Can offshoring cut inequality?

The rapid rise of offshoring has been one of the most visible trends in the US labour market over the last three decades. Despite its prevalence, the implications for wages and skill premia are still debated (see, for instance, Grossman and Rossi-Hansberg 2008 and Baldwin and Robert-Nicoud 2014).

The production structure of Apple’s iPod illustrates some of the potential effects. Like many other high-tech products, the iPod is designed in the US and is made of components produced all over the world and assembled in China. Though most production jobs are offshored, a significant number of high-skill engineering jobs and low-skill retail jobs are created in the US, and more than 50% of the value added of the iPod is captured by domestic companies. With more limited offshoring, some of the production jobs may have stayed within the US borders, increasing the demand for the services of low-skill production workers. But this would have also increased the cost and price of iPods, reducing employment not only in engineering and design occupations but also in retail and other related tasks.

In Acemoglu et al. (2014), we study the impact of offshoring on wages of high- and low-skill workers through its effect on technological progress. Returning to the example of Apple products, the variety of iPods may not have been profitable to introduce and develop if labour costs were higher – as they would have been without offshoring. More importantly, iPods and other products may have been designed differently in the face of these different labour costs.

To study these issues, we build a model where an advanced country (the ‘West’) invests in innovation to boost the productivity of either high-skill or low-skill workers, and can pay an offshoring cost to relocate part of production to a skill-scarce, low-wage country (the ‘East’).

Offshoring, innovation, and the skill premium: An inverted-U relationship

As in models of directed technical change (e.g. Acemoglu 2002, 2007), the effect of offshoring on the factor-bias of innovation works through price and market-size effects. By lowering the cost of tasks performed by low-skill workers, offshoring opportunities increase the relative price of skill-intensive products. This price effect tends to spur innovation in the skill-intensive sector. Counteracting this, however, offshoring opportunities expand the market for technologies used by low-skill labour. This market-size effect tends to induce innovations in less skill-intensive sectors.

Our key finding is that which force dominates depends on the level of offshoring. In the most plausible scenario, for low levels of offshoring (i.e. when offshoring is initially expensive), the price effect dominates, so that greater offshoring opportunities initially induce skill-biased technical change. If the level of offshoring is already high (i.e. when the offshoring cost is sufficiently low), however, the opposite pattern obtains. Thus, the inequality-promoting effect of offshoring is greatest at the beginning.

The reason for this switch in the direction of technological progress is that more offshoring increases the demand for labour abroad and thus wages in the East. In turn, the closing of the wage gap between countries mutes the price effect that was fuelling skill-biased innovation. The impact of offshoring on technology yields new implications for the evolution of the skill premium. Not surprisingly, offshoring first increases wage inequality in the West. However, as offshoring continues, technical change eventually changes direction and may even lower the skill premium. Under mild conditions, the same pattern can hold in the East as well.

But which scenario is more plausible? To address this question, we calibrated the model to roughly match wages and offshoring in the US and China. The results of our simulations suggest that, during the period 2000–2008, offshoring may have increased the skill premium by 10% and marginally eroded the real wage and welfare of US low-skill workers.

Conclusion

The predictions of our model are broadly consistent with the available evidence. The first wave of offshoring in the 1980s coincides with a sharp decline in the real wages of US low-skill workers, but as offshoring continues to expand in the late 1990s and 2000s, unskilled wages stabilize and begin rising (e.g. Acemoglu and Autor 2011). Moreover, the finding that offshoring may have triggered skill-biased technical change, thereby raising wage disparities, is consistent with recent findings that imports from China encouraged investments in information technology (Bloom et al. 2011) and reduced US employment (Autor et al. 2013).

According to the theory, however, the implications of offshoring are very different once its volume reaches a critical level. If wages in China keep rising at current rates, further offshoring may soon induce innovation in less skill-intensive sectors. Thus, the future distributional effects of offshoring could be quite different from its past impact.

Published in collaboration with VoxEU.

Authors: Daron Acemoglu is Charles P. Kindleberger Professor of Applied Economics in the Department of Economics at the Massachusetts Institute of Technology. Gino Gancia is senior researcher at CREI (Barcelona), adjunct professor at Universitat Pompeu Fabra and affiliated professor of the Barcelona Graduate School of Economics. Fabrizio Zilibotti is a Professor and Chair for Macroeconomics and Political Economics at University of Zurich, Scientific Director of the Center of Economics in Society at UBS and CEPR Research Fellow.

Image: A worker examines a circuit board inside a Foxconn factory in the township of Longhua in the southern Guangdong province May 26, 2010. REUTERS/Bobby Yip