Wage inequalities due to outsourcing, sub-contracting trade, says study

by Chakravarthi Raghavan

GENEVA: International trade does have an effect of increasing the wage gap between skilled and unskilled workers in the United States and other industrialized nations, but this is due to the so-called “trade in intermediate inputs” (production-sharing, outsourcing, sub-contracting and other methods employed by transnational corporations), a new study brings out.

The study (National Bureau of Economic Research Working Paper No. 8372) is by Robert C Feenstra of the Department of Economics of the University of California and Gordon H Hanson of the School of International Relations and Pacific Studies of the University of California.

The growing wage gap between skilled and unskilled workers in the US and other industrial nations and its causes (technological change within an industry, competition between the low-wage developing countries and the developed, or other reasons) have been a subject of controversy among trade economists and theorists.

The growing wage gap puts paid to the factor price equalization and other such theories of international trade and comparative advantage. The pure ‘free trade’ theorists first attempted to question the gap and then, faced with the data, have been seeking explanations in other elements.

For their part, the international workers groups have been pointing to the wage gaps to demand ‘protection’ against such competition, and/or try to find the explanation in the lack of unionization or restrictions on unionization in the developing countries and the low wages being a result of lack of collective bargaining.

This view in turn has led to the so-called workers’ rights and labour standards issues that are repeatedly brought up at the World Trade Organization. The argument is that if only labour in the developing world could be organized, and the core labour standards (right to organize and bargain collectively) are ensured by linkage to the WTO’s trade rules and its dispute settlement system, wage levels in the developing countries would rise, thereby creating ‘fair competition’.

However, this is challenged and questioned by not only the producers and governments of developing countries but also civil society groups in the Third World which see that the power-based WTO and its skewed enforcement mechanism will only add to the problems of workers in the South.

And there has also been the argument of the developing-country governments that the championing of the rights of workers by the international labour movement is really an attempt to deny the developing world its ‘comparative advantage’ through a form of disguised protectionism.

Outsourcing

The Feenstra-Hanson study brings out that both sides in this argument may be wrong in that there is an element of international trade that is not properly or adequately captured by the international free trade theories, which were evolved originally when factor movements (both capital and labour) between countries were static and international trade and exchange of goods thence reflected comparative advantage.

The study shows that trade in intermediate inputs has the same impact on labour demand as does skill-biased technical change. Both shift demand away from low-skilled activities, while raising relative demand and wages for the higher-skilled.

The study also brings out that it is not so much the establishment of production facilities in a developing country that rely on local raw materials and labour to produce final consumer goods that is responsible, as the so-called sub-contracting and production-sharing arrangements, often undertaken by a TNC and/or its subsidiary by means of exporting an input, having it processed further in a developing country and importing it back.

In such cases, not only does the TNC benefit from the lower cost of production abroad due to the wage levels, but it also has an important fiscal incentive - the home country charges taxes only on the value-added.

Feenstra and Hanson note that many economists researching the decline in wages of low-skilled workers during the 1980s and 1990s, both in real terms and relative to wages of skilled workers, have concluded that it is not trade which is the dominant or even important explanation for the shift in wages, but rather technological change, such as the massive influx of computers into the workplace.

Presenting a contrary view, Feenstra and Hanson argue that international trade is a source of the inequality in wages, but this is due to the trade in intermediate inputs, which is sometimes or often called production-sharing or referred to as outsourcing.

Distinguishing between change in wages due to international trade (trade in intermediate inputs) and that due to technological change, in the view of the two authors, is an empirical rather than a theoretical question.

If the contention of Feenstra and Hanson is correct, then merely providing for workers’ rights and collective bargaining will not help: in a developing country with a vast pool of unemployed unskilled labour, bargaining between labour and capital is on unequal terms. For every worker on strike, there are probably tens willing to take his/her place at lower wages; and only state intervention on behalf of labour (something frowned upon in the industrial world by the organized international labour movement and certainly opposed by capital) can help labour.

Taking the detailed data of the US, Feenstra and Hanson note that the earnings of non-production workers relative to production workers in the country moved erratically between the 1960s and 1970s, but moved substantially in the 1980s and 1990s. There was a substantial increase during that period between ratio of non-production to production workers in US manufacturing.

While this increase in the supply of workers could account for the reduction of relative wages of non-production workers from the 1970s to early 1980s, this is at odds with the increase in relative non-production wages after that.

The only explanation consistent with the facts is that there has been outward shift in the demand for more skilled workers since the mid-1980s, the two authors suggest.

Free trade theorists challenging this point to the fact that the magnitude of trade flows from the US with developing countries is too small to account for the observed wage demand.

The authors, looking at the data, conclude that merchandise trade has indeed grown substantially relative to production of these commodities in the many advanced industrial countries.

Various pieces of evidence indicate that trade in intermediate goods has played an increasingly important role in trade if one looks at ‘processing’ trade (defined by customs offices as import of intermediate inputs for processing and the subsequent export of the final product). For example, the authors find that such processing trade has grown enormously in China, with Hong Kong serving as an intermediary.

This outward processing has served not only the newly industrializing countries, but also the US, Japan and Europe.

Pointing to the intermediate inputs trade as the source of inequality, the two authors cite the example of US firms exporting intermediate inputs to the maquiladora plants in Mexico, where the assembly of inputs and other production activities take place rather than in the US.

From the data, the authors find that the decision of companies to purchase intermediate inputs from overseas will most certainly affect their employment at home, and could be expected to affect differentially skilled versus unskilled workers. Thus, outsourcing has a qualitatively similar effect on reducing relative demand for unskilled labour within an industry as does skill-biased technological change, such as use of computers.

The study finds that foreign outsourcing from US manufacturing is associated with the increased relative demand for skilled labour.

Such outsourcing could take place through foreign direct investment, as transnationals move production of parts and components or product assembly abroad. Or, it may also occur through a shift in contracting practices whereby firms replace domestic production of intermediate inputs with imports purchased from arm’s-length suppliers abroad.

A study by Matthew Slaughter (2000), “Production Transfer within Multinational Enterprises and American Wages” (Journal of International Economics), suggests that FDI is not an important channel for moving US jobs abroad or for skill upgrading at home.

Slaughter’s study, combined with the results of an earlier Feenstra and Hanson study (1999), suggest that FDI is not the means through which outsourcing has induced skill upgrading in US manufacturing. Other studies have found that inward FDI into the US, such as through construction of Japanese auto plants, did not contribute to skill upgrading in US manufacturing.

[Promoters of FDI as a panacea for development often claim that FDI brings in capital and the upgrading of skills and technology, and engenders the spread of technology within a country. There is now enough contra evidence.]

In analyzing the effects of outsourcing and investment associated with it, the study points to the example of Hong Kong China manufacturing firms moving their production facilities to mainland China, in the neighbouring province of Guangdong, managing them from headquarters in Hong Kong. These firms typically supply the plants in China with raw materials and often ship the goods through Hong Kong for final processing before exporting them to the final destination. As Hong Kong has shifted production to China, manufacturing has become a less important part of its economy.

The two authors say that existing literature has just begun to scratch the surface of how globalization of production changes industry structure and factor demand in advanced and emerging economies.

Global production-sharing and trade in intermediate inputs matter more generally for how trade models are applied to data, Feenstra and Hanson contend.

In tests of the Heckscher-Ohlin model, it is standard to assume that exports are produced entirely by combining domestic factors of production with domestically-produced intermediate inputs. This assumption, Feenstra and Hanson note, is wrong.

An issue that is not fully explored in the NBER study is the question of how much of this trade in intermediate inputs via production-sharing or sub-contracting and other arrangements is due to the low wages and how much to fiscal taxation and customs and other duties.

Research into this source of inequality is clearly needed to find solutions to the growing inequality among and within countries. Such research needs to look at the fiscal incentives that the home governments of corporations give to their firms to undertake such ‘outsourcing’ FDI (which term itself has become confused by equating bricks-and-mortar production based on domestic inputs and generating technology transfer to and diffusion within the host country, with the licensing, outsourcing and other arrangements that serve to skim off the value-added to home countries without any capital accumulation in the host or technology and skills transfer to the host country).

The moves of the industrialized countries to write investment rules into international trade agreements will accentuate this process to the detriment of development of the developing world. (SUNS5017)

The above article first appeared in the South-North Development Monitor (SUNS) of which Chakravarthi Raghavan is the Chief Editor.