Thinking About Offshoring and Trade: An Integrating Framework

Offshoring is one of the most controversial outcomes of globalisation. This column asks whether economists need a new analytic framework to understand it. New research argues that all you need is good old-fashioned trade theory to keep your thinking straight.

Globalisation is a new and important phenomenon – and has been since the age of steamships, railroads, and telegraphs. Some would take it a 1000 years further back (Findlay and O’Rourke 2009).

But while “nothing-new-under-the-sun” scepticism might make for some hearty discussion-group banter, we should not be fooled into thinking that true words have been spoken in jest. Indeed, the sceptics who suggest that globalisation is nothing new are wrong – things have fundamentally changed in the world of international trade.

Companies are engaging foreign markets in a more full-bodied manner. Trade isn’t just making things in one nation, putting them on boats, and hoping they sell abroad. Modern international commerce involves movements across international boundaries – but often within the boundaries of the firm – of intellectual property, tacit know-how, investments, management, marketing and organisational services, and key technical personnel. Meanwhile, the goods themselves may be final goods or they may be parts or components in a greater supply chain. Importantly, these are not independent initiatives – all these forms of international commerce are part-and-parcel of doing business internationally.This “trade as a package” view of international commerce has become the received wisdom among trade-policy practitioners. Just look at the major free trade agreements like NAFTA or those signed by the EU and Japan. When US, EU, and Japanese exporters push their governments to negotiate bilateral trade deals, they insist on lower tariffs and other border measures of course – but that’s just the start. These arrangements routinely cover matters ranging from key infrastructure services (e.g. over-night express cargo), to intellectual property rights, to temporary visas, to competition and subsidies policies, to rights-of-establishment, and so on (Estevadeordal et al. 2009, Horn et al. 2009).

Yet this “trade as a package” paradigm has only just started to filter down into academe. Academic journals are still filled with articles that focus on only one aspect of modern international commerce, spotlighting for example, only trade in goods, or only foreign direct investment, or only offshoring, or only international services trade, or only intellectual property trade.

Recent research on integrating the ingredients of modern commerce

In a recent paper (Baldwin and Robert-Nicoud 2010), Frederic Robert-Nicoud and I explore how two high-profile aspects of modern international commerce – trade in goods and offshoring – fit together logically. As it turns out, the standard analytic frameworks used to explain these two phenomenons can be dovetailed in a rather straightforward manner.

In short, thinking clearly about trade and offshoring is simpler than you might have thought. You don’t need to learn a new paradigm to think systematically about trade in goods and “trade in tasks” (the Grossman and Rossi-Hansberg 2006a moniker for offshoring). All you need to do is some mental gymnastics on tried-and-true trade theory, specifically the Heckscher-Ohlin trade model, or its Nobel-prize-winning generalisation by Paul Krugman and Elhanan Helpman (Helpman and Krugman 1985).

Received wisdom trade theory

The core logic behind standard trade theory is dead simple. It’s best illustrated with a thought experiment. Suppose trade in goods were impossible, but productive factors were perfectly mobile internationally. Without migration, unskilled labour, for instance, would tend to be under-priced in nations that were relatively rich in unskilled workers and over-paid in nations where such workers constituted a small share of the workforce. Migration – from the unskilled-abundant nation to the unskilled-scarce nation – would tend to even-out these wage difference.

Now swap the assumptions. Trade in goods is perfectly free but migration is impossible.

Without commerce, the under-/over-paid wage pattern would be reproduced, but these would make the nation with abundant unskilled labour super-competitive in the production of goods that use such labour intensively. The result would be a trade-in-goods pattern that reproduces the migration pattern. Not directly, but in terms of the productive factors embedded in the traded goods. In essence, shipping goods abroad that embody relatively large amounts of unskilled labour is just like shipping out the workers and making the goods abroad. For example, whether the US imports shirts sown by Mexican workers in Mexico, or “imports” Mexican workers to do the sewing in the US, the basic effect is the same.

Technological difference

This standard story – due to Nobel laureate Bob Mundell (Mundell 1957) – is taught in classrooms across the globe. But it misses an important trick. Technology is not the same in the US and Mexico. US technology is superior across the board, so US productive factors earn more across the board. What gets equalised between the two nations is the relative wages, say, between skilled and unskilled workers. (Or at least that’s how it would work in the perfect-theory world.)

This is the heart of standard trade theory; trade is driven by factor endowment differences (the Helpman-Krugman model shows that this insight works in more realistic economic settings that allow for scale economies and imperfect competition, and they also show that scale-economies generate two-way trade in similar products even between nations with similar factor endowments).

Offshoring: The new source of angst

Offshoring is globalisation’s new angst. In a widely read paper first presented at the 2006 Jackson Hole conference, two Princeton economists, Gene Grossman and Estaban Rossi-Hansberg, wrote: “Revolutionary progress in communication and information technologies has enabled an historic (and ongoing) break-up of the production process. Countries like England and Portugal still produce some goods from start to finish, but increasingly they participate in global supply chains in which the many tasks required to manufacture complex industrial goods (or, increasingly, to provide knowledge-intensive services) are performed in several, disparate locations.” (Grossman and Rossi-Hansberg 2006a, p.1).

Another Princeton economist – Alan Blinder – goes so far as to call offshoring the next industrial revolution (Blinder 2006). He argues that up to a quarter of all US jobs are offshorable (Blinder 2009).

Paul Krugman, however, was the first Princeton economist to write on this. In an easy-to-read, tongue-in-check essay, Krugman (1996) paints a dystopia where offshoring has proceeded so far that America’s best jobs are dog-groomer and divorce lawyer. (Makes you wonder what they put into the coffee over at Princeton’s economics department.)

Do we need a new analytic framework to understand offshoring?

Even if you believe only half of Blinder’s predictions, offshoring is clearly something you need to understand. The good news is that to keep your thinking straight about this new form of international commerce¹, all you need is old-fashioned trade theory.

A key driver of offshoring is the fact that companies based in high-wage, high-tech nations can use their firm-specific technology when they employ workers in low-tech, low-wage nations. Toyota Motor Corporation, for example, can set up a factory in Thailand to produce parts for Toyota cars. Toyota brings the technology, machinery, management knowhow, and often its own managers when setting up the Thai factory. The Thai workers will typically get a premium over the local going-wage, but they get far less than Japanese workers who used to do the job in Nagoya.

We can think of this as just “shadow migration”. It is as if the Thai workers moved to Nagoya, used Japanese technology, but got paid Thai wages – the equilibrium outcome is identical.

Wage and trade implications

Putting as baldly as I have – “it is as if Thai workers moved to Nagoya, used Japanese technology, but got paid Thai wages” – sounds like a very bad thing for Japanese unskilled workers – a conclusion reached by many economically illiterate thinkers like Thomas Freidman (2005). But a nation’s pattern of employment and wages depends in a complex way on many, many factors – or as my 15-year-old son puts it: “In economics, things affect things that affect things”. Writers like Freidman, who describe things or, at best, describe how things affect things, routinely arrive at the wrong answers. Freidman writes so well, however, that you have to think very hard to see his logical flaws (see the iconoclastic review of Friedman’s book by Ed Leamer 2006).

For example, with offshoring, Toyota is more competitive in the world car market; they sell more cars than they otherwise would have. This alters the demand for all sorts of Japanese productive factors.

Offshoring as biased technological progress

To think systematically about the wage effects of offshoring (the big issue in the US) or the employment effects of offshoring (Europe’s preoccupation), it is useful to realise that offshoring allows Toyota to produce a car with fewer Japanese workers. That is the definition of a labour productivity gain. Quite formally, offshoring can be viewed as technological change – that’s the flip side of shadow migration.

The impact of productivity gains on wages is complex. For example, suppose the productivity gain is sector-specific – and to be concrete – suppose it occurs only in the export sector. This is exactly like a terms-of-trade gain, but instead of selling the same cars, made with the same workers for higher prices, the effect happens by selling more cars with the same workers for the same price. As far as wages are concerned, the two are equivalent. The Stolper-Samuelson theorem tells us that the factors used intensively gain, while at least some other factors will lose. The seemingly paradoxical effect – which attracted much attention when Grossman and Rossi-Hansberg pointed it out at Jackson Hole – is that Japanese auto workers could gain from offshoring jobs in the auto sector. This sounds strange until you think of offshoring as a productivity gain.

By contrast, if offshoring acts like factor-specific technical progress (e.g. only unskilled tasks are offshored) then the wage effects are more difficult to predict. What matters, as Jones (1965) showed, is the relative size of the cost savings by sector.

Dotting i’s and crossing t’s

The point of theory is to avoid telling particular stories like the two examples above by working out the full range of possibilities in a compact and logically airtight format. Baldwin and Robert-Nicoud (2010) does this by integrating the standard Heckscher-Ohlin-Helpman-Krugman trade theory with the theory of offshoring. More precisely, it develops offshoring analogues to the four famous standard trade theorems (Heckscher-Ohlin, factor price equalisation, Stolper-Samuelson, and Rybczynski). It also shows that the standard gains-from-trade theorem does not hold for offshoring.²

Hopefully this makes it easier to think about the pros and cons of offshoring in an economically literate framework where things are allowed to affect things that affect things.

References

•Baldwin, Richard (2006a), “Globalisation: the great unbundling(s)”, contribution to the project Globalisation Challenges for Europe and Finland organised by the Secretariat of the Economic Council.
•Baldwin, Richard (2006b), “Managing the Noodle Bowl: The Fragility of East Asian Regionalism”, CEPR DP5561, March.
•Baldwin, Richard and Frederic Robert-Nicoud (2010) “Trade-in-goods and trade-in-tasks: An Integrating Framework”, CEPR Discussion Paper 7775
•Blinder, Alan (2006) “Offshoring: The next industrial revolution?”, Foreign Affairs, March/April
•Blinder, Alan (2009), “On the measurability of offshorability”, VoxEU.org, 9 October.
•Estevadeordal, Antoni, Kati Suominen and Robert Teh (eds.) (2009), A guide to the interplay between regional and multilateral trade rules, Cambridge University Press.
•Fieldman, Thomas L (2005), The World Is Flat: A Brief History of the Twenty-first Century, Farrar, Straus & Giroux.
•Findlay, Ronald and Kevin H O’Rourke (2009), Power and Plenty:Trade, War, and the World Economy in the Second Millennium, Princeton University Press.
•Helpman, Elhanan and Paul Krugman (1985), Market Structure and Foreign Trade: Increasing Returns, Imperfect Competition, and the International Economy, MIT Press.
•Horn, Henrik, Petros C Mavroidis, Andre Sapir (2009), “Beyond the WTO? An Anatomy of EU and US Preferential Trade Agreements”, CEPR Discussion Paper 7317.
•Jones, R. (1965). “The structure of simple general equilibrium models”, Journal of Political Economy, 73(6), 557-572.
•Krugman, Paul (1996), “White collars turn blue”, article for centennial issue of The New York Times Magazine.
•Leamer, Edward E (2006), “A Flat World, A Level Playing Field, a Small World After All, or None of the Above? Review of Thomas L Friedman, The World is Flat”, April.
•Markusen, James (2010) “Expansion of Trade at the Extensive Margin: A Gains-from-Trade Theorem and Some Examples”, Manuscript, February.
•Mundell, Robert A (1957), “International Trade and Factor Mobility”, American Economic Review, 47:321-355.

¹ Actually offshoring is not new, but it has only recently risen to the top of policymakers’ agendas. It started in a big way in the mid 1980s across the US-Mexican border and within East Asia (or Factory Asia as it is sometimes called). See Baldwin (2006a) in general, or Baldwin (2006b) for the Factory Asia story.
² Also see Markusen (2010) on the gains from trade point.

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