The case for American outsourcing

A friend of ours who was recently visiting India from the US had a relevant concern for his own well-being: is the US losing its competitiveness?

This concern seems somewhat well-founded if we observe instances of bans on business process outsourcing in various states of the country, starting with New Jersey, that has been recently superceded by a federal bill that prevents certain departments (US departments of treasury and transportation) from subcontracting their work to overseas companies.

Why do we expect the US to be afraid of the loss of jobs? The share of agriculture in total national output of the US is small, the share of manufacturing has been steadily falling, and all of us know what the service economy of most of the nations has become, led by the US itself.

Thus, it should be a cause for concern if a lot of this service activity is outsourced to countries like India and China where the labour is cheaper.

Just because a majority of service activity is outsourced to other countries, is there a reason for the US to worry? Various theories of international trade (primarily those proposed by Ricardo and Heckscher-Ohlin) show the allocative efficiency that is expected to result from trade liberalisation.

That is, a labour-abundant country would have a low relative price of labour when compared to a labour-scarce country. Similarly, in a capital-rich country, capital would be available at a cheaper price compared to countries where capital is scarce.

Hence it would be economically most efficient if the capital-rich country exported capital-intensive products and for the labour-surplus country to export labour-intensive products.

What does this mean for American competitiveness?

In an attempt to empirically test this theory, in the early 1950s, Wassily Leontief computed the ratios of capital stock to the number of workers in the US export industries and import-competing industries.

The test provided by the Heckscher-Ohlin model, if it was right, was that the US export bundle should have a higher capital-labour ratio, than that embodied in import-competing industries.

He found the paradoxical result that the US was, in fact, exporting labour-intensive goods to the rest of the world in exchange for capital-intensive imports! Leontief found that the factors responsible for the paradoxical results were:

Skills and human capital: It was found that human skill, not essentially labour, is the factor of production in which the US was most abundant, so that the amount of capital used per worker was less.

Thus, the export bundle appeared as if it was labour-intensive. Note that labour intensity implies that the capital-output ratio is low. This implies efficiency in the use of labour even when the amount of capital used per unit of output is small, being attributable to skills.

Trade barriers: The US did not import labour-intensive goods because it wanted to protect its high-cost labour-intensive industries.

So while it protected its labour-intensive industries, it allowed imports of capital-intensive goods that could easily compete with its cheap capital-intensive goods produced at home. If there was free trade, the US would have imported more labour-intensive products than it actually did.

Thus, free trade allows a country to focus on the factors in which it has a comparative advantage. Protectionism moves a nation away from low-cost towards high-cost sources.

Precisely because of the high labour skills component, one could, in fact, believe that the US will not lose its competitiveness. Further, note that the US is a warehouse of the best infrastructure and incentive structures, so it can attract the best skills available.

However, take the case of India. It is paradoxical that in a country like ours, which has practised various forms of socialism, we can actually practice the comparative advantage that a free enterprise encourages!

That is, manpower is available cheaply at various skill levels; so, for instance, we can recruit household help for routine work and can concentrate on our area of expertise. In a free enterprise economy like the US, however, it cannot utilise its human resources optimally.

Leaving aside rich Americans, rarely do we find middle-class Americans recruiting someone to do their chores. To this extent, the innovation and creativity is stifled. In India and in other labour-surplus countries, however, we have this advantage that scarce skills can flourish whereas lesser skills are affordable and can be managed by others.

If nothing, it is this -- expensive labour -- that could sound the deathknell for many American companies and jobs. Note that it is not efficiency, but the price of American labour that is under discussion. So, what can be done?

In the market economy, obviously, wages cannot be lowered for a given skill level. However, the US can increase the supply of its labour. If it were to do this, according to the theory of comparative advantage, the price of labour will decrease, providing the US competitive advantage.

A good way for it to do this is to remove bans on BPO and increase the supply of skilled manpower so that, in the long run, the price of American labour is also reduced to the same extent observed for foreign labour in the US.

Thus, the solution is certainly not to ban outsourcing, but to actually encourage it, so that Americans with similar skills also become reconciled to lower wages in a globalised economy. In other words, practising free trade works to the US's advantage in the long run.

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