Does offshoring hurt domestic innovation activities?

Bernhard Dachs, Bernd Ebersberger, Steffen Kinkel, Oliver Som 07 September 2013

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Offshoring of production activities has been a topic of economic policy debates for at least the last decade. A central issue in these debates are the economic effects of offshoring on firms in the home country. Most contributions investigated the effects of offshoring on output, employment or skills (see the surveys of Lipsey 2002, Olsen 2006, Crinò 2009) and find a complementary relationship between foreign and domestic economic activity, at least in the long run.

The effects of offshoring on innovation and technology investment came into focus only recently. Conventional economic wisdom suggests that offshoring changes the internal division of labour between various parts of the firm and strengthens capital-, technology-, and skills-intensive types of economic activity in the home country, including headquarter services such as innovation and research and development. Studies on the changing skills composition of offshoring firms (for example Becker et al. 2013) provide empirical support for this assumption.

This view has been challenged by various authors who point to possible negative effects of offshoring on national innovation capabilities. Gary P Pisano and Willy C Shih (2012), for example, state that “mass migration [of manufacturing] has seriously eroded the domestic capabilities needed to turn inventions into high-quality, cost-competitive products”. Pisano and Shith argue that close linkages between production product development are main source for product innovation. This idea goes back to the notion of the ‘factory as a laboratory’ (Leonard-Barton 1992) and to interactive models of the innovation process (Kline and Rosenberg 1986), and has also been brought forward recently by Ketokivi and Ali-Yrkkö (2009) for Finland. Offshoring cuts these ties.

An empirical test of the link between offshoring and innovation

Hypotheses on the effects of offshoring are difficult to test empirically. An experiment has to observe a firm at one point in time as an offshoring and as a non-offshoring firm, which is impossible. Thus, we construct a control group of non-offshoring firms with propensity score matching (Blundell and Costa Dias 2000, Czarnitzki 2005). This control group is mostly identical to the sample of offshoring firms except that the firms in this group did not move production activities abroad in the period 1999-2006 (see Dachs and Ebersberger 2013 for details). We then compare the innovation behaviour of these two groups between 2007 and mid-2009 to examine the causal effects of offshoring.

Data is provided by the European Manufacturing Survey (EMS),1 a survey of product, process, service, and organisational innovation in European manufacturing. The sample includes 3,106 manufacturing firms from seven countries. German firms have the largest share in the dataset. Innovative input is measured by the share of personnel engaged in research and development and design. Product innovation is operationalised by a dummy that indicates if the firm has introduced products new to the firm and new to the market and by the turnover share of firm and market novelties; finally, process innovation is captured by information on the implementation of 13 different production technologies.

Are offshoring firms more innovative?

We first test for effects of offshoring on innovation input.

  • Results suggest that offshoring firms employ a significantly higher share of employees in research and development and design.

Research and development and design personnel accounts for 13.7% of total employment in offshoring firms, compared to 11.9% in non-offshoring firms.

This result supports the view that offshoring firms specialise on skill-intensive, non-routine tasks and rejects fears of a lower innovation performance due to offshoring.

  • Offshoring firms are also more likely to introduce new products to the market, including market novelties.

58.7% of the firms which have offshored production between 1999 and 2006 have introduced products new to the market between 2007 and mid-2009. The corresponding share for non-offshoring firms is 51.7%. The difference is significant at 10% error level. Internationalisation via offshoring may increase sales expectations of firms, which in turn spur product development. However, offshoring firms do not yield larger benefits from product innovation than non-offshoring firms. Sales from new products as a share of total turnover reveal no significant difference. This may rather reflect the uncertainties of the innovation process than to adverse effects from offshoring.

To study process innovation, we construct an involvement index that resembles the index used in Bozeman and Gaughan (2007, 2011). This procedure weights up (relatively) rare utilisation of technologies, and weights down (relatively) common ones. We calculate an overall involvement index, and sub-indices for production technologies, value chain integration technologies, and product development technologies.

Results reveal a positive effect of offshoring on process innovation (see Figure below). Offshoring firms invest significantly more frequent in production technologies and in technologies that facilitate the management and integration of global value chains. These technologies are a means to facilitate the integration of production processes between suppliers and clients across firm boundaries and therefore promote the trade in tasks. Investment in technologies for product development show no significant difference.

This result clearly contradicts the assumption that offshoring is associated with a loss of domestic production activity. However, it supports the international economics literature which predicts that offshoring firms in the home country will focus on skill-intensive and capital-intensive activities. An explanation is that offshoring firms concentrate on the most advanced, most productive equipment – which can compete with low wages at locations abroad – in the home country to avoid involuntary knowledge spillovers to foreign competitors and increase flexibility.

Figure 1. Process innovation in offshoring and non-offshoring firm, 2007 to mid-2009

Notes: ***, (**,*) indicates significance at the 1%, (5%, 10%) level.

Source: EMS.

Overall, we see no negative effect of production offshoring on innovation and technological capabilities of firms in the home country. Most indicators reveal that offshoring is associated with a higher innovation performance at the firm level. We explain this result by the changing specialisation patterns of offshoring firms towards research and development, design and innovation in their home country. Moreover, innovation activities in the home countries may also benefit from additional demand generated abroad. Fears that offshoring hurts innovation because it cuts links between production and product development are not supported by our results. An important limitation of the results, however, is the fact that we cannot observe firms that offshored all their production activities.

Implications for research and policy

Our findings provide fresh evidence on the relationship between offshoring and innovation, a field where empirical results were scarce so far. They support a view on internationalisation of firms that regards offshoring as a strategy of international expansion, and not a passive reaction of firms to a loss of their competitiveness.

With respect to policy, the analysis does not confirm fears of a weakening of national competitiveness due to offshoring:

  • Activities that add to the technological capabilities of firms and their ability to create competitive advantage – such as research and development, design or process innovation – are positively associated with a firm’s decision to offshore production activities.
  • Concerns that offshoring may hurt innovation because of lost links between production and product development are not supported by the evidence.

On contrary, offshoring firms have higher propensity to invest in advanced production technologies in the home country than the control group of non-offshoring firms.

Our findings also point to complementarities between domestic education and innovation policies and internationalisation:

  • Domestic firms are likely to specialise in knowledge-intensive activities when they internationalise their production activities.
  • Policy can help to take full advantage of the benefits from internationalisation by promoting education and qualifying personnel early enough, particularly in countries or regions where talent is short.

Editor’s note: The authors gratefully acknowledge support by the Research Center International Economics (FIW), which was commissioned by the Austrian Federal Ministry of Economy, Family and Youth as part of the Austrian Federal Government’s Internationalisation Initiative.

References

Becker, S O, K Ekholm, and M-A Muendler (2013), "Offshoring and the onshore composition of tasks and skills", Journal of International Economics, 90(1), 91–106.

Blundell, R, and M Costa Dias (2000), "Evaluation Methods for Non-Experimental Data", Fiscal Studies 21(4), 427-468.

Bozeman, B, and M Gaughan (2007), "Impacts of grants and contracts on academic researchers’ interactions with industry", Research Policy, 36(5), 694-707.

Bozeman, B, and M Gaughan (2011), "How do men and women differ in research collabourations? An analysis of the collabourative motives and strategies of academic researchers", Research Policy 40(10), 1393-1402.

Crinò, R (2009), "Offshoring, Multinationals and Labor Market: A Review of the Empirical Literature", Journal of Economic Surveys, 23(2), 197–249.

Czarnitzki, D (2005), "The Extent and Evolution of Productivity Deficiency in Eastern Germany", Journal of Productivity Analysis 24, 211-231.

Dachs, B, and B Ebersberger (2013), "The Effects of Production Offshoring on R&D and Innovation in the Home Country", Vienna, FIW-Research Reports 2013/14 N° 01, June.

Ketokivi, M, and J Ali-Yrkkö (2009), "Unbundling R&D and Manufacturing: Postindustrial Myth or Economic Reality?", Review of Policy Research, 26(1-2), 35-54.

Kline, S, and N Rosenberg (1986), "An Overview of Innovation", in R Landau and N Rosenberg (eds.) The Positive Sum Strategy - Harnessing Technology for Economic Growth, 275-305, Washington, National Academy Press.

Leonard-Barton, D (1992), "The factory as a learning labouratory", Sloan Management Review, 34(1), 23-38.

Lipsey, R E (2002), "Home and Host Country Effects of FDI", NBER Working Paper, Vol. 9293, Cambridge, MA.

Olsen, K B (2006), "Productivity Impacts of Offshoring and Outsourcing: A Review", Paris, OECD STI Working Paper 2006/1.

Pisano, G, and W C Shih (2012), "Does America Really Need Manufacturing?", Harvard Business Review, 90(3), 94-102.


1 Available at http://www.isi.fraunhofer.de/isi-en/i/projekte/fems.php?WSESSIONID=e45e53f285086770e768a3ac41a53e3e.

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Topics:  Productivity and Innovation

Tags:  R&D, Labour Markets, offshoring

Senior Scientist at the Innovation Systems Department, AIT Austrian Institute

Professor, Management Center Innsbruck (MCI); Guest Scientist, Technical University of Berlin

Professoe at the Faculty of Computer Science and Business Information Systems, Karlsruhe University of Applied Sciences

Deputy Head of the Competence Center "Industrial and Service Innovation", Fraunhofer Institute for System and Innovation Research