SHEPERD ECON 123 - Offshore Outsourcing: The Economist’s View

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Offshore Outsourcing: The Economist’s View Offshore outsourcing leapt to prominence in the early 2000s when we noticed that firms in the United States and other industrialized countries were shifting service activities and jobs to developing countries, especially India. For a typical firm, international outsourcing can reduce its cost of these service activities by about half.Why this outsourcing has received so much attention is part of what makes international economics different. Firms are always attempting to lower the costs that they incur in their production activities. If this occurs within the country, people tend to view it as just part of everyday business decisions, with outsourcing being the “buy” part of the make-or-buy problem—how a firm sources the various materials, components, and services that it needs to carry out its overall production. But if the outsourcing crosses national boundaries, it can become a controversial political issue. What’s new here is that international competition from developing countries is directly affecting white-collar workers in service activities that had previously been largely insulated.The political uproar reached a crescendo in February of 2004 when N. Gregory Mankiw, a Harvard professor then serving as chairman of the White House Council of Economic Advisors, commented on the phenomenon. Offshoring, Mankiw said, is only "the latest manifestation of the gains from trade that economists have talked about at least since Adam Smith. ... More things are tradable than were tradable in the past, and that's a good thing." Although Democratic and Republican politicians alike excoriated Mankiw for his callous attitude toward American jobs, economists lined up to support his claim that offshoring is simply international business as usual. The start of the international outsourcing story is in India, which until 1991 had been following a policy aimed at self-sufficiency and government direction of the economy, with poor results. In 1991 the Indian government enacted a set of major liberalizations, including opening its economy to international trade and foreign companies. In the 1990s a number of U.S. and British companies quietly began to shift some back-office work, like payroll processing to India, to take advantage of the availability of low-cost but educated workers who could speak English. Other firms, including Indian firms like Wipro and Infosys, noticed how successful this was, and began to expand the business further. At the same time the cost of voice and data transmission plummeted (a cost decline of more than 80 percent since 2000) as the bandwidth in place between India and the United States and Britain increased rapidly.This international outsourcing includes a range of business services, including data entry, telephone call centers, and software development. Firms in the United States and Britain are the largest users of international outsourcing. In addition to India, the Philippines, China, Russia, and the countries of Central Europe are also important providers.Is Offshore Outsourcing of Services a Large Problem?How large is this offshore outsourcing? It seems to be rather surprisingly small for all the attention that it has received, though it is growing. A reasonable estimate is that by 2005 perhaps 600,000 service jobs (in total, not per year) had been shifted from the United States to India and other developing countries, a number which is less than one percent of service sector jobs in the United States. Another way to gain perspective on this number is to compare it to the flow of job gains and losses in the U.S. economy. Each year about 30 million people lose or quit their jobs (and usually more than 30 million new jobs are filled).Which kinds of jobs have been affected, or might be affected in the future? The jobs that are being outsourced overseas generally involve work that is repetitive and routine. In the United States offshoring seems to be a driver behind the decline in the number of lower-paid and somewhat less-skilled white-collar positions such as data entry keyers, phone operators in call centers, and computer programmers. Even though there is some offshoring of higher paid and more skilled positions in the computer services area, thenumber of U.S. workers in such positions as computer software engineers has increased since the late 1990s, and their wages have risen faster than the economy average. Further, the United States overall is a large net exporter of business services [exports exceed imports]. U.S. firms actually gain much business though the consequent “inshoring” of work in such areas as computer consulting, research, architectural design, industrial engineering, legal services, and production and distribution of movies, videos, and records. The jobs gained from exports of services appear to be more skilled and higher paying than service sector jobs in general: in 2002, business service firms that exported paid an average annual salary of $63,000 compared to a $43,000 salary paid by business service firms that did not export.More generally, there is a limited range of service jobs that can be offshored because positions that require substantial face-to-face contact with customers or in-depth local knowledge cannot readily be done overseas. Essentially, the work that is most readily offshored is work that can flow internationally over wires.Economist Alan Blinder estimates that the sectors in which jobs will be most vulnerable to outsourcing in the future, besides computer services, are financial services (selling insurance and financial products in which people can invest their savings), information services (telephone operators and help desks), and professional and business services (like accounting). Most health care services cannot be outsourced. Butthere are exceptions such as radiology (reading x-rays is somewhat repetitive and the results can be delivered electronically). More generally, laboratory tests are already outsourced by most physicians. Whynot out of the country rather than just out of town? And with a little imagination, one can envision other medical procedures being performed by doctors who are thousands of miles away. Indeed, some surgery has already been performed by robots controlled by doctors via fiber-optic links. Educational services are also best delivered face to face, but they are becoming increasingly expensive. Electronic delivery will


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SHEPERD ECON 123 - Offshore Outsourcing: The Economist’s View

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