Globalization and Offshoring of Software

The Economics of Offshoring

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2. The Economics of Offshoring

Much of the economic debate about offshoring centers around whether the theory of comparative advantage applies to the offshoring of software and IT services. Economists have argued on both sides of the issue. The arguments are sophisticated and nuanced, and the results often depend on whether the underlying assumptions hold in the current context. While a majority of economists believe that free trade “lifts all boats” equally, the underlying question is an empirical one and can be answered by analyzing reliable data when it becomes available.

The theory of comparative advantage states that if each country specializes in the production of goods where it has a comparative (relative) advantage, both countries can enjoy greater total consumption and well-being in aggregate by trading with each other. Offshoring enables, for example, US firms to lower costs and save scarce resources for activities in which they have a relative advantage, while offshoring has led to significant employment and wage gains for Indian workers and rapid profit and revenue increases for Indian businesses.

What the theory of comparative advantage does not mean is that all members of society will benefit from trade. In general, imports of an “input” have economic effects that are similar to those of an increase in the supply of the input, namely, lower returns to the suppliers of the input, lower costs of production, and lower prices for consumers. If the input were a service, the wages and salaries of those producing the service would fall, but so also would costs for firms that are buyers of the service. In the exporting country, the opposite effects hold. That is, the returns to the owners or suppliers of the service or input increase and the wages of the employees at the service providers increase due to the higher demand.

Economists believe that trade generally leads to significant benefits for the trading countries. These gains are not inconsistent with employment losses in specific sectors that will cause economic pain to the workers affected. To achieve an equitable result, many analysts believe that it is important to establish a safety net that provides income and training opportunities to affected workers. Components of the safety net might include extended unemployment benefits, wage insurance, and retraining.

A key assumption underlying the theory of comparative advantage is that the economy enjoys full employment. Thus, this theory is best thought of as a theory of the long-term, in which workers displaced by imports or offshoring find work in other sectors. By contrast, most popular discussions of the offshoring phenomenon tend to focus on questions such as “where will the new jobs be created” and “can the workers be retrained for these new jobs”. In general, peering into the crystal ball to predict where and what types of new jobs will be created is both difficult and unrewarding. A dynamic economy such as that of the United States creates and destroys millions of new jobs in response to changes in tastes, and more importantly in response to innovations and advances in technology. There is no guarantee that the economy will continue to create these new jobs, but policy makers can take some comfort from the historical evidence that thus far it has managed to do so. The key to job creation is of course the ability of the economy to rapidly generate and adopt innovations—new types of goods and services, and productivity-enhancing process improvements.

In general, trade stimulates innovation and economic growth in both trading partners. Some, such as Ralph Gomory and William Baumol, have argued that completely free trade, can create new possible conflicts of interest between trading partners. For example, insofar as offshoring stimulates, in countries such as China, innovation and productivity growth in goods and services where developed countries such as the United States enjoy a comparative advantage, this will cause the “terms of trade” to become less favorable over time for the United States. In other words, even if free trade is the best policy, it may well be that free trade, by stimulating innovation overseas, may impose long-term losses. However, Gomory and Baumol’s analysis shows that this conflict of interest (deriving from unequal benefits of free trade) is most pronounced when the two trading partners are at similar stages of development. Since most offshoring involves countries at very different levels of development, this conflict of interest is still in the future.

In the IT services sector, there is a related concern. Currently, it is efficient to offshore “low-end” IT services, such as coding or maintenance, to a low-wage country while “high-end” activities, such as requirements analysis, design, and R&D, remain in the high-wage country. The concern is, however, that eventually the high-end IT activities would also move offshore. Were this to happen, the current technology leaders (United States, Germany, Japan, United Kingdom, et al.) may relinquish that leadership role. There is some anecdotal evidence that some IT process innovations are moving to low-wage, offshoring operations.

Most economists, however, argue that current technology leaders will not lose their technological leadership position. Even if production moves to other countries, history shows that in many industries the locus of production and the locus of invention are physically separated. There are two key resources required to remain at the center of innovation in software: access to talented designers, software engineers, and programmers; and proximity to a number of large and technically sophisticated users. Current technology leaders, and the United States in particular, currently dominate on both counts. More broadly, the United States has other important capabilities, including the best universities and research institutions, highly efficient capital markets, flexible labor markets, the largest consumer market, business-friendly immigration laws, and a large and deep managerial talent pool. As a result, the evolution of business in the United States has followed a consistent pattern: launch innovative businesses here, grow the business, and as products and services mature migrate lower-value-added components and intermediate services over time to lower-cost countries. Nevertheless, there are those who argue that globalization will diminish the comparative advantage of current technology leaders, which may lead to the loss of their current dominant position and create a long period of adjustment for their workers.

Data on current and future trends of offshoring leave much to be desired. First, the definitions of offshoring vary from one study to another, making it hard to compare statistics. For example, some studies count all service jobs, some count IT jobs, some include IT-enabled jobs, and some are simply not precise about what they are counting. Second, there is a question of what metric to use in measuring the extent and trends in offshoring. One might measure, for example, jobs lost in the developed country, jobs in the developing country’s IT industry, or dollar value of business outsourced. In the case of each of these metrics, however, it is either difficult to make the measurement or the metric is not directly enough relevant to the offshoring situation. For example, it is difficult to calculate dollar value of business offshored because these are internal transfer costs for multinationals, which they may not be willing to report or do not report in an appropriately disaggregated way.

Projections of future trends are more suspect than data on the current situation. One type of projection identifies types of jobs that are vulnerable to offshoring. These vulnerability projections provide at best a high upper bound on expected job loss, and for this reason they are blunt policy-making tools. It may be that routine programming jobs are vulnerable to offshoring, but it is highly unlikely that every last one of them will be lost to offshoring. Moreover, even in cases where the methodology is sound and soundly applied, projections of any kind about the future are much less likely to be accurate than data about today’s or yesterday’s situation since it is difficult to predict all the factors that will come into effect over time.

Another important issue to consider is the source of the data. Data from the United States and many other national governments tends in general to be reliable. The US government, however, collects data to handle established policy issues. If a new phenomenon arises, the existing data sets may not be well suited to studying the new policy issue. This is the case with offshoring. US data on job layoffs and on service trade are both designed for other purposes, and there is widespread belief among economists that both seriously undercount offshoring trends. Data collected and analyzed by trade associations and consulting firms may be very useful, but there is skepticism in the economic community about the quality of these data in many cases because the methods for collecting and analyzing the data are often not made available for scrutiny, the data they collect (from members of their organization) may not be a representative sample of society as a whole, and these organizations have particular objectives in mind that they hope their data will bolster.

The United States is the source of the greatest number of offshored jobs and where the phenomenon has received the greatest attention. But even for the US, it is difficult to be certain of the extent of offshoring. Federal data is not very helpful, and most of the existing data comes from consulting firms. The numbers generally indicate that 12 to 14 million jobs in the United States are vulnerable to relocation through offshoring, and that annual losses have ranged from under 200,000 to about 300,000 service jobs from the United States to offshoring. The number of IT jobs is somewhat lower than these estimates because these estimates include service jobs such as working in call centers and sometimes other IT-enabled services such as business process and knowledge process offshoring. Importantly, these estimates do not include newly created jobs. The consensus seems to be that about 20% of US companies are currently offshoring work but that the percentage is rising. The current value of offshoring contracts from the United States seems to be in the $10 to 20 billion range, with an expectation of rapid growth. It should be remembered, however, that we do not know the methods used to arrive at these numbers and how independent the data from one consulting firm’s study is from that of another.

Statistics for the entire world or for other individual countries are even harder to come by and more suspect than those for the United States. The annual dollar value of worldwide offshoring trade for recent years has been estimated to be between $1.3 billion and $32 billion, depending on whether certain exported products are counted and whether the numbers for multinational companies are included. An estimated 30% of the world’s largest 1000 firms are offshoring work. Europe has lower levels of offshoring than the United States. It is estimated that only 5% of European businesses (of all sizes) are offshoring, and at most 2 to 3% of European IT workers will lose their jobs to offshoring by 2015. The United Kingdom has the highest rate of work sent offshore of any European nation, with an estimated 61% of firms now offshoring. In Germany, only 15% of companies are now offshoring, and perhaps a total of 50,000 German jobs have been lost to offshoring so far; however, there seems to be an increase in German offshoring in the recent past. Statistics about India show a vibrant IT industry, with annual growth of 20 to 30%, the vast majority of the growth coming in the export rather than the domestic market. Data on the rest of the world are too spotty to trust.

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