Can offshoring lead to reduced inequality?

Karolina Ekholm, Karen-Helene Ulltveit-Moe, 20 August 2007

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The received wisdom is clear. Globalisation in general, and offshoring of manufacturing production to low-wage countries in particular, raise wage inequality in industrialised countries. No wonder that a recent poll shows that an overwhelming majority of people in the US and Europe view globalisation as a negative force. Citizens of the US and the EU look to their governments to undertake actions that can reduce what they perceive as unjustified rewards to corporate executives triggered by globalisation. Among the most popular initiatives are trade protection and tax reforms.

If offshoring produces increased wage inequalities, policy makers do indeed face challenges that require policy actions at the national level. Tax and transfer systems need reforming and increased focus on education is essential.

But is the received wisdom correct? Is the view that offshoring produces more wage inequality justified by empirical evidence?

There has been a substantial increase in offshoring of manufacturing production -- driven by falling costs of transportation and communication -- during the last few decades. According to Feenstra and Hanson (1999), imported inputs roughly doubled in the US during the period from 1972 to 1990, measured as the share of imports in total intermediate purchases

There is also plenty of empirical evidence that offshoring matters for relative wages. For instance, Canals (2006) found that offshoring of unskilled labour-intensive activities accounted for 28% of the observed relative wage change between 1980 and 1999 in the US.

But a closer look at the numbers shows that recent developments in US manufacturing do not conform to the pattern of increased wage inequality. The evolution of relative wages between non-production and production workers has in fact been bell-shaped over the last three decades.

Source: US Census

As the figure shows, the relative wage of non-production workers increased in US manufacturing during the period from the late 1970s to around 2000, but thereafter this development was reversed. The last few years have been characterised by a decline in the relative wage at the same time as the skill intensity, measured by the ratio of non-production to production workers, has increased.

Is this pattern related to globalisation and offshoring? We believe it is. Our recent research into the economic logic connecting wage inequality to globalisation and offshoring argues that there are two cross-cutting forces at work (see Ekholm and Ulltveit-Moe, 2007).

Starting from the basics, we view relative wage for skilled labour in rich nations as determined by the interaction of relative supply and relative demand. The relative supply is fairly constant over recent years, so the key drivers are to be found on the labour demand side. Here, globalisation and offshoring create two different effects. (1) a specialisation effect, and (2) a competition effect.

The logic of the first effect is straightforward. Globalisation triggers offshoring and vertical specialisation based on comparative advantages. Following the usual logic of trade theory, high-income, skill-abundant countries specialise in skill-intensive activities. This increases their relative demand for skilled labour and puts upward pressure on the relative wage of skilled workers. This ‘specialisation effect’ is the basis for the received wisdom about the relationship between offshoring and wage inequality.

However, there is another effect as well. As trade barriers fall and protective measures are abolished, globalisation brings fiercer competition among firms. Competition induces firm exit as well as mergers and acquisitions, implying a reduced number of firms. As a result, headquarters' activities such as management, marketing, accounting – all exclusively involving non-production workers – are squeezed. In relative terms, the demand for non-production workers falls and there is downward pressure on the relative wage of these workers.

We believe that these two opposing forces on the relative wage of non-production workers explains why the straight-line increase in globalisation and offshoring has not produced a straight-line growth in relative wages (as per Figure 1). Depending on the details of the exact nature of the globalisation and offshoring that is occurring, and the initial situation in the country, either force may dominate. Thus contrary to received wisdom, we may observe a decrease rather than an increase in wage inequality.

What are the lessons for policy? The analysis of the opposing impacts of globalisation makes clear that what matters for the impact on wage inequality is the degree of international integration. The bell-shaped evolution of the relative wage goes hand in hand with falling trade and communication costs. Hence, any policy initiative that would aim at dampening negative distributional effects of globalisation by impeding free trade is misguided. In fact, it may very well be that promoting globalisation is not only good for efficiency, but for equality as well. The increased competition that follows from further international integration affects the wages of those who so far have been relatively sheltered from competition. This involves skilled workers much more than unskilled workers, who are already exposed to fierce competition. Increased focus on abolishing remaining protective measures that impede the free movement of goods and services should therefore be the way ahead. Not only for the sake of economic efficiency, but also to promote equality.

References

Canals, C., 2006, "What explains the widening wage gap? Outsourcing versus technology.", mimeo, Columbia University.

Ekholm, K. and K.H. Ulltveit-Moe, 2007, “A new look at offshoring and inequality: specialization versus competition”, CEPR Discussion paper no. 6402

Feenstra, R. C. and G. Hanson, 1999, "Productivity measurement and the impact of trade and technology on wages: Estimates for the U.S., 19772-1990.", Quarterly Journal of Economics 114: 907-940.

Topics: Poverty and income inequality
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Comments

Are you advocating a race to the bottom?

I find Ekholm and Ulltveit-Moe’s argument puzzling. I don’t see how the existence of downward pressures on the relative wage of skilled workers is positive. Ekholm and Ulltveit-Moe’s advocacy for further globalization relies on the belief that it will reduce inequality not by lifting low wages but by reducing high wages. In another words, it indirectly supports the claim that globalization entails a race to the bottom wage-wise. This is not the best defense of globalization I’ve read. I still prefer to the Paul Krugman line.

Marcos Ancelovici
http://mancelovici.wordpress.com/

offshoring and reduced inequality

so offshoring will reduce inequality by depressing all wages, both for skilled and for unskilled workers ?
forgive me if I do not find this comforting. I'm not sure that enabling offshoring in the context of this result is really a good policy goal.
Also, this appears to neglect the USA phenomenon, whereby inequality is not a product of wage differentials so much as it is one of the investor and C-classes (CEO, etc) being massively overcompensated.

Deputy Governor of Sveriges Riksbank and CEPR Research Affiliate

Professor of Economics at the Department of Economics, University of Oslo and CEPR Research Fellow