Model Assumptions and Backgroud »
1. Small country case (no effect on world prices)
2. 2 inputs, K and L (no specific factors)
3. 2 goods, x and y; y is export good, x is import good (or import competing industry within country)
4. K-abundant country
5. Industry X (and import competing industry) outsources L-intensive components of good x
Figure 1
- The vertical axis measures capital (K)
- The horizontal axis measures labor (L)
- X and Y are expansion paths for goods x and y. Their slopes show the optimal K to L input ratio for production for each good. Thus, y is K-intensive and x is L-intensive.
- w/r is the wage rate to rental rate (the cost of employing
capital as an input) ratio. This measures the relative cost of
employing inputs.
- x0 and y0 are isocost curves denotion the various input combinations that yield an output of x0 or y0, respectively. For example, any point of K, L on line x0 will yield the same number of units of good x.
Figure 2
- 1a: Outsourcing L-intensive components shifts the expansion path for good x to X1
toward a higher ratio of K-inputs (within the country) because the
L-intensive components are now produced in foreign markets. That is,
the in country production and assembly of good x is more K-intensive.
- 1b: Subsequently, this outsourcing shifts isoquant x0 as
overall production costs fall due to the lower cost supply through
foreign production. It is now cheaper to produce the same unit of x at
the same (w/r) ratio.
- General effects: The prices of both goods remain
unchanged (no change in Px/Py), so producers will expand output of good
x due to lower costs resulting from outsourcing (the marginal cost
curve for the production of good x shifts down, allowing for higher
production). This in turn increases DL/DK (given that industry X is L-intensive), which increases wages within the country.
Figure 3
- 2: The increased wages (higher w) increase (w/r) to
(w/r)'. That is, the ratio of the wage to the rental rate of
capital increases.
- The new wage rate to rental rate ratio is tangent to the isoquants y0 and x0. This shift in (w/r) changes the costs of production for given input levels. The industries adjust accordingly by using new expansion paths for both goods in order to optimize costs. This change is seen in the following diagram, figure 4.
Figure 4
- The new expansion paths (Y' and X1') illustrate the new optimal K/L ratios for production of goods x and y.
- We note the increase of K/L ratios in both sectors due to a higher (w/r) ratio.
Thus ends the comparative statics of our model. In the figure below,
we will analyze some additional effects of outsourcing by looking at
the "starting point" (initial endowment of K, L; allocations of K, L to
each good) and the and the end result.
Figure 5: Additional Effects
- For an endowment of E (K, L), the economy initially allocates their K and L to y at Y0 and x at X0.
- After outsourcing, the allocation of K,L to y is at Y1, and X1 for good x.
- We find that fewer inputs are devoted to production of Y, and
more inputs are devoted to production of X. The X industry
expands and the Y industry contracts.
Summary
We find that wages have increased, and
more amounts of labor are utilized in industry X--the import competing
goods sector. The results of this model contradict the claim that
outsourcing reduces wages and reduces employment. For a more in-depth
explanation of the theory behind outsourcing, see "Globalization and the Open Economy" by Sven W. Arndt.