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michael at intrafi.com michael at intrafi.com
Mon Sep 20 09:28:55 PDT 2004


Dear Civic,

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The Economics of Offshoring

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Sep 16th 2004  

Nagging doubts about the benefits of globalisation, and a look at the

WHEN David Ricardo, a 19th-century economist, criticised England's
protectionist corn laws, he based his argument on the notion of
"comparative costs", these days called comparative advantage. The idea,
in brief, is that all countries can raise their living standards
through specialisation and trade. Even if one country can make
everything more cheaply than every other it still gains from focusing
on the goods in which its relative advantage is greatest--ie, in which
it has a comparative advantage--and importing the rest. But trade in Mr
Ricardo's day involved grain sent by ship from Germany, not computer
code sent by e-mail from India. As the production of goods and,
increasingly, services is "outsourced" or "offshored" to developing
countries, many people in rich countries worry that this new
development in international commerce will do them and their national
economies more harm than good.

Does such trade defy Mr Ricardo's insights, or does it lead, just like
the old-fashioned kind, to greater overall prosperity? Two papers in
forthcoming issues of the JOURNAL OF ECONOMIC PERSPECTIVES, both by
greatly respected economists, confront this question. The first
paper*[1] is by Paul Samuelson, a Nobel laureate whose textbook has
introduced students to economics for decades. He paraphrases the
defence of free trade by "economists John and Jane Doe spread widely
throughout academia":

Of course, says Mr Samuelson, Ricardo was right. Take the example of a
poorer, less productive economy, and a richer, more productive one:
say, China and America. In the classical model, trade does indeed
benefit both economies. Though there are both winners and losers, the
winners' gains exceed the losers' losses. Productivity gains in China's
export sector raise total wealth in each country.

But, he adds, not so fast. Suppose the poor country, spurred by
technical progress, improves productivity in the rich country's export
goods: think of China's advances in semiconductors or India's in
financial services. Then, says the theory, trade can turn entirely to
the poor country's advantage. The improvement in productivity in the
poor country can reduce the price of the rich country's exports by
enough to make it worse off, despite the increased availability of
cheaper goods. It may be that not just some Americans lose, but that
the country as a whole is worse off. 

Few mainstream economists doubt that this is possible, at least in
theory. Mr Samuelson himself described the idea in the 1970s. Europeans
worried about American growth in the 1950s for this reason, and
Americans later worried about Japan. But evidence that it has been
borne out in practice is thin. Mr Samuelson suggests that the move of
textile manufacturing to the American South may have caused net losses
in the North. Or that Malaysia's leap in rubber production may have had
the same effect on Brazil. But both conclusions are uncertain, and
there are not many other examples available.

Might the new wave of outsourcing to poor countries be different, and
make rich countries poorer? On the empirical side, a paper†[2] by
Jagdish Bhagwati, author of a recent book on globalisation (and listed
by Mr Samuelson alongside John Doe), Arvind Panagariya, his colleague
at Columbia University, and T.N. Srinivasan of Yale provides more help.
They show, also using classical trade models, that outsourcing is no
different in economic terms from the trade that has been going on since
Ricardo's time. The standard results still hold, including the
possibility that a country's export prices could fall so much that it
becomes worse off. Then the authors cast an eye over the empirical

How likely is offshoring to hurt America, they ask? Not very. The
threat posed by Chinese and Indian innovation is overblown. The number
of graduates likely to take white-collar jobs from westerners is
nowhere near the 300m often said to be ready. As skills in China and
India improve, trade with them will become more like that with other
rich countries, from which America has historically benefited.

In any event, outsourcing abroad is too small to matter much. One of
the most popularly cited estimates, by Forrester Research, is that 3.4m
jobs will be outsourced by 2015. That may sound enormous, but it
implies an annual outflow of only 0.5% of the jobs in the industries
affected. In an average year, the American economy destroys some 30m
jobs and creates slightly more, dwarfing the effect of offshoring.

The authors take a sanguine view about the quality of jobs that will
replace those lost to outsourcing. American radiologists need not be
condemned to flipping burgers when their work is shipped to Chennai.
They can turn their skills to the obesity epidemic, or to the
burgeoning field of plastic surgery. There is, surely, more than enough
work to be done.

Does all this amount to a "proof" that trade can only help America's
economy? No. But the marshalling of the evidence on outsourcing, such
as it stands, should calm even the worst bout of trade jitters. Mr
Samuelson's worries, for all his brilliance, can remain safely on the

* "Where Ricardo and Mill Rebut and Confirm Arguments of Mainstream
Economists Supporting Globalization". JOURNAL OF ECONOMIC
PERSPECTIVES[3], Summer 2004.

† "The Muddles over Outsourcing[4]". JOURNAL OF ECONOMIC
PERSPECTIVES[5], Fall 2004.

[1] http://www.economist.com/#footnote1
[2] http://www.economist.com/#footnote1

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