Outsourcing/offshoring: Effect of Outsourcing on Wages: Evidence from the 1980s
Much of the academic and policy interest in outsourcing is due to its potential effect on wages and employment. During the 1980s there was a surprising movement in wages and employment in the United States and other countries. During that decade, the real wage of less-skilled workers (with high-school education or less) fell in the United States, whereas the real wages of the more highly skilled workers (college graduates) rose. Therefore, the ratio of the skilled wage divided by the unskilled wage or the relative wage of skilled/unskilled workers rose. At the same time, the relative employment of skilled/unskilled workers also went up, especially in manufacturing. That pattern is surprising because normally when the relative wage of skilled/ unskilled workers rises, we expect that companies will hire fewer skilled employees (since they are more ex- pensive); instead, the opposite happened and companies hired relatively more skilled workers. The only explanation for this pattern is that the relative demand for skilled workers must have increased, especially in themanufacturing sector.What factors can explain this increase in the relative demand for skilled workers?
Two factors that can explain the increase in relative demand for skilled workers are: (1) the increased use of computers and other high-technology equipment, and thus an increase in the skilled workers needed to operate them; and (2) outsourcing. To understand howoutsourcingwill increase the relative demand for skilled labor, we use the ‘‘value chain’’ of a firm,which includes all the activities involved in the production of a good or service, from research and development (R&D) to assembly to marketing and after-sales service. For the purpose of modeling outsourcing, rather than arranging activities in the order they are actually performed, we instead arrange them in increasing ratio of skilled/unskilled labor used in each activity, as shown in figure 1.
Assembly uses the least amount of skilled labor relative to unskilled labor in figure 1, followed by component production, then marketing and sales, and finally R&D. A firm that is outsourcing to another country with lower relative wages for unskilled laborwillwant to send those activities using themost unskilled labor. So in figure 1, activities to the left of the line AA will be sent offshore to the foreign country, while activities to the right of the line AA will be performed at home.
Now suppose that the home firm wishes to offshore more activities. The reason for this could be a trade agreement with the foreign country, leading to reduced tariffs; or improvement in the infrastructure in the foreign country, leading to reduced costs there; or an increase in costs at home. When deciding what extra activities to offshore, the firm will look to those activities that were just on the borderline of being outsourced before, that is, those activities just to the right of the line AA, which used to be profitably performed at home but now are shifted abroad. The borderline between the activities performed at home and abroad therefore shifts from the line AA to the line BB.
What is the impact of this increase in outsourcing on the relative demand for skilled labor at home and abroad? Notice that the activities no longer performed at home (i.e., those in between AA and BB) are less skill-intensive than the activities still done there (those to the right of BB). This means that the range of activities now done at home is more skilledlabor intensive, on average, than the set of activities formerly done at home. For this reason, the relative demand for skilled labor at home increases, as occurred in the United States during the 1980s. That increase in demandwill also increase the relativewage for skilled labor.
What about in the foreign country? The activities that are newly sent offshore (those in betweenAAand BB) are more skill-intensive than the activities that were initially outsourced to the foreign country (those to the left ofAA).Thatmeans that the range of activities now done abroad is more skilled-labor intensive, on average, than the set of activities formerly done there. For this reason, the relative demand for skilled labor in the foreign country also increases. With this increase in the relative demand for skilled labor, the relative wage of skilled labor also increases in the foreign country. That outcome occurred in Mexico, for example, during the 1980s, as well as in Hong Kong.