Crawl Across the Ocean

Saturday, January 20, 2007

Is Offshoring Always Good for the Economy?

OK, the previous post talked a bit about The Economist's issue on how globalization was driving CEO pay so high that there was a risk non-CEO's might take action to lower it a little. In this post I want to talk a bit about the economics of offshoring. Here's a quote from, "Hard truths about helping the losers from globalisation":

"In the neat world of economics text-books the downside of globalisation looks much like Galax. Low-skilled workers in a rich country, such as America, suffer when trade expands with a poorer country with plenty of much cheaper low-skilled workers, such as China.

If labour markets are efficient in the rich country the displaced workers should find new jobs, but their wages will probably fall. Although the country overall gains handsomely, these people are often worse off."


My question is, is the (unstated as such) assumption that 'the country overall gains handsomely' justified?

Consider an example. Let's say that in Scotland, 100 workers produce all the Glenfiddich Whiskey for the whole world, and this Whiskey production generates profits (not including wages) of $1 Billion (annually).

Furthermore, let's say that the owner of the distillery, Mr. Glen Fiddich, takes $500 million of the profits and his 100 workers get the remaining $500 million.

Now, let's say that Mr. Fiddich has an opportunity to move the operation to China. Mr. Fiddich can make the whiskey with 100 workers in China and only pay them $5 million. Assume that the hundred workers are currently in jobs in China where they produce $1 million of value-added. Further assume that the laid off workers in Scotland will get new jobs which add $10 million in value. Finally, assume that because the operation in China is not as high-quality as the one in Scotland, and there are higher shipping costs and so on, it only generates total before wage profits of $800 million, not $1 billion.

To summarize, the initial situation:
Annual value added in Scotland: $1 billion
Annual value added in China: $1 million
Profit to Mr. Fiddich: $500 million

Afterwards:
Annual value added in Scotland: $805 million (Mr. Fiddich's profits and the workers $10 million of value added at their new jobs)
Annual Value added in China: $5 million
Profit to Mr. Fiddich: $795 million

Leaving aside the specific dollar amounts, this seems like a pretty plausible scenario to me. The owners can move production offshore, make an inferior product with a higher cost structure, but still come out ahead due to the huge savings on labour. The workers who used to have very high value added jobs and received some of that value in wages get jobs which pay much less. The economy of Scotland seems worse off to me in this scenario, which seems a very common one. Am I missing something. Why is there this assumption that having high value added jobs sent overseas would be good for an economy?

I'm only partly being snarky here, mainly I'm just curious. It is such an article of faith in economics that the country as a whole benefits from offshoring that there must be some reasoning behind it, but it's not clear to me what this reasoning is.

7 Comments:

  • I'd certainly love to see an answer to your question. I'd also like to take this a little further, and ask about the costs of re-training these workers for new types of jobs, and the social costs that might occur if a) their jobs are lowering paying or b) they can't get new jobs at all. (Like the Flint, Michigan scenario.)

    By Anonymous Deanna, at 12:23 PM  

  • Yes, all those 'friction' costs such as retraining - not to mention the human cost in uncertainty and stress and broken relationships from people being laid off - would be included in a proper accounting of the net benefits.

    By Blogger Declan, at 8:31 PM  

  • Assuming that other whiskey manufacturers can also outsource to China, he will have to lower the price of his whiskey by $295 million as prices fall across the industry. He has no power of monopoly to maintain high prices in the face of competition.

    The extra $295 million will therefore stay in the pockets of whiskey consumers. 5 million will go to the chinese workers, and $200 million to shipping costs.

    It is very possible that in the short term, the layed-off scottish workers will not earn as much money.

    By Anonymous Anonymous, at 5:22 AM  

  • Why would the other whiskey manufacturers lower their prices when they'd be benefiting in the exact same way as Mr. Fiddich? Why would they cut into their own profits? (Of course, if they all follow your logic in perfect competition, their profits will go to zero...)

    It is very possible that in the short term, the layed-off scottish workers will not earn as much money.

    They may not earn as much (or any!) money in the medium and longer term as well. Either way, they won't be buying much Scotch.

    By Blogger Josh Gould, at 3:12 PM  

  • There are at least two things missing: costs other than wages (wages are a cost, not a component of profit) aren't accounted, and the effect on the price point of the whisky (unless Glen has a monopoly). What benefits a national economy is that all of the inputs formerly used to produce Mr F's scotch are now available to produce something else to everyone's benefit (for domestic use and/or export) - eg. a higher grade of more refined scotch. It is true that any particular case doesn't have to be good for the local economy (if you assume there is a uniform and complete failure of human ingenuity that results in all former employees finding only lesser employment and a uniform and complete failure of competition such that the domestic consumption of the product remains at the same total price), but the sum of all such transactions (trade) generally is easily observed in the real world.

    A proper accounting of the net benefits would also add the human profits in terms of human security and political stability and social justice due to the increased incomes of the offshore workers. After all, most progressives seem to believe even small amounts of additional income at the bottom end of income scales provide the most bang for buck. Is this assumption invalidated when the income crosses an international boundary?

    What's at stake is comparative advantage. The starkest real-life example is agricultural protectionism. The general expectation is that if developed countries removed their subsidies and marketing boards, they'd lose market share in the formerly protected crops to underdeveloped nations. But the developed nations would see a general reduction in food prices and the developing nations would see a general increase in GDP (win-win). The "losers" would be the out-of-work producers in developed nations: those who could not find either more lucrative crops (eg. those which require higher tech to produce, and so are beyond the competitive reach of the developing nations) or employment providing the same or better income. Historical trends strongly favour betting on human ingenuity.

    By Blogger AwaWiYe, at 6:07 PM  

  • Anon - Suggesting that Glen Fiddich has no power of monopoly is a bit off (as Josh says) - how do you think they command such high prices currently? Anyway, whether the labour savings accrue to the consumer or to Mr. Fiddich doesn't really affect my question one way or the other.

    Awawiye - Again, the price point is irrelevant, as are non-wage costs, this is why I left them out of the example.

    You don't need a universal failure of ingenuity, just the common proposition that if some of the highest value added jobs in an economy disappear, they are likely to be replaced by lower value added jobs.

    Sure we can measure trade, but that doesn't really get to the point of whether some forms of offshoring are bad for the economy.

    Since you graciously agree that there can be individual cases of offshoring which aren't beneficial (which was all I was trying to say, really), I'll concede that for the most part, I think that if foreign countries can make something for us cheaper, we should let them and we'll all be better off in the long run. Farming is probably a good example of this.

    But I do think that this process is a lot more efficient when there aren't large wage differentials as it is the big difference in wages which drives the inefficiency and counter-productive nature of the offshoring in my example. It wouldn't surprise me if protectionist measures targetted to certain high value added fields (esp. vs. low wage countries) were seen to be beneficial to a country's economy, but I haven't seen any such studies.

    As for the benefits to foreign workers, it's a fair point to include those in the analysis, although what I was getting at with 'friction costs' is the cost of the change itself, rather than the effect of the change. i.e. As a result of the change some are worse off and some are better off, but the discontinuity of change is it's own negative regardless of the net results of the change.

    By Blogger Declan, at 6:31 PM  

  • >Awawiye - Again, the price point is irrelevant, as are non-wage costs, this is why I left them out of the example.

    They are not irrelevant to understanding how and why the local economy improves. If you insist on leaving out two of the most important factors by which things can become "good for the [local] economy", then don't be surprised at your conclusion. "We will consider all these bad things. We will assume away these good things. Now, what do we find?"

    Comparative advantage reaps the most gains when the cost differentials (wages or otherwise) are the greatest, whether you are looking at differentials between two towns or two nations.

    >It wouldn't surprise me if protectionist measures targetted to certain high value added fields (esp. vs. low wage countries) were seen to be beneficial to a country's economy, but I haven't seen any such studies.

    I'm not aware of any formal studies either, but the general benefit of low import tariffs shouldn't surprise anyone who incorporates the social spending factor. One big problem with offshoring is that it can externalize (albeit sometimes only temporarily) some things that were internalized. Example: if we ever enter into international cap-and-trade schemes for emissions, we should immediately levy broad import tariffs against all jurisdictions which have laxer emission standards in order to remove the cost advantage to industry of relocating.

    The discontinuity of change is a cost we've paid since most people moved off of farms and into cities, out of the agricultural and resource extraction industries into the the manufacturing industries and then, later, into the service industries. It's well worth paying, IMHO.

    By Blogger AwaWiYe, at 1:44 PM  

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