Procurement that pays: Foreign outsourcing, innovation, and profit dynamics

Holger Görg, Aoife Hanley, 7 September 2009

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Outsourcing is an emotive issue. It is an issue on which elections are fought. Consider US President Barack Obama’s fixation on outsourcing in the run up to the November election and the subsequent changes to the US tax system designed to retain US jobs. Business Week (2009) summarised American fears of outsourcing: “US voters have always responded to the fear that the best American jobs could flee overseas…Nobody ever lost a popularity contest by calling outsourcing or offshoring bad names”.

Despite the rhetoric, the effects of foreign offshoring are largely undocumented. Economists have recently begun to report findings based on micro data for outsourcing firms. Services outsourcing in particular is such a new phenomenon (fuelled by internet procurement) that the jury is still out on overall benefits to firms and the economy from its growth.

One recent finding where there is agreement is that foreign outsourcing generates efficiency gains for outsourcing firms (Hijzen et al., 2009, Görg et al., 2008 and Tomiura, 2007). But efficiency is not enough if it masks a “hollowing out” of production, whereby foreign supplying firms absorb ever higher skilled employees and domestic outsourcing firms outsource tasks heretofore carried out by high-skilled employees. This is where technology plays a role. If it can be shown that technology is upgraded with foreign outsourcing, a more solid argument can be made for foreign outsourcing from a welfare perspective. If it can further be shown that technology can be continuously upgraded with foreign outsourcing, we can make an even better case for foreign outsourcing.

What theory says about sustainable outsourcing

The question is whether innovation can be self-sustaining – can it work in a closed loop of globalisation and profitability? This is no longer just an interesting, academic question. This question is fundamental to whether purchasing foreign inputs is good for the economic health of a country. It is an existential, political question.

In a globalised world, firms that outsource inputs have a greater opportunity to reconfigure their innovation. Innovation is financed from a firm’s profits. I Is there a virtuous cycle in which international outsourcing generates profits that feed increased innovation? This is a more complex question that remains to be answered satisfactorily. Theory has already said that this can work. Glass and Saggi (2001) have formulated a model that shows how factor-cost-motivated international outsourcing can induce efficiency changes in a plant that feed through to higher innovation. Higher innovation then can feed back into further outsourcing because a technology gap remains. Figure 1 shows how such a simple system could work with foreign service inputs exerting both a direct (e.g. induced by efficiencies from plant restructuring) and indirect (mediated through profits) effect on innovation. However, empirical evidence for such an “outsourcing-profit channel” has been missing.

Figure 1. Outline of the “innovation-profit” channel

Therefore what remains to be done is to understand the mechanisms of how international service procurement generates gains for outsourcers.

At first glance, outsourcing firms are more innovative

Using unique information on the domestic and foreign services buying behaviour of approximately 2,000 Irish firms for 2002 to 2004 inclusive, we tackle this question in Görg and Hanley (2009). Our analysis considers causal relationships between the procurement of services and firm performance (innovation and profits).

Figure 2 shows that firms most heavily committed to international service procurement manifest higher levels of innovation than non-active firms. The innovative capability of international service outsourcers shows them to have a technological edge over other non-outsourcing firms. Figure 3 shows the breakdown by origin of services purchased by firms. The overwhelming majority of services are purchased locally. Both Figure 2 and Figure 3 are derived from averages in the data. In order to impute any effects on profits and innovation to foreign service inputs, we need to take the data to a regression model.

Figure 2. Innovative capability differences

Figure 3. Foreign services share is small

We set up our regression model in this way. We have two equations, one for innovation and one for profits. We first estimate these two equations separately. Then we estimate them as a closed system in a final step.

How foreign procurement increases innovative capability

First, consider the innovation equation. The theoretical idea behind the innovation model is that outsourcing affects profits, which in turn enhances a firm’s ability to invest in innovation (indirect effect in Figure 1). In order to investigate whether our data is in line with this explanation we include a firm’s profits as a controlling variable. It is likely that foreign service inputs have an effect on innovation even when we control for profitability, for a number of reasons. The first is the issue of timing. The impact may be very long-term, longer than the three-year window in our data. Secondly, economic profitability is notoriously difficult to capture accurately. Thirdly, outsourcing may have a more direct effect on innovation if it compels plants to restructure their work processes, the result of which restructuring brings about profit improvements. Our final, estimated innovation model also contains a set of other influences expected to drive innovation, such as domestic service inputs (not expected to have as high an impact as international service procurement due to more limited scope for factor cost savings by firms) and characteristics of the firm such as industry sector.

A critic could argue that this picture of outsourcing is not very representative, encompassing only services outsourcing. A firm outsources a broad range of intermediates, most of which are tangible. Therefore, we expand this description of outsourcing to include material inputs, both domestic and foreign.

Table 1 shows that foreign service inputs contribute greatly to a firm’s innovation.1 Domestic services also contribute to innovation, but less so. This is in line with our earlier conjecture that foreign services offer greater scope for factor cost reductions than their domestic counterparts. In percentage terms, this corresponds to a 2.5% increase in innovation for each 1% increase in the value of foreign services outsourced. Interestingly, the effect on innovation is not all mediated through the “innovation-profit” channel. Part of the effect continues to arise directly as a result of foreign services purchased.

Table 1. How innovation and profits change when outsourcing changes

Notes: Coefficients for firm’s exporting status, size, industry, and time are unreported. Models in (1) and (2) assume reverse causation for outsourcing variables. Estimated using IV technique with within-transformed variables. Model results in (3) and (4) uses 3SLS technique. Model fit, and regression diagnostics not included for brevity and clarity. Profits are defined as profits/sales. Innovation defined as R&D/sales.

Foreign procurement also increases a firm’s profits

Now we turn to our profits model. Column 2 of Table 1 shows that foreign services are beneficial for overall profitability, more so than for any other type of input. A 1% increase in foreign services causes profits to rise 0.4%.

Critics might argue that it is not very informative to estimate innovation and profits separately. Surely, the two are inextricably linked in a closed-loop framework – innovation affecting profits and vice versa? This is why, as a final step (columns 3 and 4) we put the data to a simultaneous model that estimates innovation and profits as a complete system. This final step does not change our results much at all. Once again, foreign service inputs represent good news for both innovation and profits. A 1% increase in foreign services purchased raises innovation and profits by 2.5% and 0.9% respectively.

The verdict: No “hollowing out” of production

We do not find any evidence for “hollowing out” in our data. On the contrary, we see that even when the complexities of causal relationships between innovation, profits, and foreign input outsourcing are taken into account, a firm’s technological edge (innovation) moves up a gear when firms outsource foreign services. There is also a difference in effects for domestic versus foreign inputs. Foreign-sourced service inputs bring about by far the highest profit and innovation dividend. This we already expected given the greater scope for factor-cost reductions when firms forage more widely and outsource on foreign markets.

Overall, the outsourcing of international services is seen in our analysis as a force for the good. A firm’s innovation rate rises hence allowing plants to continue to shift their technological frontier further outwards, thus sustaining their competitive position.

References

Business Week (2009), “Obama vs. Outsourcing”, May 6.
Glass, A. and K. Saggi, 2001, “Innovation and wage effects of international outsourcing”, European Economic Review, 45, 67-86
Görg, H., A. Hanley and E. Strobl (2008), “Productivity effects of international outsourcing: Evidence from plant level data”, Canadian Journal of Economics, 41, 670-688.
Görg, H. and A. Hanley (2009), “Services outsourcing and innovation: An empirical investigation”, CEPR Discussion Paper 7390.
Hijzen, A., T. Inui and Y. Todo (2009), Does offshoring pay? Firm level evidence from Japan, Economic Inquiry, forthcoming.
Tomiura, E. 2007, Foreign outsourcing, exporting, and FDI: a productivity comparison at the firm level, Journal of International Economics 72, 113-27


1 We should note that we had to apply further refinements to the simple model before our outsourcing measure was correct in this model. Therefore, the results reported here are derived having instrumented for our outsourcing variables.

 

Topics: International trade
Tags: outsourcing, trade in services

Professor of International Economics, Kiel Institute for the World Economy
Lecturer, University of Kiel