What are the effects of offshoring?

Not what you may think.

The Economist's blog Free Exchange has a posting that looks at research on the effects of offshoring and its results may well not be what you expected.

The Free Exchange posting looks at new research that draws on a U.S. pilot study utilising the 2010 National Organisations Survey (NOS). The NOS collected data on the sourcing practises of American firms, and did so according to eight standardised business functions: primary business function (i.e., the company’s core activity), R&D, sales and marketing, logistics, customer service, administration, information technology (IT) and facilities. This enabled the researchers to see precisely which functions were being offshored—and what impact such shifts had back home.

Although 23% of American companies undertook some offshoring, when it came to their primary business functions—which account for two-thirds of domestic employment—an average of only 4% by cost was offshored. For large goods-producing companies the figure was much higher, at 10.5%. Because the products those manufacturers make tend to be highly visible (e.g., smartphones, clothing), this increases the impression that masses of American jobs are being exported. As co-author Tim Sturgeon of MIT points out, the researchers found “a tale of two economies”: large manufacturers, and everyone else. “Services, health care, public agencies and small firms of all kinds tend to be very domestically oriented,” he notes. And these types of organisation account for about 80% of America’s employment.

The second surprise was that the majority of offshoring (57% by cost) was to locations with costs that were the same as or higher than America, such as Canada and Western Europe, rather than to low-cost developing countries (29%)—the ones typically suspected of gobbling up American work. By way of explanation, the researchers note that Western Europe and Canada are America’s largest and oldest trading partners, and point to a long history of foreign direct investment by American firms in these regions. Presumably, at least some of this investment and sourcing is reciprocated, though it will fall to future studies to determine how much. Interestingly, mid-cost emerging economies were almost entirely out of the mix, caught in what Mr Sturgeon calls the “middle income trap”—they are neither sufficiently attractive markets in their own right nor sources of cheap labour.

In terms of jobs, the researchers found that the more companies offshored a particular function, the fewer low-paid jobs they had in the same function at home. An obvious reason for this could be that offshoring is siphoning away low-paid jobs. It is possible, however, that cost-reductions enabled by offshoring raise overall demand for firms' products, and therefore increase the demand for skilled workers in tasks that haven't been outsources.

Perhaps the most interesting points in the quote are the point about the small manufacturing and service sectors being "domestically oriented" - remembering the large contribution these sectors make to local employment - and the point about the substitution of low-paid jobs for high-paid jobs. Fewer low-paid jobs is what many people would expect offshoring to lead to but the increase in high-paid jobs is more unexpected.

Offshoring and its effects on innovation in emerging economies

Outsourcing is still a controversial practice in most countries around the world. This is just as true for emerging markets as it is for the industrialised economies. The effects of outscouring are increasingly understood for industrialised countries but what of emerging markets? A new column at VoxEU.org looks at the effects of outsourcing on firm-level innovation in emerging markets. The authors find robust evidence that outsourcing is positively related to various innovation measures. However, outsourcing only leads to increased R&D spending in countries where intellectual-property rights are well-protected.

Most of the empirical work that has been done on the effects of outsourcing on firms has looked at firms in the industrialised countries. However outsourcing is not just an industrialised country phenomena, it is also common in emerging economies. Firms in middle-income countries split up their production processes similarly to firms in developed countries. Recent research analyses the benefits to emerging market firms from outsourcing, focusing mainly on productivity and innovation effects. The latter are particularly important, since innovation is a key determinant of productivity improvements and – ultimately – growth.

The VoxEU column, Offshoring and its effects on innovation in emerging economies, summaries the research contained in a recent paper Fritsch and Gorg (2013). This paper finds robust evidence that outsourcing is associated at the firm level with:

• Spending on research and development.
• The introduction of new products.
• Upgrading existing products.

But, significantly, Fritsch and Gorg show that firms only increase their R&D effort after outscouring if intellectual property right are well protected.The interpretation given to this is that a lack of protection of intellectual property prevents firms from restructuring towards innovation activities.

Intellectual property rights protection does not matter for the introduction of new products or for upgrading. Since we control for R&D spending at the firm level, offshoring activity reflects access to better technology from foreign firms. Of course, protection of this external knowledge does not matter for the sourcing firm. Thus, intellectual property protection matters whenever firms engage in innovation effort through their own R&D.

Fritsch and Gorg distinguish in their analysis between domestic outsourcing - getting another local firm to supply a component of production - and offshoring – getting a foreign company involved in the supply chain. Fritsch and Gorg write,

In terms of innovation effects, we have two mechanisms in mind:

• First, outsourcing allows firms to reduce factor costs and restructure their operations towards higher value-added activities such as R&D and innovation [...] – a channel highlighted in the context of developed countries.
• Secondly, if offshoring takes place to technologically advanced countries, it may provide access to higher quality inputs [...]). This allows the firm to learn new technologies and expand its technological frontier.

While the restructuring effect is present for both outsourcing and offshoring, the technology effect is likely to be particularly important for offshoring. The use of imported inputs – in particular from industrialised countries – can provide strong learning effects for emerging-market firms, thus enhancing their technology level and innovation activities [...]. Studies for a multitude of developing economies have shown that imports enhance the productivity of firms in these countries. Thus, we would also expect to see that firms in emerging economies increase innovation as a result of engaging in offshoring, which is an alternative method of international sourcing.

Fritsch and Gorg's conclusions,

Our study shows that outsourcing and offshoring induce positive effects on innovation for firms in emerging economies. This corroborates the view that outsourcing is beneficial for firms. It also implies that outsourcing might help emerging economies to enhance their productivity and hence increase their competitiveness. Although we cannot explicitly test the complementarity of firms sourcing superior technology and upgrading their own technology, we suspect that this mechanism is at work. If this is indeed the case, then outsourcing would allow firms in these countries to offer more sophisticated products and services.

Ref.:

• Fritsch, Ursula and Holger Görg (2013), “Outsourcing, Offshoring and Innovation: Evidence from Firm-level Data for Emerging Economies”, Kiel Working Paper No. 1861, Kiel Institute for the World Economy.