August 25 2004 To be published in revised form in The Journal of Economic Perspectives The Muddles over Outsourcing Jagdish Bhagwati Arvind Panagariya and T N Srinivasan Jagdish Bhagwati is University Professor Columbia University and Andre Meyer Senior Fellow in International Economics Council on Foreign Relations both in New York New York Arvind Panagariya is a Professor of Economics and the Jagdish Bhagwati Professor of Indian Political Economy Columbia University New York New York T N Srinivasan is Samuel Park Jr Professor of Economics Yale University New Haven Connecticut We acknowledge helpful comments from Alan Deardorff Douglas Irwin Katherine Mann and Lori Kletzer and invaluable assistance from James Hines Andrei Shleifer Michael Waldman and above all Timothy Taylor 1 In the early 1980s outsourcing typically referred to the situation when firms expanded their purchases of manufactured physical inputs like car companies that purchased window cranks and seat fabrics from outside the firm rather than making them inside But in 2004 outsourcing took on a different meaning It referred now to a specific segment of the growing international trade in services This segment consists of arm slength or what Bhagwati 1984 has called long distance purchase of services abroad principally but not necessarily via the electronic mediums such as the telephone fax and Internet and includes for example phone call centers staffed in Bangalore to serve customers in New York and x rays transmitted digitally from Boston to be read in Bombay 1 Thus in February 2004 the members of President Bush s Council of Economic Advisers stated Outsourcing of professional services is a prominent example of a new type of trade Mankiw Forbes and Rosen 2004 The chair of the CEA Gregory Mankiw made a similar point in a press interview Andrews 2004 I think outsourcing is a growing phenomenon but it s something that we should realize is probably a plus for the economy in the long run We re very used to goods being produced abroad and being shipped here on ships or planes What we are not used to is services being produced abroad and being sent here over the Internet or telephone wires But does it matter from an economic standpoint whether values of items produced abroad come on planes and ships or over fiber optic cables Well no the economics is basically the same 1 While the text refers to transactions by firms final consumption by individuals can also include purchases of manufactured components and of on line services Thus an individual might order a toner for her fax machine directly from an offshore manufacturing firm and she may use an offshore firm to get her living room s interior redesigned In the data that we discuss below both purchases by firms and by individuals are included as the data do not distinguish among them nor should they 2 Mankiw s comments caused a considerable stir with critics complaining that he had endorsed shipping U S jobs overseas Journalists jumped on the bandwagon with Lou Dobbs of CNN going so far as to list on his program the American companies that presumably outsource jobs and ship jobs abroad without any clarity as to the definition of outsourcing since he was evidently not confining his list to firms that bought arm slength services offshore Senator Kerry joined in as well again without clarity regarding the phenomenon that he was targeting by castigating firms that bought components not just arm s length services abroad or simply invested abroad as Benedict Arnolds that were shipping jobs abroad and thus being traitors Many Americans had similar concerns for example an Associated Press Ipsos poll in May 2004 found that 69 percent of Americans thought that outsourcing again not unambiguously defined hurts the U S economy against only 17 percent who think it helps reported at http www pollingreport com trade htm The public debate over outsourcing has been marred by two sets of serious muddles The first set of muddles relate to what is meant by outsourcing with many of the concerned politicians and journalists even some economists going beyond trade in offshore arm s length services to include without analytical clarity phenomena such as simple offshore purchase of manufactured components and even direct foreign investment by firms The second set of muddles is more subtle the few economists who use the phenomenon correctly to characterize the trade in arm s length services still tend to worry whether the outsourcing debate is just a replay of the long standing disputes over free trade or whether it presents different analytical issues 3 In this paper we first address the muddles over the definition of outsourcing We discuss in some detail how outsourcing properly defined as the offshore trade in arm s length services is addressed in the World Trade Organization in its General Agreement on Trade in Services We also discuss recent estimates of the extent of outsourcing and why the outsourcing issue erupted in 2004 We then present some models to illustrate outsourcing and we use them to consider how trade in offshore purchase of such arm s length services might affect national output wages and distribution of income Addressing the concerns that such outsourcing presents novel problems we argue that outsourcing is fundamentally just a trade phenomenon that is subject to the usual theoretical caveats and practical responses outsourcing leads to gains from trade and its effects on jobs and wages are not qualitatively different from those of conventional trade in goods We also distinguish between first the analysis of outsourcing which has to do with the effects on the United States of new trade possibilities which convert previously non traded services into traded arm s length services at any given skills and factor endowments of countries and second the analytically different issue of what prospects the United States faces as skills accumulate in countries such as India and China in IT related activities that augment internationally traded arm s length services I Muddles over the Definition of Outsourcing We will first consider here trade in services and discuss where offshore trade in arm s length services which is the proper definition of offshore outsourcing fits into this broad category We will then consider how such outsourcing is muddled with other phenomena that must be sharply distinguished analytically and empirically from it 4 Categorizing Trade in Services The economics
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