The Economic Implications of Outsourcing

Prepared by

Shalley Dash
Fellow, Economics area
Institute of Integrated Learning and Management
3, Lodhi Institutional Area
Lodhi Road
New Delhi 1100 03
Mobile : 9350837459

shalley.dash@ iilm.edu

Abstract

For a developing economy such as India with a large pool of trained manpower outsourcing
represents a huge economic opportunity. In the West there has been considerable media led agitation
against outsourcing due to the unemployment it causes. The key point is that jobs created by
outsourcing are not really in Indian hands. It becomes imperative to understand what the political and
economic imperatives are governing outsourcing in the West. If political conditions in the West turn
adverse towards outsourcing it is likely to lead to protectionist tendencies and restrictions on
companies outsourcing to India.

This paper examines the economic implications of outsourcing within the context of the standard
Ricardian Comparative Advantage framework. An attempt is made to identify what are the benefits
and costs of outsourcing to both the US and India both theoretically and empirically. Key predictions
from trade theories are identified and the analysis distinguishes between losers and gainers both in
the short and medium run. This is further explored by looking at the evidence regarding employment
and outsourcing trends in the US and identifying future trends in outsourcing. The implications of
increased protectionist tendencies in the West for growth, and outsourcing are also explored.

Introduction

For a developing economy such as India with a large pool of trained manpower outsourcing
represents a huge economic opportunity. A study by the McKinsey Global Institute predicts that the IT
sector is expected to employ 4 million Indians and generate US$57 billion, or 7% of the GDP, by
2006.1 Outsourcing offers employment possibilities to trained labour without requiring labour mobility.
This has macroeconomic benefits too as increased employment adds to Indias national income and
purchasing power which adds to demand leading to a cycle of further growth.

From the perspective of the West outsourcing is in line with what neo classical economics suggests.
Firms outsource because they find that certain processes can be performed more cheaply elsewhere,
possibly developing economies. Outsourcing therefore represents a form of labour mobility without
actual movement of labour. Outsourcing reduces costs for firms and increases productivity. In the long
run both the individual firms and the economy can only benefit from such reduced costs and
increased profitability. But in the short run outsourcing causes unemployment .It is the short run where
we have to consider what is the euphemistically termed by international trade theories as adjustment
costs or redistributive effects of such policies and their implications for the future of outsourcing.

From the Indian perspective, outsourcing clearly represents a win win situation. Outsourcing brings in
jobs, provides employment for Indias large population of the educated unemployed graduates. In fact
as the Economist points out India has become one of the most important global offshoring
destinations primarily because of the more than 300,000 English-speaking college graduates a year
2

being churned out by the Indian educational system. If we factor in the macro effects of this
increased employment, it implies more expenditure, savings, demand for goods and services.

The theory of comparative advantage predicts that countries will specialize in production of goods
and services that they have a relative comparative advantage in and would import goods in which
other countries are more efficient. In this case the issue is that of the relative edge that the two
countries enjoy in the area of service exports. A key prediction from the International trade theory is
that for the outsourcing country there will be an increase in productivity, growth and employment in

sectors that benefit from outsourcing, whereas sectors facing outsourcing will shrink both in terms of
output and employment. A major problem that has surfaced with outsourcing has been the high
pitched emotional reaction of the American public, press and even politicians to the issue of jobs lost
due to outsourcing.

The key point is that jobs created by outsourcing are not really in Indian hands. We do the work but it
is created elsewhere. Therefore it becomes imperative to understand what are the political and
economic imperatives governing o utsourcing in the West. If political conditions in the West turn
adverse towards outsourcing it is likely to lead to protectionist tendencies and restrictions on
companies outsourcing to India. The moment this happens the flow of jobs to India or any other
outsourcing destination may start to dry up.

This paper seeks to provide an analysis of the costs and benefits associated with outsourcing within
the framework of international trade theories. An attempt is made to identify what are the benefits and
costs of outsourcing to both the US and India. The analysis distinguishes between losers and gainers
both in the short and medium run. The conclusions and predictions based on trade theories are
examined for relevance in the real world.

The structure of the paper is as follows: Section 1 examines the basic dimensions of the outsourcing
issue. Section 2 analyzes the outsourcing problem in a more formal way within the framework of the
theory of Comparative Advantage. Section 3 examines the empirical evidence regarding size and
benefits of outsourcing. One of the main problems associated with outsourcing is the perception that
outsourcing is moving up the skill ladder and upper end White Collar jobs are also being exported to
cheaper destinations. Section 4 anal yzes evidence of recent trends in outsourcing. Section 5 looks at
the effect of outsourcing on the American economy in terms of industrial growth, productivity and
employment. A major fall out of the recent media debate on is that there have been increasing calls
for protectionism by many sections of American society. Section 6 analyzes the likely fall out of
possible protectionist measures on the American economy. Section 7 summarizes the main
conclusions and offers some policy implications both for India and the US.

Section 1
Traditionally, outsourcing has been described as the sub-contracting of services from one company to
another - an activity as old as the first firms. Today, the term has come to encompass the specific
trend of importing services from low-cost providers located offshore offshoring.

The outsourcing market for Information Technology (IT) services has been transformed over the past
decade. Rapid changes in communications and IT technology have reduced both the cost and time
required in transferring large amounts of data. For example advances in telecommunications have
resulted in an 80% rate reduction for a one -minute telephone call between India and US/Britain since
2001 and have made India one of the world's most attractive destinations for the offshoring of
3

services. Further outsourcing has started to diversify from its traditional strongholds of IT services to
many other types of business services for example the Call Centre is an example of outsourcing to
handle service-rel ated problems. Outsourcing has rapidly expanded to encompass a wide range of
services and back room operations of companies.

Companies in several sectors including healthcare, industrial, and information and communication
technologies have been establishing R&D bases in Asia - especially China and India. For instance,
Microsoft has set up its R&D arm in China, while GlaxoSmithKline plans to conduct four clinical trials
in India in 2004. Industrial companies including Visteon are launching R&D centers in China while
automotive companies such as General Motors have chosen India to outsource its complicated,
technical white-collar work to. The spread of this trend has been so pervasive that it has spread to all
kinds of services for example newspapers report that churches in the US and Europe are
outsourcing Holy Mass to parishes in Kerala in India where it is now known as the Dollar Mass.

Empirical evidence on the size of outsourcing presents a confused picture. Statistics are few and far
between, though there are a lot of emotional claims regarding the size of outsourcing to India and
other developing economies. Yet, in the absence of hard numbers, the public debate that has been
generated in the US is in danger of obscuring the powerful technolo gical and organizational changes

driving this phenomenon. Few large companies are now even prepared to discuss their outsourcing
strategies in public.

The Political and social dimensions of the outsourcing debate

Why is the export of service sector jobs causing so much of public anxiety? Outsourcing of
manufacturing jobs, for example, has been going on for a much longer time and probably affected far
more workers in the early 70s? Outsourcing was one of the dominant issues in the recent 2004
elections with some political and organizational bodies demanding regulations on offshoring.

The outsourcing debate got a serious fillip when George Manikiw: Chairman of Economic Advisers to
the white house came out strongly in favour of outsourcing. His now much quoted comment goes as
follows:
Outsourcing is a growing phenomenon, but its something that we should realize is probably a plus
for the economy in the long run. Were very used to goods being produced abroad and being shipped
here on ships or planes. What we are not used to is services being produced abroad and being sent
here over the Internet or telephone wires. But does it matter from an economic standpoint whether
values planes and ships or over fiber-optic cables? 5

Manikiws comment provoked a virtual storm of protest from all quarters of the American public.
Shorn of political rhetoric and media hype the main fear of the American public at large is that in a
world, where technology is evolving rapidly, the information revolution (especially the Internet) has
accelerated the decimation of U.S. manufacturing. Even service-sector jobs once considered safe,
can now be easily outsourced to cheaper destinations in the developing world.

The next section examines at the economics behind Manikiws com ment and its validity in the context
of the theory of Comparative Advantage.

Section 2

An Analysis of Outsourcing Within the Framework of Ricardian Comparative Advantage

As Manikiws comment shows there is nothing intrinsically different between imports of services and
imports of manufactured goods. The outsourcing problem lends itself to being analyzed most simply
using the simple Ricardian Comparative Advantage Model. In this section we overview the main
elements of this approach and it applicability to the outsourcing problem. An attempt is made to derive
predictions and hypotheses regarding the course of outsourcing and the impact of outsourcing on
other domestic sectors. The analysis is as yet in the preliminary stages and no attempt is made to
fo rmalize it into a mathematical model. Although the Ricardian model represents a gross
simplification of reality, it can still offer important guidance on the current outsourcing controversy,
expected benefits for the American economy and predictions for future trends.

Current day trade theory has its beginning in the late eighteenth century by David Ricardo who first
articulated the key concept of Comparative Advantage. Ricardo demonstrated that for two nations
without input factor mobility, specialization and trade could result in increased total output and lower
costs than if each nation tried to produce in isolation. Key to Ricardos analysis is the distinction
between absolute and comparative advantage for a country.

Comparative Advantage Explained

A country has a comparative advantage in producing a particular good if the opportunity cost of
producing that good in terms of other goods is less than in another country. The key point about
Ricardian Comparative Advantage is that it allows a country to specialize in producing the good in
which it has a comparative advantage. Even if one country can make everything more cheaply than
the other, it still gains from focusing on the goods in which its relative advantage is greatesti.e., in
which it has a comparative advantage and importing the rest.

We now introduce the great outsourcing debate. If we assume that America has a comparative
advantage in high technology items such as defense equipment, NASA rockets, supercomputers, etc.
India, on the other hand, has a comparative advantage in the production of or generation of low end
services, i.e., Call centers, computer code writing, etc.

The comparative advantage argument would go as follows: America should specialize all its
resources in the productio n of high tech products both, service and manufactured, and import cheap
services from India. This essentially enables America to focus its resources on high tech and avoids
wastage of resources on low-end services. This situation would result in the greatest possible
increase in national output and hence growth and social welfare for both nations. Why? America
benefits because it specializes in production of high tech products, which it can then export to other
countries. India, which has a ready supply of educated manpower and hence low wages and where
the level of technological development is still behind America, can specialize in producing and
exporting low end services as cheaply as possible.

America benefits because it gets services at a much lower cost than they would cost in America. This
means the bottom line of American companies improves and they can invest more resources in areas
more in line with American comparative advantage. India benefits because of the increased
employment and income generated by the booming service exports. It appears to be a win win
situation for both countries.

However not all economists regard the benefits as being so clear-cut. In America the outsourcing
debate has polarized economists sharply. Two recent papers in the Journal of Economic
Perspectives , both by greatly respected economists, confront this question. The first paper is by Paul
6

Samuelson, a Nobel laureate and grand old man of current day economics. Samuelson raises a word
of caution against free trade always being beneficial. He takes the example He takes the case of a
poor country, where technical progress, improves productivity dramatically in the rich country's export
goods: again we can think of China's advances in semiconductors or India's in fi nancial services. In
this case its possible trade can turn to the poor country's advantage. The improvement in productivity
in the poor country can reduce the price of the rich country's exports by enough to make it worse off,

despite the increased availability of cheaper goods. It may be that not just some Americans lose, but
that the country as a whole is worse off.

The reply to this paper has come from Jagdish Bhagwati, Arvind Panagariya, and T.N. Srinivasan.

They show, using the classical trade model, that outsourcing is no different in economic terms from
the trade that has been going on since Ricardo's time. The standard results still hold including the
possibility that a country's export prices could fall so much that it becomes worse off.

Howeve r they also review empirical evidence available regarding such negative effects of free trade.
They find that historically, as productivity levels rise in developing economies, wages in these
economies also tend to rise. This phenomenon has been seen in the case of South Korea for
example. Secondly they are of the view that the skilled labour potential of economies such as India
and China has been over claimed. The supply of high quality skilled labour capable of taking away
American white collar jobs is no where near as large as the figure of 300 million which is often
claimed. Thirdly they are of the view that the current size of outsourcing is too small compared to the
total turnover of jobs in the American economy in an year to be a significant source of unemployment.
For example the figure of 3.4 million jobs by Forrester Research to be outsourced by 2015 represents
only .5% of the jobs in the industries affected. In an average year, the American economy destroys
some 30million jobs and creates slightl y more, dwarfing the effect of offshoring. 8 The view of the
authors is that even if many jobs that can be done cheaply do get outsourced this will after a period of
temporary unemployment result in reemployment in other high growth sectors. Thus they give the
example of American radiologists who lose out to their Indian counterparts. But if Radiology as whole
shrinks in America , other sectors such as advanced surgeries, etc may show higher growth.

Problems with Outsourcing

What are the problems as predi cted by theory? One view shared by Bhagwati and Manikiw among
others is that outsourcing can only benefit the American economy. Samuelson has raised a word of
caution when interpreting the impact of outsourcing on the American economy. The Ricardian model
predicts that one of the effects of outsourcing on the American economy will be to cause the service

sector in America to contract as jobs are outsourced. This leads to some unemployment. Trade
theories predict that this unemployment is basically frictional and the unemployed labour will be soon
absorbed by other sectors that are booming. The gap between what theory predicts and what the
American worker perceives as a net fall out of outsourcing represent the areas of controversy.
Analysis of some of the media and political commentary that has appeared on this issue over the last
few months suggests the following list of key questions which need to be answered:

1.

The first problem appears to be the fears of unemployed American labour not getting jobs or no t
getting jobs quickly enough.

2.

The second problem is that Americans are worried about the types of jobs being outsourced.
They were quite happy to outsource manufacturing activities to developing economies where they
can be done more cheaply. But they are less comfortable about exporting out white -collar jobs.

3.

Thirdly and most fundamentally is the perception of the American public regarding the changing
nature of the comparative advantage of America. For quite some time America has led the world
in the ar ea of IT services. Now it seems developing countries are not just catching up in this area
but could also possibly actually take over other services that were earlier considered
nontradables. The much quoted example is that of outsourcing of work to Radiologists in India for
example.

These represent the core issues around which much of the American public angst against outsourcing
is centered. The only way to answer these questions is to look at the actual track record of
outsourcing and its impact on the American economy in terms of growth, employment, etc. Key
issues that need to be investigated are as follows:

Is the current size of outsourcing of sufficient size to merit the kind of hue and cry that has
been made over it?

What is the evidence regarding the impact of outsourcing on unemployment?

Granted that theory predicts the benefits of outsourcing what is the evidence regarding size of
benefits from outsourcing ?

What evidence is there of the changing nature of comparative advantage in America?

There are few serious studies available which can concretize any of the claims and counterclaims
being associated with outsourcing and its impact on the economy. The next few sections overviews
such evidence as there is available on this issue.
Section 3
Current size of outsourcing and it impact on unemployment

Loss of American jobs is an emotive issue; yet is the current size and scale of current levels of
outsourcing significant enough to have a significant impact on employment in America? The main
problem can arises due to limitations of short run labour mobility across sectors. To put it crudely: can
a displaced call center employee join NASA? Obviously not. Nevertheless we need to explore
whether the generalized benefits of outsourcing actually resul t n generating more employment
opportunities even for them? There is no one answer to this issue. Ultimately we need to analyze
facts to determine how valid are the fears of the American public.

Evidence regarding size of outsourcing

The key question is whether in the current scenario the scale of outsourcing is such as to justify the
current reactions to outsourcing? Empirical evidence on the size of outsourcing presents a confused
picture. Statistics are few and far between, however there are a lot of emotional claims regarding the
size of outsourcing to India and other developing economies. For example Forrester Research
updated a 2002 report in which it predicted an offshore migration of 588,000 US service-sector jobs
by year's end 2005 and 3.3 million by 2015. While the updated estimates reflect only a marginal
increase to 3.4 million jobs departing in the 2015 tally, the predicted jobs lost in the short term was
9

raised by 40%, to 830,000 through 2005. A study by Gartner suggests that 1 in 10 IT jobs will be
offshored, and that revenues from offshoring will grow from US$1.3 billion in 2003 to US$3.0 billion in
2004.

10

However these figures need to be interpreted with caution keeping in mind the total volume of service
exports in the US. For example Amiti and Wei(2004) find that U.S. business service imports as a

share of GDP have roughly doubled in each of the past several decades, from 0.1 percent in 1983 to
0.2 percent in1993 and 0.4 percent in 2003.
The share of India in total service imports to the US is still very small. In 1992, imports of private
services from India were only 1/2 of 1 percent of total U.S. imports of private services. In 2002,
imports of private services from India to the United States increased to nearly 1 percent of total
imports of these services. There was a larger increase in U.S.
imports from India in business servicesa subcategory of private serviceswhich has been the focus
of most of the media attention. They increased from 0.45 percent in 1992 to nearly 2 percent o f total
imports of business services in 2002. In fact the largest supplier of private services to the United
States is, in fact, Canada.

11

Again in terms of trading partners: contrary to popular perceptions the data shows the bulk of US
trade in services is with other industrialized countries. Imports of private services from developing
economies are low: In 1992, only 28 percent of U.S. imports of private services came from developing
countries. Although this share increased between 1992 and 2002, it still remains quite low at 32
percent; 68 percent of service imports originate in other industrial countries.

12

Empirical evidence therefore suggests that at least some of the hype is misplaced. Services account
for a very small proportion of total trade for the American , though it is a growing segment. Secondly
the US is itself a large exporter of services and most of US trade in services is with other developed
countries rather than developing countries.

Section 4
Impact of outsourcing on employment in the US

There is little hard evidence and much media hue and cry regarding the effects of outsourcing on
unemployment in America.

Amiti and Wei (2004) analyze data for the effects of foreign outsourcing of services on employment
and labor

productivity in U.S. industries between 1992 and 2001. The sample included all manufacturing
services and five service industries for a total of 100. Their results show that increases in service
outsourcing in
U.S. manufacturing and services sectors go hand in hand with g reater labor productivity. Why might
this be? This is likely due to firms relocating their least efficient parts of production to cheaper
destinations.
For manufacturing firms, the largest category of outsourced services is, indeed, business ser-vices.
Their results indicate that, when looking at finely disaggregated sectors, you find that only a small
number of jobs are lost as a result of service outsourcing. For example, when disaggregating the U.S.
economy to
450 industries, there is a small negative effect on employment. But aggregating up to 100 sectors,
there were no joblosses associated with service outsourcing. This implies that a worker could lose her
job due to outsourcing but then she, or an unemployed worker, may find a job in another firm within
the broader industry classification. Hence, aggregated data would indicate that there are no net job
losses when there is sufficient job creation in another sector. Similar results for found for the U.K. and
other European countries.

13

They conclude that although service outsourcing is growing rapidly, it still remains a small fraction of
industrial countries GDP. And it is not dominated by lopsided, one-way outsourcing from developed to
developing countries. In fact, most industrial countries do not outsource more (when adjusted for
economic size) than many developing countries. The United States, for example, which is a large
importer of business services, is also a large exporter of these services and, as has been noted, has a
growing net surplus i n business service trade. As for fears about job loss, our studies show that jobs
are not being exported, on net, from industrial countries to developing countries as a result of
outsourcing. In fact, the evidence suggests that job losses in one industry o ften are offset by jobs
created in other growing industries.

Trends in outsourcing

14

The outsourcing trend started with software development, and back office work. But the trend has
spread to often more technologically sophisticated, service sectors too . For example, estimates of
cost savings from outsourcing select engineering, information technology and other support functions
in the automobile component industry range up to nearly 50 per cent, compared with performing the
same functions in the U.S. S imilarly, the cost of developing a new drug, currently estimated at
between $600 million and $900million, can be cut by as much as $200 million if development work is
outsourced to India.15

This has led to fears that jobs in fields ranging from architectu re to radiology are at risk. Although
firms were able to relocate abroad in the past, they had to give something uptheir closeness to
important markets, for example. With the new technologies, they can retain these links while also
obtaining access to che ap but well -trained labor. As a result, there does appear to be a backslide in
support for free trade policies, particularly among white-collar workers. This reinforces the perception
that outsourcing is moving up skill ladder threatening many White Collar jobs.
The evidence in this area is largely anecdotal. However according to figures by Forrester Research, it
is estimated that 3.3m American service-industry jobs will have gone overseas by 2015 this is a
very small proportion of the 7million -8million jobs lost every quarter in America through job-churning.
Further the bulk of these exports will not be the high-flying jobs of IT consultants, but the mindnumbing functions of code-writing. 16

An online study by Freetrade.org reports that the biggest drop in employment was among jobs that
are relatively low on the skill ladder such as data entry keyers and electrical and electronic equipment
assemblers. Such jobs may require vocational training but not typically a bachelor's degree. 17 Job
losses were also heavy among IT occupations requiring even less education and training, such as
billing and posting clerks, machine operators, communications equipment operators, and computer
and office machine operators. From 1999 through 2002, total jobs in the first category requiring
moderate education and training declined 14. 6 percent, and those in the second category requiring
18

the least education and training declined by 10.5 percent.

In contrast, the number of jobs in the IT industry that required a relatively high level of training and
education was actually slightly higher in 2002 than it was in 1999. In the year before the dot.com and

telecom bubbles burst, the industry employed 3.43 million workers whose jobs required an associate's
degree, bachelor's degree, or work experience plus a bachelor's degree or more. After a surge of
hiring in 2000, followed by a painful shakeout, the number of such highly skilled workers stood at 3.51
million in 2002, up 2.3 percent from 1999.

19

The recovery and expansion of job creation that has already begun in the IT sector should continue
into the future. According to the U.S. Department of Labor's biannual projections, the number of jobs
in computer and mathematical science occupations is expected to increase from three million to four
million in the next decade, a rate of growth twice as fast as employment in the rest of the private
economy.

U.S. companies are also discovering the limits to outsourcing. There are perfectly good, market-driven
reasons why U.S. companies will continue to do most of their IT work onshore if not in-house. Foreign
outsourcing can generate costs of its own, such as the need for more travel, training, and
management oversight. Depending on the type of project, those costs can eat into if not entirely erase
the costs savings from lower wages abroad. Sending work abroad can also risk the loss of control of
sensitive personal and financial data and copyrighted material. It can mean the loss of control over
time-sensitive aspects of a project or becoming too reliant on outside firms. As some U.S. companies
have discovered, it can result in reduced quality of service if the providers are not sensitive to cultural
differences or lack specialized information expected by customers.

Section 5

Benefits of outsourcing
The benefits to the US economy are textbook. Outsourcing essentially implies that companies can
outsource some part of their activities to other countries where the work can be carried out more
cheaply as skilled labour salaries in developing economies are a fraction of what they are in the US.

It is obviously in the interests of profit maximizing firms to outsource activities. This will have the effect
of reducing costs and hence increasing profitability. This is the neoclassical side of the argument. The

benefits of outsourcing should therefore translate into higher productivity levels and output for the
firms benefiting from outsourcing. For the economy as a whole also outsourcing should be beneficial,
as it should result in higher growth and output levels for the economy as well.

Yes, some Americans in low value service jobs do lose their jobs due to outsourcing. But this should
be more than compensated by the increase in employment and output in industries higher up the
technological ladder that are more in line with Americas comparative advantage. The lost jobs and
lower wages in the U.S., should be more than offset when countries specialize like this, leading to
more robust exports and lower prices on imported goods. We have alrea dy seen that there is some
evidence this is already occurring.

A recent widely-cited report by the McKinsey Global Institute estimates a net cost reduction of 58
cents on every $1 offshored by firms, even as they gain a better (or identical) level of service.
Further the McKinsey Global Institute has estimated that for every dollar spent on outsourcing to
India, the United States reaps between $1.12 and $1.14 in benefits. U.S. firms save money and
become more profitable, benefiting shareholders and increasing returns on investment. Foreign
facilities boost demand for U.S. products, such as computers and telecommunications equipment,
necessary for their outsourced function. U.S. labor can be reallocated to more competitive, betterpaying jobs; for exam ple, although 70,000 computer programmers lost their jobs between 1999 and
2003, more than 115,000 computer software engineers found higher-paying jobs during that same
period.20 Outsourcing thus enhances the competitiveness of the U.S. service sector (which accounts
for 30 percent of the total value of U.S. exports). Contrary to the belief that the United States is
importing massive amounts of services from low -wage countries, in 2002 it ran a $64.8 billion surplus
in services.

21

This is further corrobor ated by an Institute for International Economics study by Catherine Mann that
finds that globalization of computer hardware manufacturing led to a 10 to 30 percent decline in
prices, making such equipment more affordable and leading to a far greater increase in jobs in the
long run. Mann believes globalization of Information Technology (IT) services will yield even stronger
job demand in the United States for workers with IT proficiency and skills. Indeed, she notes that

overall employment in job classifications most affected by IT service outsourcing is rising, not falling.
22

Apart from the cost factor outsourcing also has some other benefits to outsourcing. Some of these are
:

Increase in Product Availability. An Institute for International Economics study by Catherine Mann
notes that globalization of computer hardware manufacturing led to a 10 to 30 percent decline in
prices, making such equipment more affordable and leading to a far greater increase in jobs in the
long run.

Stronger U.S. Job Demand. Mann believes globalization of Information Technology (IT) services will
yield even stronger job demand in the United States for workers with IT proficiency and skills. Indeed,
she notes that overall employment in job classifications most affected by IT service outsourcing is
rising, not falling.

Competitive Gains for Small Businesses. Researchers have also found that small firms and new
startups gain more from outsourcing than large corporations. The latter have managerial structures
that hinder their ability to take full advantage of outsourcings benefits. Smaller and younger
companies can easily organize themselves to utilize outsourcing, thereby gaining sales and
competing better in todays global marketplace.

Rising Standards of Living. Indians now doing jobs outsourced from America are seeing a rapid rise in
their wages and standard of living. In the process, they are becoming more like Americans, which is
translating into demand for American goods and lifestyles. Thus, according to the McKinsey Global
Institute, for every $1 outsourced, the economic gain to the United States as a whole is $1.12 to
$1.14; whereas the country to which a job is outsourced gains just 33 cents.

Researchers have also found that small firms and new startups gain more from outsourcing than large
corporations. The latter have managerial structures that hinder their ability to take full advantage of
outsourcings benefits. Smaller and younger companies can easily organize themselves to utilize

outsourcing, thereby gaining sales and competing better in todays global marketplace.

Indians now doing jobs outsourced from America are seeing a rapid rise in their wages and standard
of living. In the process, they are becoming more like Americans, which is translating into demand for
American goods and lifestyles. Thus, according to the McKinsey Global Institute, for every $1
outsourced, the economic gain to the United States as a whole is $1.12 to $1.14; whereas the country
to which a job is outsourced gains just 33 cents.

Sect ion 6
Adverse Effects of Protectionist Measures

So far the American government has stood squarely by outsourcing as being in the best interests of
the nation. Imposing tariffs makes Americans in general poorer. The workers in a "protected" industry
may have higher wages than they otherwise would under free trade, but US consumers would be
worse off because of higher prices. Most economists favor free trade because (at least under classical
assumptions) when the government imposes a tariff, the monetary gains to the winners are
outweighed by the monetary losses to the losers.

Since productive jobs are created by private companies, not the government, it is argued that
hamstringing U.S. firms with protectionist measures won't help them compete with their counterparts
in China or India or Singapore. Further such protectionist regulations may lead to retaliatory measures
by foreign countries. To prosper in the years ahead, U.S. firms need to have market access to the
large Indian and Chinese markets.

Outsourcing has led to calls for increased protection by workers and the media in the West. For
example in the UK British Telecoms employee union initiated a series of one day strikes in 2003 to
resist the company decision to set up a call center in India and to force the High Court to intervene to
stop it. In the U.S., at the federal level, a flurry of bills like the Job Protection Act were introduced in
2003, designed to eliminate the tax incentives for offshore production and instead to provide tax
incentives to produce in the US. Another example is that in January 2004, the US Senate passed an

amendment that would prevent private companies from using offshore workers in order to compete
successfully against government workers on some contracts opened up to competition. Similarly
Drezner (2004) notes that coupled with statistics from various research organizations predicting an
exodus of service-sector jobs to offshore service providers, elected officials have begun calling for
tariff barriers, tax penalties for jobs -exporting companies, and other protectionist measures in an effort
to stem the offshoring
tide.

Proposed protectionist measures that have been suggested include a requirement for a company to
notify workers 90 days in advance of its intenti on to outsource their jobs overseas. Such measures
would be difficult to enforce, since it would be complicated to determine which jobs were transferred
overseas, rather than eliminated. In Europe, eliminating obsolete jobs is an expensive, lengthy
process for businesses. Burdensome job protection measures create a climate in which European
businesses are very reluctant to create jobs in the first place. Rather than outsource jobs, their
corporations make job-creating investments in other countries to begin with including the United
States. Thus unemployment rates are far higher in Europe than in the United States.

Section 7
The Future of Outsourcing and Conclusions

Outsourcing is not a new concept. Blue-collar manufacturing jobs have been outsourced for 100
years. Textile jobs in South Carolina today were originally outsourced from Massachusetts. While the
transition was painful for Massachusetts textile workers in the short run, they soon found better jobs in
new industries. The same will be true for the current wave of outsourcing to developing economies.
The benefits of outsourcing to American workers and the U.S. economy greatly outweigh the costs.
Restrictions on outsourcing may save a few jobs in the short run, but they will come at the expense of
better jobs in the future jobs that will not be created. Putting quotas and tariffs to stop people from
importing software and data from other countries over the Internet when it therefore makes little
economic sense.

For America the answer to outsourcing lies not in acceding to calls for protectionist measures.
Protectionism always hampers the growth of organizations by raising costs. In a fast changing world
where technological and comparative advantage equations change rapidly between nations,
measures that put legislative brakes on a firms ability to reduce costs and increase productivity will
ultimately damage growth prospects in the US. The evidence reviewed in the foregoing sections has
shown that by and large the unemployment created by outsourcing is more than made up the new
jobs created. In the short run there is however a case for providing a cushion to dislocated workers in
terms of soft educational loans, etc.

For India the future of outsourcing if allowed to continue is rosy. According to NASSCOM, the Indian
industry's lobby, the country's exports from the software, other IT services and business-processoutsourcing industries grew by more than 25% to $12 billion last year, of which infrastructure services
accounted for just over $300m. But the potential is huge. A report by Deutsche Bank puts the entire
size of the global infrastructure-management market at $86 billion.

However the supply of cheap , skilled man power will definitely become a severe crunch According to
a Forbes report it is estimated that India would need to have 1 million qualified software engineers to
support exports of $50 billion. Currently it graduates around 110,000 computer science students a
year. With a dearth of experienced project leaders already on the horizon, that problem will reach a
crisis point as outsourcing continues to expand at a rate of more than 50% a year.23 India therefore
needs to invest aggressively in its educational system to ensure that it is able to produce the required
number of skilled labour .

Footnotes

Relocating the back office, The Economist, December 13 2003.

Ibid.

Ibid.

See Rai, Saritha (2004). Short on Priests, U.S. Catholics Outsource Prayers to Indian
Clergy, New York Times , June 13, 2004 : A15.

See the report in the New York Times, Feb 11, 2004, page A26. For a statement in the same

vein, see the Council of Economic Advisors Testimony before the Joint Economic Committee, US
Congress, available at:
http://www.whitehouse.gov/cea/economic\_report\_20040210.html)

Samuelson, P.A.,(2004). Where Ricardo and Mill Rebut and Confirm Arguments of Mainstream

Economists Supporting Globalization Journal of Economic Perspectives , Summer 2004, Vol. 18, No.
3

Bhagwati, Jagdish, Panagariya,.A. & Srinivasan, T. N., (2004). The Muddles over Outsourcing.

Journal of Economic Perspectives, Vol. 18, No. 4 September 2004.

For details on the estimates cited in this paragraph, see McKinsey Global Institute (2003). McKinsey

Global Institute (2003). Offshoring: Is It a Win-Win Game? San Francisco, CA,August 2003.
Available at: http://www.mckinsey.com/knowledge/mgi/rp/offshoring/perspective/

See http://www.forrester.com/Research/Document/Excerpt/0,7211,34539,00.html

10

Gartner Research, http://www4.gartner.com/Init

11

See Demystifying Outsourcing:The numbers do not support the hype over job losses,Mary Amiti

and Shang-Jin Wei in Finance and Development IMF Dec 2004)

12

Ibid.

13

See Demystifying Outsourcing:The numbers do not support the hype over job losses, Mary Amiti

and Shang-Jin Wei in Finance and Development IMF Dec 2004)

14

Ibid.

15

For details on the estimates cited in this paragraph, see McKinsey Global Institute (2003). McKinsey

Global Institute (2003). Offshoring: Is It a Win-Win Game? San Francisco, CA,August 2003.
Available at: http://www.mckinsey.com/knowledge/mgi/rp/offshoring/perspective/

16

17

18

19

The great hollowing-out myth The Economist print edition, Feb 19th 2004

HYPERLINK "http://www.freetrade.org/pubs/FTBs/FTB -010.html" \l "_edn5" \o ""

Ibid.

For details on the estimates cited in this paragraph, see McKinsey Global Institute (2003). McKinsey

Global Institute (2003). Offshoring: Is It a Win-Win Game? San Francisco, CA,August 2003.
Available at: http://www.mckinsey.com/knowledge/mgi/rp/offshoring/perspective/
20

21

Ibid.

See Demystifying Outsourcing:The numbers do not support the hype over job losses,Mary Amiti

and Shang-Jin Wei in Finance and Development IMF Dec 2004)

22

Cathernine Mann Study on Outsourcing, Institute for International Economics

http://www.iie.com/
23

Todd Jatras Can India Retain Its Reign As Outsourcing King? Forbes.com,

Available

at

References

Alden, Edward, Lu ce, Edward and Merchant Khozem (2004). The Logic is Inescapable Financial
Times, Jan 28, 2004:19.

Anderson, William L.,( 2004), The Economics of Outsourcing

posted on Ludwig Von Mises Institute http/

Balls, Andrew and Swann Christopher (2004). Feds Bernanke Says Outsourcing Not Responsible for
Weak U.S. Jobs Growth. Financial Times, Mar 31, 2004:10.

Bardhan, Ashok and Kroll, C. (2003). The New Wave of Outsourcing. Fisher CenterResearch Report
#1103, Fisher Center for Real Estate and Urban Economics, University ofCalifornia at Berkeley.

Besley, Timothy and Coate, S., (1998), Sources of Inefficiency in a Representative Democracy: A
Dynamic Analysis. American Economic Review , March 1998, 88(1):139-56.

Bhagwati, Jagdish, and Daniel Tarullo, A ban on capital controls is a bad trade-off, Finanical Times,
March 16 2003, cited in Singh (2003) 28. See also Joshi (2003) 17.

Bhagwati, Jagdish, Panagariya,.A. & Srinivasan, T. N., (2004). The Muddles over Outsourcing.
Journal of Economic Perspectives, Vol. 18, No. 4 September 2004.

CNET News.com 2004http://smh.com.au/articles/2004/05/19/1084917631433.html

Council of Economic Advisors Testimony before the Joint Economic Committee, US Congress,
available at:
http://www.whitehouse.gov/cea/economic\_report\_20040210.html)

Dornbusch, R., Fischer, S.& Samuelson. P,(1977) Comparative Advantage, Trade and Payments in
a Ricardian Model with a Continuum of Goods. American Economic Review 67, December 1977, pp.
823-839

Drezner, Daniel W. (2004). The Outsourcing Bogeyman. Foreign Affairs, May/June

2004.

Fernandez, Raquel and Dani Rodrik (1991). Resistance to Reform: Status Quo Bias in the in
thePresence of Individual-Specific Uncertainty. American Economic Review, December 1991,
81(5):1146-55.

Gonzalez, Kris Collin(2004) Comparative Advantage versus the Race to the Bottom: Evaluating
Offshoring Paradigms with Emphasis on Development in Emerging Countries, County Community
College

Jain, Sanjay , Kapur and Mukand, Sharun (2005).

Outsourcing and International Labor Mobility: A Political Economy Analysis, Forthcoming, Labor
Mobility and the World Economy Berlin, Heidelberg: Springer Publishers, 2005.

Jatras, Todd Can India Retain Its Reign As Outsourcing King? Forbes.com ,

Forrester Research http://www.forrester.com/Research/Document/Excerpt/0,7211,34539,00.html

HYPERLINK "http://www.freetrade.org/pubs/FTBs/FTB-010.html" \l "_edn5" \o ""

Gartner Research htt p://www4.gartner.com/Init

Jain, Sanjay and Mukand, S.W., (2003). Redistributive Promises and the Adoption of Economic
Reform. American Economic Review, March 2003, 93(1):256-264.

Kapur, Devesh (2003). Comments on paper by Kevin ORourke and Richard Sinnott,
Migration Flows: Political Economy of Migration and the Empirical Challenges. ABCDE 2003, World
Bank.

Kohler, Wilhelm (2001). A specific- factors view on outsourcing. North American Journal of
Economics and Finance , 12 (2001): 31-53.

MacDoug all,G.D.A,(1952) British and American Exports: A study Suggested by the Theory of
Comparative Costs. Economics Journal 61( December 1951), pp. 697-724
Mann, Cathernine(2005) Study on Outsourcing, Institute for International Economics Available at
http://www.iie.com/

Mayda, Anna Maria (2002). Who is against Immigration? A cross-country investigation of individual
attitudes toward immigrants. Mimeo, Harvard University.
McKinsey Global Institute (2003). Offshoring: Is It a Win-Win Game? San Francisco, CA, August
2003. Available at:http://www.mckinsey.com/knowledge/mgi/rp/offshoring/perspective/

News.com.com May 04 2004, <http://news.com.com/2009-1070_3-5198156.html>.

ORourke, Kevin and Richard Sinnott (2003). Migration Flows: Political Economy o f Migration and the
Empirical Challenges. Paper presented at ABCDE 2003, World Bank.

Rai, Saritha (2004). Short on Priests, U.S. Catholics Outsource Prayers to Indian Clergy, New York
Times, June 13, 2004: A15.

Schumer, Charles and Paul Craig Roberts , (2004). Second Thoughts on Free Trade, New York
Times, January 6, 2004: A23.

Steven Rattner (2004). Offshoring Should Be the Least of America's Worries. Financial Times,
March 31, 2004:15.

Samuelson, P.A.,(2004). Where Ricardo and Mill Rebut and Confirm Arguments of Mainstream
Economists Supporting Globalization Journal of Economic Perspectives , Summer 2004, Vol. 18, No.
3

The great hollowing-out myth, The Economist print edition, Feb 19th , 2004

Staff, SMH.com.au, May 19

Shalley Dash

Shalley Dash is Associate Professor Economics in the School of Arts & Management Sciences
(SAMS) and Rai Business School. Shalley has completed her Masters in Economics from the Delhi
School of Economics and an M. Phil in Economics from J.N.U. She has also worked for several years

in marketing research agency ORG-Marg Pvt. Ltd. Her current areas of interest include Managerial
Economics, Macroeconomics, International Economics and Marketing Research.

Email: shalley.dash@raifoundation.org