International Trade 4th Edition Feenstra

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7 Offshoring of Goods and Services

1. What type of occupation would you like to pursue after graduation? To see what is
available, to the Bureau of Labor Statistics website at: https://www.bls.gov/ooh/.

a. Find four occupations that you think fit the four categories shown in the
horizontal axis of Figure 7-11: nonroutine manual jobs; routine manual jobs;
routine cognitive jobs; and nonroutine cognitive jobs. For each occupation, what
is the growth in employment in the United States, and how does it compare with
the employment growth since 1990 shown in Figure 7-11?
Answer:
Nonroutine manual jobs: Home health aides with growth rate (38%)
Routine manual jobs: Assemblers and fabricators with growth rate (–1%)
Routine cognitive jobs: Secretaries and administrative assistants with growth rate
(3%)
Nonroutine cognitive jobs: Mathematicians with growth rate (21%)
There is a polarization pattern compared to the situation decades ago. The
nonroutine cognitive and nonroutine manual jobs grow much faster than before,
whereas the middle jobs grow slowly.

b. Choose an occupation that you would most like to pursue, and explain why you
wish to pursue it. What is the employment growth for that occupation?
Answer: This is an open question; one can answer it from various dimensions, for
example, the expected return of the chosen occupation.

Work It Out

Consider an offshoring model in which the the hours of labor used in four activities in the
United States and Mexico are as in the table follows.

Note that labor hours in Mexico are twice those in the United States, reflecting Mexico’s
lower productivity. Also note that the ratio of high-skilled to low-skilled labor used in
each activity increases as we move to the right, from 1/6 in assembly to 10/1 in R&D.
Suppose that the wage of U.S. low-skilled workers is $10 per hour and that of high-
skilled workers is $25 per hour, and that the wage of Mexican low-skilled workers is $1
per hour and that of high-skilled workers is $5 per hour (these values are made up to be
convenient, not realistic). Also suppose that the trade costs are 25%, 30%, or 50%, which
means that an additional 25%, 30%, or 50% is added to the costs of offshoring to Mexico.

Hours of Labor Used in Each Activity (per unit of output):

Assembly Component Office R&D

Production Services
Low-skilled labor Mexico: 24 Mexico: 16 Mexico: 16 Mexico: 4
 U.S.: 6 U.S.: 4 U.S.: 4 U.S.: 1
High-skilled labor Mexico: 4 Mexico: 4 Mexico: 8 Mexico: 40
U.S.: 1 U.S.: 1 U.S.: 2 U.S.: 10
High-skilled/low- 1/6 1/4 1/2 10/1
skilled ratio

a. Fill in the blank cells in the following table by computing the costs of production
of each activity in each country (two cells are filled in for you).

Assembly Component Office R&D

Production Services
Mexico $44
United States
Imported by United States from
Mexico, Trade Costs = 25%
Imported by United States from $57.2
Mexico, Trade Costs = 30%
Imported by United States from
Mexico, Trade Costs = 50%

Answer: In italics in the following table:

Assembly Component Office R&D

Production Services
Mexico $44 $36 $56 $204
United States $85 $65 $90 $260
Imported by U.S. from Mexico, $55 $45 $70 $255
Trade costs = 25%
Imported by U.S. from Mexico, $57.2 $46.8 $72.8 $265.2
Trade costs = 30%
Imported by U.S. from Mexico, $66 $54 $84 $306
Trade costs = 50%

R&D, research and development; U.S., United States.

b. With trade costs of 50%, where is the value chain sliced? That is, which activities
are cheaper to import from Mexico and which are cheaper to produce in the
United States?
Answer: With trade costs of 50%, assembly and component production are done
in Mexico because the gross costs of importing these activities are lower than
their respective costs in the United States. On the other hand, office services and
R&D activities are done in the United States.

c. With trade costs of 30%, and then 25%, where is the value chain sliced?
 Answer: With trade costs of 25%, all activities are offshored to Mexico, whereas
with trade costs of 30%, assembly, component production, and office services are
done in Mexico (R&D is still done in the United States).

2. Consider an offshoring model in which Home’s skilled labor has a higher relative
wage than Foreign’s skilled labor and in which the costs of capital and trade are
uniform across production activities.

a. Will Home’s offshored production activities be high or low on the value chain for
a given product? That is, will Home offshore production activities that are high-
skilled-intensive, or low-skilled-intensive? Explain.
Answer: The high relative wage of Home high-skilled labor makes high-skilled-
labor-intensive activities more expensive at Home relative to Foreign.
Equivalently, the low relative wage of low-skilled labor makes low-skilled-labor-
intensive activities less expensive at Home relative to Foreign. As a result, Home
will undertake production activities lower on the value chain while offshoring
higher value activities to Foreign. For example, Boeing outsourced part of its
R&D to Germany.

b. Suppose that Home uniformly increases its tariff level, effectively increasing the
cost of importing all goods and services from abroad. How does this affect the
slicing of the value chain?
Answer: A uniform increase in the tariff level causes fewer activities to be
offshored. The slicing of the value chain reflects this increased cost as a rightward
shift; Home expands the set of activities that it does at Home to include
incrementally high-value activities, whereas the set of high-value offshored
activities shrinks.

c. Draw relative labor supply and demand diagrams for Home and Foreign showing
the effect of this change. What happens to the relative wage in each country?
Answer: An expansion in the set of production activities done at Home (to
include higher-value ones) increases the average skill intensity of Home
production. This increases the relative demand for high-skilled labor at Home.
Similarly, because Foreign ceases to do its least skill-intensive activities, the
average skill intensity in Foreign increases and hence the relative demand for
high-skilled labor increases. See the following figure.
3. Consider a U.S. firm’s production of automobiles, including research and
development and component production.

a. Starting from a no-trade equilibrium in a PPF diagram, illustrate the gains from
offshoring if the United States has comparative advantage in component
production.
Answer: See the following figure, where the offshoring equilibrium is B and C.
Since the United States has comparative advantage in component production, the
world relative price of components is higher and correspondingly steeper in the
figure. Production will shift to point B, and by exporting components and
importing R&D along the world price line, the U.S. firm ends up at point C.
Production of the final good at point C is Y1, which exceeds the production Y0 in
the no-trade equilibrium. Thus the U.S. firm enjoys greater gains from offshoring
when the output of automobiles increases from Y0 to Y1.

b. Now suppose that advances in engineering abroad decrease the relative price of
 research and development. Illustrate this change on your diagram and state the
implications for production in the United States.
Answer: See the following figure, where the new equilibrium is B′ and C′. A
lower R&D price will shift the world price line further down along the PPF curve
and the new tangency is B′. Given this higher world relative price of components,
the United States is able to produce even more automobiles at Y2 level.

c. Does the U.S. firm gain from advances in research and development abroad?
Explain why or why not.
Answer: Because the United States imports R&D and exports components, a
decrease in the relative price of R&D abroad represents an improvement in the
U.S. terms of trade; as a result, U.S. output increases to Y2 so there are gains for
the United States.

4. Consider the model of a firm that produces final goods using R&D and components
as inputs, with cost data as follows:

Components: Total costs of production = PC · QC = 200

Earnings of high-skilled labor = WH · HC = 20
Earnings of low-skilled labor = WL · LC = 80
Earnings of capital = R · KC = 100
Share of total costs paid to high-skilled labor = 20/200 = 10%
Share of total costs paid to low-skilled labor = 80/200 = 40%
R&D: Total costs of R&D = PR · QR = 200
Earnings of high-skilled labor = WH · HR = 80
Earnings of low-skilled labor = WL · LR = 20
Earnings of capital = R · KR = 100
 Share of total costs paid to high-skilled labor = 80/200 = 40%
Share of total costs paid to low-skilled labor = 20/200 = 10%

a. In which factor(s) is components intensive? In which factor(s) is R&D intensive?

Answer: Component production is intensive in the use of low-skilled labor,
because the cost share of low-skilled labor in components (40%) exceeds the cost
share of low-skilled labor in R&D (10%). Similarly, R&D is intensive in the use
of high-skilled labor, because the cost share of high-skilled labor in R&D (40%)
exceeds the cost share of high-skilled labor in components (10%). Notice that
capital is used equally in both activities, so it is not intensive in either one.

b. Suppose that due to the opening of trade, the price of components falls by ∆ PC/PC
= –10%, and the price of R&D remains unchanged, ∆PR/PR = 0. Using the hint
below, calculate the change in the wage of skilled and low-skilled labor.

Hint: We follow a procedure similar to that used in Chapter 4 when calculating

the change in factor prices in the Heckscher–Ohlin model.

First, write the total costs in each activity as consisting of the payments to labor
and capital:

PC · QC = R · KC + WH · HC + WL · LC, for components

PR · QR = R · KR + WH · HR + WL · LR, for R&D

Because we assume that 50% of costs in components or R&D are always paid to
capital, then R · KC = 0.5(PC · QC) and R · KR = 0.5(PR · QR), so we can rewrite
the above two equations as

0.5(PC · QC) = WH · HC + WL · LC, for components

0.5(PR · QR) = WH · HR + WL · LR, for R&D

Taking the change in these equations:

0.5(∆PC · QC) = ∆WH · HC + ∆WL · LC, for components

0.5(∆PR · QR) = ∆WH · HR + ∆WL · LR, for R&D

Dividing the equations by (∆PC · QC) and (∆PR · QR), respectively, we can rewrite
the equations as

 ∆P   ∆WH   WH ·HC   ∆WL   WL ·HC 

=
0.5  C    +   , for components
 PC   WH   PC ·QC   WL   PC ·QC 
 ∆P   ∆WH  WH ·H R   ∆WL  WL ·H R 
=
0.5  R    +   , for R&D
 PR   WH  PR ·QR   WL  PR ·QR 

Use the cost shares and price change data in these formulas to get
  ∆WH   20   ∆WL   80 
=−5%   +   , for components
 WH   200   WL   200 
 ∆WH   80   ∆WL   20 
=0   +   , for R&D
 WH   200   WL   200 

Now solve these two equations for the change in the high-skilled wage,
(∆WH/WH ), and the change in the low-skilled wage, (∆WL/WL).

Answer: There are many ways to solve the last two equations for the change in
the wages (∆WH/WH), and (∆WL/WL). One method is to eliminate the term for the
percentage change of the high-skilled wage; this can be done by multiplying the
first equation by 4 and subtracting the second equation from it, to get:

 ∆WL   300 
−20% =
  
 WL   200 

It follows that (∆WL/WL) = –13.3% so that the wage for low-skilled labor falls by
13.3% when the price of components falls by 10%. To find the change in the high-
skilled wage, we can take this solution, and plug it back into the equation for the
change in wages in R&D, to get: (ΔWH/WH) = 13.3% · (10/40) = 3.3%. The wage for
high-skilled labor increases by 3.3% when the price of components falls by 10%.

c. What has happened to the relative wage of high-skilled/low-skilled labor? Does

this match the predictions of the offshoring model in this chapter?
Answer: With the wage for high-skilled labor going up, and the wage for low-
skilled labor going down, it follows that the relative wage of high-skilled labor
(WH/WL) also rises. Equivalently, the relative wage of low-skilled labor, which is
(WL/WH), falls. This is as predicted by our model in this chapter, where a fall in
the relative price of components or a rise in the relative price of R&D benefits
high-skilled labor.

5. Consider the model of a firm that produces final goods using R&D and components
as inputs, with cost data as follows:

Components: Total costs of production = PC · QC = 200

Earnings of high-skilled labor = WH · HC = 50
Earnings of low-skilled labor = WL · LC = 50
Earnings of capital = R · KC = 100
Share of total costs paid to high-skilled labor = 50/200 = 25%
Share of total costs paid to low-skilled labor = 50/200 = 25%
R&D: Total costs of R&D = PR · QR = 200
Earnings of high-skilled labor = WH · HR = 60
Earnings of low-skilled labor = WL · LR = 40
Earnings of capital = R · KR = 40
 Share of total costs paid to high-skilled labor = 60/200 = 30%
Share of total costs paid to low-skilled labor = 40/200 = 20%

a. In which factor(s) is components intensive? In which factor(s) is research

intensive?
Answer: Component production is intensive in the use of low-skilled labor,
because the cost share of low-skilled labor in components (25%) exceeds the cost
share of low-skilled labor in R&D (25%). Similarly, R&D is intensive in the use
of high-skilled labor, because the cost share of high-skilled labor in R&D (30%)
exceeds the cost share of high-skilled labor in components (20%). Capital is used
more intensive in components (50%) than in R&D (20%).

b. Suppose that due to the opening of trade, the relative price of R&D increases,
∆PR/PR = 10%, whereas the price of components stays unchanged, ∆PC/PC = 0.
Calculate the change in the relative wage of high-skilled and low-skilled labor.
Answer: Following the same hint that was given for Problem 4, we end up with
the following two equations:

 ∆WH   50   ∆WL   50 
=0   +   , for components
 WH   200   WL   200 
 ∆WH   60   ∆WL   40 
=8%   +   , for R&D
 WH   200   WL   200 

It follows that ∆WH/WH = 80% and ∆WL/WL = –80%. The wage for low-skilled
labor falls by 80% and that of high-skilled labor increases by 80%, when the price
of R&D rises by 10%.

c. What has happened to the relative wage of high-skilled/low-skilled labor? How

does this result compare to Problem 4, and explain why it is similar or different.
Answer: With the wage for high-skilled labor going up, and the wage for low-
skilled labor going down, it follows that the relative wage of high-skilled labor
(WH/WL) also rises. Equivalently, the relative wage of low-skilled labor, which is
(WL/WH), falls. The change in the relative wages is the same as what we found in
Problem 4, because a fall in the relative price of components or a rise in the
relative price of R&D has the same effects: to benefit high-skilled labor. Wage
changes found in this problem are larger because the cost shares in the two
activities are more similar than those in Problem 4.

6. Read the following excerpt, and using what you have learned in this chapter, discuss
how offshoring creates opportunities for the countries involved.

Sudhakar Shenoy, chief executive of Information Management Consultants (IMC)

in Reston, makes an effective pitch for offshoring.
Several years ago IMC saw a market developing for software that would allow
biotech companies to make better and faster use of the new human genome
 research. Doing it here, Shenoy calculated, would cost several million dollars,
which he figured would have priced the product too high for most customers. But
by having a small group of engineers at IMC’s Indian subsidiary do much of the
coding work, he was able to bring the project in at $500,000. The result: IMC now
has a thriving line of business in bioinformatics, with major clients and a growing
payroll of six-figure PhDs here. And there are more engineers than ever—six here
for every one in India.
But that’s only part of the good-news story. In Pune, where IMC’s Indian
operations are located, an airport under construction will require lots of U.S.
engineering, design and electronics. At the same time, IMC’s Indian engineers,
who earned annual salaries of $3,500 a decade ago, now command up to
$12,000—enough to buy all manner of imported consumer goods.
Source: Excerpted from Steven Pearlstein, “Still Short of the Offshoring Ideal,”
Washington Post, March 12, 2004.

Answer: By offshoring software in India, IMC is able to pass the cost savings to
biotech companies researching the human genome. Moreover, the derived demand
from Indian engineers by successful companies like IMC contributes to higher
salaries for the local talents. In addition, the need for reliable infrastructure resulting
from a growing economy boosted by companies such as IMC has led to the demand
for U.S. engineering, design, and electronics.

7. The quote from the 2004 Economic Report o f the President at the beginning of the
chapter generated a lot of controversy that year. The chairman of the Council of
Economic Advisers, N. Gregory Mankiw, made the following additional comments
in a speech while presenting the report: “Outsourcing is just a new way of doing
international trade. More things are tradable than were tradable in the past, and that’s
a good thing.”
Those statements quickly led to reactions from both Democratic and Republican
members of Congress. Tom Daschle, then the Democratic Senate minority leader,
said, “If this is the administration’s position, they owe an apology to every worker in
America.” Dennis Hastert, then Republican Speaker of the House, said, “Outsourcing
can be a problem for American workers and the American economy.” John Kerry,
the 2004 Democratic presidential candidate, referred to businesses that offshored as
“Benedict Arnold corporations.” In response, Mankiw clarified his earlier comments:
“My lack of clarity left the wrong impression that I praised the loss of U.S. jobs.”
You might feel that these statements just represented a squabble between
politicians trying to score points during a presidential campaign. Statements about
outsourcing and offshoring are made during many presidential campaigns, including
in 2016 when Donald Trump said that he’s “never eating another Oreo again”
because its parent company is “closing a factory in Chicago and they’re moving to
Mexico.” With all this media attention, it is worth trying to sort out who gains and
who loses from offshoring.

a. Why does Mankiw say that “outsourcing is a good thing”? Who is it good for in
the United States? Are there overall gains for the United States? Explain with a
diagram.
Answer: Mankiw says that offshoring is “a good thing” because there are overall
 gains from the trade of production activities relative to autarky. As seen in Figure
7-10, both countries benefit by specializing in certain production activities and
offshoring others. Trade in production activities allows for higher levels of output
employing the same amount of domestic inputs. However, within each country
these gains may not be spread evenly across workers of different skill levels, as
changes in the number of tasks offshored lead to changes in the relative wage of
high-skilled workers.

b. Later in this chapter, Paul Samuelson is quoted as saying that there is no

necessary surplus of winning over losings” due to offshoring. Use Figure 7-12 to
carefully explain why Samuelson says this.
Answer: Samuelson points out that loss due to offshoring may occur as a result of
the deterioration in a country’s terms of trade. That is, from one offshoring
equilibrium to another there are not necessarily gains since an increase in the
relative price of a production activity hurts the importer of that activity. Of note,
though, gains from offshoring are always greater than the situation with no-trade.

c. Go online to find out whether Nabisco still produces Oreo cookies in the United
States, how many jobs are being moved to Mexico, and why.

8. In Figure 7-14, we saw that a fall in the relative price of components leads to an
increase in the amount of components imported but that the amount of R&D exported
from Home does not necessarily increase. To explore this further, complete the
following:

a. Let the relative price of components continue to fall in Figure 7-14, and show in a
graph what happens to the equilibrium point on the isoquant for the final good.
Answer: As the relative price of components continues to fall, the use of
components in the final good increases. Imports of components increase as the
equilibrium production point moves out to the flatter portion of the final good
isoquant, and the level of final good output increases (but at a diminishing rate
due to diminishing returns in production). See the following figure.
b. Now draw another graph that has the relative price of components on the vertical
axis and the imports of components on the horizontal axis. Start at the no-trade
relative price of components, where imports are zero. Then label the various
world relative prices of components on the vertical axis, and graph the quantity of
imports at each price. Can we be sure that the import demand curve slopes
downward?
Answer: As the relative price of components decreases from the Home autarky
level, Home components imports as well as the final goods produced increase. As
long as incremental components are still useful in final good production,
components imports will increase as their relative price decreases, which is
guaranteed by the shape of the isoquants. See the following figure.

c. Now draw a new graph that has the relative price of R&D on the vertical axis and
 the exports of R&D on the horizontal axis. Start at the no-trade relative price of
R&D, where exports are zero. Then label the various world relative prices of
R&D on the vertical axis, and graph the quantity of exports at each price. When
the relative price of R&D is high enough, what do you notice about the export
supply curve?
Answer: See the following figure:

As the relative price of R&D increases from its autarky level, Home specializes
further in R&D services and exports increase. However, for a sufficiently high
relative price, import demand in the rest of the world diminishes as countries
abroad substitute components for R&D in final good production. As a result, as
Home approaches full specialization in R&D, exports of that activity approach
zero.

9. Why might it be relatively easier for developing country like India to export service
activities through offshoring than to participate in the global economy by producing
manufacturing components?
Answer: Because offshoring of manufactures involves the trade of intermediate
inputs across several borders, there is an extra cost associated with transporting the
goods. Therefore, a country must have good infrastructures such as developed
roadways to participate in the global economy. In India, for example,
communications technology developed rapidly, whereas transportation developed
more slowly, which allowed the South Asian country to partake in service offshoring.
The wages of educated workers are much lower in India than in the United States.
India also has a proficiency in the English language, which is a necessity for service
activities.

10. It is widely noted that even though China is the favored destination for manufacturing
 offshoring, it is far behind India in the business of offshored services. What
differences between these two countries might account for this causal observation?
Answer: Although wages are also low in India, because of its weak transportation
infrastructure, it is unable to successfully compete against China in manufacturing
offshoring. However, it has an advantage over China in service offshoring because
the country has developed an advanced communication infrastructure. Moreover, as a
former British colony, India has a proficiency in the English language. The workforce
in India is well educated and highly skilled in information technology. In addition,
Tarun Khanna, a professor at the Harvard Business School, notes that India has a
thriving entrepreneurial effort unhampered by government bureaucracy, unlike China
(McKinsey Quarterly, 2004). This includes a low level of government intervention in
the Indian capital markets and no regulations in industries such as software.

11. Chinese hourly manufacturing wages have increased by 12% per year on average
since 2001, which is much higher than wage growth in developed or other developing
countries. How will this wage growth in China affect its ability to serve as an offshoring
location?
Answer: This is an open question. Example answers are listed below.

The direct impact of rising wage in China is that it decreases China’s ability to serve as
an offshoring location, as firms from developed regions no longer benefit from the
advantage of low cost in China. In response, these firms may re-offshore the production
to countries with lower cost or even bring the offshored jobs back to their home
countries.

On the other hand, wage increase in China also implies a rise in Chinese demand. It could
stimulate firms to sell more to China and expand their production scale, which may
increase the demand of offshoring and offshoring more jobs to China.
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