Atanu Dey On India's Development

Is Outsourcing Good for the Universe

Via Rajesh Jain, I came to know of NY Times report on Paul Samuelson’s essay in an upcoming issue of JEP. I am probably one of the very few who have not read Samuelson’s celebrated book on introductory economics. That is so because I never studied undergraduate economics. My introduction to economics was at the graduate level and the first books on economics I read were Hal Varian’s Microeconomic Analysis and Bhagwati and Srinivasan’s Lectures on International Trade. I learnt undergraduate economics later while teaching undergraduate classes. OK, enough of this biographical aside.

The issue of outsourcing appears to be a very hot topic. Here is how I think about it. I go back to the basic facts.

Fun fact #1: Trade is good. Whether between two people on eBay or between two countries across an ocean, trade increases welfare. While that is true in general, there are well-known conditions under which trade can be harmful and decreases welfare. If any of those conditions exist, then you need to take corrective measures which may include the extreme measure of banning the trade.

Fun fact #2: Trade occurs only among two dissimilar entities. If I have an excess of peanut butter and you have an excess of bread, then we can trade and both end up enjoying peanut butter sandwiches. But if both of us have exactly the same ratio of peanut butter to bread to start off with, then we could not trade.

Fun fact #3: Increasing the supply of any good or service (all other things being equal) reduces its price. This is not rocket science but the ignorance of this fact is as widespread as the ignorance of rocket science.

Fun fact #4: Most change gives rise to winners and losers. Walmart in your neighborhood helps you and hurts the little stores in your neighborhood. Imported Chinese junk helps the consumers of junk but hurts the domestic manufacturers of junk. Basically, lower prices help those who consume the good or service but hurt those who produce it.

OK, so here is the story about outsourcing, the US, and India. India and US are dissimilar. Wages are lower in India as compared to the US. Why? Because wages depend on the average productivity of the country. India is a low productivity country. Why that is so is another story that we will not go into right now. Because Indian labor is cheap, producers who can use Indian labor will have an incentive to use them. If you are producing goods, you can get the goods produced abroad and sell them in the home country. Winner: the domestic consumers. Losers: the domestic workers who were replaced by cheaper labor. While labor is immobile internationally (immigration laws and all that), labor is said to be embodied in the goods that are produced abroad. Think of it as if the worker is virtually present in the US and is working for a wage much lower than the domestic worker would demand.

In the past, India supplied some goods to the US, mostly commodities. Then when communications technology improved, services could be exported. It was as if a couple of million Indians moved to the US. Increased supply immediately translates into lower prices. Basic economic logic, not rocket science at all. Lower prices help the consumers and hurt those who worked in that sector before the supply of labor increased. Globally, that movement of labor (virtual movement, of course) is welfare improving. It is undoubtedly good for India because the average wage of those workers increases and since Indians are in general not consumers of the stuff these workers produce, Indian consumers are not hurt. But is it good for the US?

What is good for GM is good for America is only true if all Americans work for GM, otherwise it is an open question. So also, if the US workers displaced by the virtual migration of Indian labor move on to more productive jobs, then the change is an unmitigated good for the US. Then of course, one has to consider the question from the temporal angle as well and distinguish between the short- and long-term impact of the change.

In the long-term (not the real long term, of course, in which we are all dead as Keynes astutely observed), Heckscher-Ohlin’s factor price equalization theorem takes effect. Here is a definition from About.com:

Factor price equalization is an effect observed in models of international trade — that the prices of inputs to (“factors of”) production in different countries, like wages, are driven towards equality in the absence of barriers to trade. This happens among other reasons because price incentives cause countries to choose to specialize in the production of goods whose factors of production are abundant there, which raises the prices of the factors towards equality with the prices in countries where those factors are not abundant. Shocks to factor availability in a country would cause only a temporary departure from factor price equality.

The basic theorem of this kind is attributed to Samuelson (1948) by Hanson and Slaughter (1999) who also cite Blackorby, Schworm, and Venables (1993). The context of the theorem is a Heckscher-Ohlin model.

Programmers and call center operators are a factor in the production of many goods and services in today’s global economy. Since barriers to trade have come down both due to free trade agreements and to technological advances in telecommunications, it has led to a “mobile” labor market for those workers. Increased supply implies lower prices for that sort of labor. Lower prices implies winners and losers, as argued earlier.

So is it good for the US and if not, could the US do something about it and if it could, should the US do something about it? Good question. The answer is forthcoming. What we have to remember when it comes to change is the good old theory of the second best which Bhagwati had written about years ago and which I believe throws light on the present debate.

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