Home but the most skill-intensive for Foreign.
- Result: Relative demand and wages for skilled labour rise in both countries.
gains from outsourcing
- Outsourcing increases relative wages for skilled workers (WH/WL goes up) – thus decreasing relative wages for unskilled workers (WL/WH goes down).
- It reduces production costs and prices
Simplified outsourcing model:
- Two activities:
- Component production, which is L intensive
- Research and development, which is H intensive
- Assumption: the costs of capital are equal in both activities
Production in Absensce of outsourcing
- The tangent to the isoquant at point A shows the firm’s valuation of components relative to R&D. i.e. (Pc/Pr)^a
-Amount y1 of the final good cannot be produced in the absence of outsourcing, since it lies outside the firms PPF.
-
Production with outsourcing
- A higher level of production (isoquant) is possible by trading intermediate activities.
- Assume (Pc/Pr)^w1 < (Pc/PR)^A
- consistent with WL/WH < WL/WH
- hence home firms are outsourcing components (cheaper abroad) while exporting R&D
gains to home firm (Production with outsourcing)
- production increases (y1-y0)
- production increases while H,L are unchanged, thus cost of production decreases
- ## expected to cause a fall in the price (consumer gains also)
Comparison of no trade and equilibrium in Outsourcing
- Assuming that the world’s relative price differs from that at home. There are always overall gains from outsourcing
Foreign increases relative productivity in components
- Fall in the price of components
- Home specialises even more in R&D and produce even less components at boint B’ rather than B
- gains from trade increase even more moving from output y1 to y2
Foreign increases relative productivity in R&D
- Fall in the price of R&D
- Home firm reduces it’s R&D activities and increases its component activities as their R&D is less profitable
- experiences a ToT loss, as it can no longer export each unit of R&D for as many components in the initial outsourcing equilibrium
- still more productive thn in autarky
- output moves from y1 to y3
