The Economics of Outsourcing
by William L. Anderson
The latest political fallout of the current "outsourcing" debate came recently when the Bush Administration's designated "manufacturing czar" turned out to be Anthony F. Raimondo, whose "crime" was to be the head of a firm that recently opened a factory in China. The embarrassed Bushies quickly urged Raimondo to withdraw his nomination, as the Democrats (and a number of Republicans) made hay over the whole thing.
Of course, the idea that the United States needs a "manufacturing czar" continues the misguided policies that gave us a "drug czar" and, during the 1970s, an "energy czar." (At least the first "energy czar," William Simon, had the good sense to note that the very presence of his office was counterproductive and downright dictatorial and dangerous. Subsequent "czars" have, instead, reveled in their powers and have continued the deception.)
This is not a discussion about the necessity of "czars" to guide public policy â€“ unless the "czar" calls for laissez-faire and closes up shop. (Unfortunately, "czars" labor under the delusion, as do the political classes and the general public, that their labors are the only thing between prosperity and chaos.)
Instead, I directly address the issue of "outsourcing," from an Austrian point of view. Now, in the current political climate, "outsourcing" is bad and is blamed for unemployment and other social evils, and already Congress has jumped into the fray, framing legislation that will deny firms to do business with the federal government if the companies have invested in overseas operations that Congress deems having "cost" American jobs.
Others writers have dealt with the issue, and there is no need to repeat their arguments, as sound as they have been. What I look to do is to point out how Austrian Theory not only debunks the fallacies that the anti-outsourcing advocates have been spawning, but also points out why the process makes sense economically, and not just for the countries where the investment takes place, but also the nations where the final goods are sold.
In defending his company's decision, Raimondo declared that the goods his factory built in China were making were for sale in that country, not the United States. Those who have been beating the anti-outsourcing drum have said that "outsourcing" is harmful when a company located in one country invests in a lower-wage nation, then exports the goods manufactured there back to the home country. As Paul Craig Roberts has claimed, the problem is that whatever savings consumers might gain from the cheaper goods sold here is more than nullified by the loss of income to workers in this country who either have lost their jobs due to the "outsourcing" move or have lost potential income from the investment not made here.
This point of view, not surprisingly, has many adherents in Congress from both parties. When George W. Bush's chief economic advisor Gregory Mankiew said in testimony before Congress that the "outsourcing" practice ultimately would be good for the U.S. economy, the outrage from both Democrats and Republicans forced Mankiew to make a hasty retreat. (For example, Tennessee Republican Congressman Zack Wamp â€“ and old friend of mine â€“ called for Mankiew's immediate dismissal and has been at the forefront of trying to outlaw overseas investment.)
Members of Congress have no problem when firms headquartered in other countries invest in operations located in the United States. For example, Toyota, Mercedes-Benz, and Nissan, among others, have automobile manufacturing plants here, with the products not shipped back to Japan or Europe, but rather are sold in this market. If "outsourcing" were such a harmful practice, then one would expect members of Congress to be introducing bills to close down these factories. That they do not displays either total ignorance of their stated position or rank hypocrisy. I leave it to the readers to decide which is true.
One of the most important contributions made by Austrians and especially the "founder" of the Austrian School of Economics, Carl Menger, has been the description of how the various factors of production receive their value. The Classical School, beginning with Adam Smith, said the valuation of goods runs upward, beginning with the raw factors of land and labor, and continuing to the manufacturing of the final product that is sold to consumers.
From this point of view, the notion of "value added" at each stage of production becomes vital in describing how the final product receives its value. In this way of thinking, value is "added" whenever the factors undergo change. For example, when crude oil comes from the ground, it is in an unusable form until it goes through a refinery, where the petroleum is "cracked" and made into a number of products, from fuel oil to gasoline to an intermediate good used in the making of synthetic threads like nylon and polyester (that are intermediate products for goods as diverse as artificial turf to ready-to-wear clothing.)
Thus, the value of the final good, in this way of thinking, simply is the sum of the various valuations that are made at each production stage. Prices of goods are derived from that summation of previous prices of production. (Thus, we hear advocates of government medicine claim that marketing done by private medical firms simply "drives up" the cost of medicine. Eliminating private medicine, they argue, would lower final costs because government health care providers would not need to engage in marketing. The quality of care, they claim, ultimately would improve.)
If that description of economic processes were true, then the outsourcing critics would be correct, since they argue that whatever savings consumers might gain from cheaper products imported from "cheaper labor" countries overseas are more than offset by the losses incurred by the disappearance of the various stages of "value added." However, there is a problem in that analysis, one that even the Classicals, including Adam Smith, recognized. It was Smith who noted that the purpose of production is consumption. To put it another way, the only way the anti-outsourcing advocates could be correct would be if production were an activity carried on for its own sake.
One of the (many) fallacies of the communist paradigm was that the centerpiece of economic society was the "worker." As a production-oriented ideology, communism was based upon the fallacy of production itself being the ultimate purpose of economic activity. Therefore, factories were seen as the logical center for political organizing and activity; what actually was made and how it was made and the quality of the final product took second stage (actually being completely off stage) to the issue of employment â€“ any employment. Apologists for communism in the western nations praised the fact that everyone in communist countries was assigned a job, thus eliminating dread unemployment, which leftists claim is the Achilles Heel of the capitalist system.
Menger's contribution in this particular arena of economic analysis is vital to understanding why the anti-outsourcing crowd is just plain wrong. The value of a final product did not arise from the series of "added value" that occurred at the different stages of production. Instead, the valuation of the factors of production ultimately came from the value that consumers placed upon the final product itself. To put it another way, the imputation of value did not run upward first from the factors and ultimately to the final product; instead it occurred the other way around. Consumers, through their valuation of a good, indirectly determined the value of each factor of production and each intermediate stage of manufacturing.
This insight is the antidote against the claim that "outsourcing" harms the U.S. economy. As I said in an earlier article on this subject, the anti-outsourcing advocates make the claim that the ultimate source of wealth in an economy comes from costs of production. The higher the costs, the wealthier a society becomes.
One manifestation of this fallacy is the notion that Henry Ford, when he doubled the pay to his employees at his Dearborn, Michigan, plant to $5 a day, he instantly created a consumer society. The reasoning goes as follows: Ford doubled the pay of his workers, and by doubling that pay enabled them to become "consumers" by being able to afford to "buy back" the products they were creating. (Henry Hazlitt has a wonderful criticism of the "buy back the product" fallacy in his classic Economics in One Lesson.)
Such a claim, however, is absurd, since what they are actually saying is that by doubling his labor costs, Ford was able to sell more cars. In reality, Ford increased employee pay in order to retain his workers, correctly assessing that the high costs associated with employee turnover and constant training of new employees who were not enamored by the boredom of the conveyor-belt assembly lines, or at least not enamored with putting up with such boredom for $2.50 per day. Ford's actions ultimately lowered his total production costs, something that the "Ford created the consumer" advocates miss entirely.
Yet, there is something that is seemingly disturbing when a company closes a plant in the United States, which means layoff here, and builds a plant in another country in large part because they can make the same goods there with substantially lower labor costs. Roberts gives the example of one software firm in this country laying off employees making up to $150,000 a year and opening a new operation in India, paying those employees $20,000 (a very high salary in India). As he sees it, the value of the lost income from American software losing their jobs to lower-paid Indians is more than whatever the value that consumers save â€“ and extra profits earned for stockholders â€“ by having these products made more cheaply. Multiply this across an entire economy, from textiles to parts for airliners, and the result is a lower standard of living for all.
As compelling as this argument sounds â€“ and it certainly is going to be compelling to the families of individuals who lose high-paid jobs and cannot find comparable compensation for their skills â€“ it still is based upon the "value added," production for its own sake fallacy. Before they can make their case that the practice of outsourcing is harmful to the U.S. economy as a whole, the anti-outsourcing advocates must be able to demonstrate that the ultimate purpose of production is not consumption, but rather production itself. This is not an arbitrary claim on my part, for unless those who wish to outlaw "outsourcing" can clearly demonstrate why it is that an economy benefits from higher costs of production versus lower costs, then they have no argument at all.
The Mengarian analysis hardly begins and ends with international trade, as one can easily apply it within an economy. For example, I currently live in an area (Allegany County, Maryland) that at one time was a thriving manufacturing center. In the past 40 years, however, almost all of the manufacturing plants that employed thousands of people have closed and the population of the county has fallen substantially. Furthermore, the rate of unemployment here is relatively high and many jobs pay low wages.
When this locality was in its manufacturing heyday, places like Greenville, South Carolina, were considered backwaters of low pay and a relatively low standard of living. Today, the situation is reversed, yet I would argue that because factors of production were freely permitted to move within this country, in the end the absolute standard of living in Greenville and Allegany County has risen.
Application of Menger's principle here is that when a less-costly way to make a good is discovered, whether it be through the application of new capital or through lower wages, then the value of the factors used for that good has changed as well. An economy cannot gain when the state attempts for force up the price of some factors so that the owners of those factors of production are able to gain an advantage. We are dealing here with the hoary fallacy of protectionism, period.
For all of the popularity of their arguments at this time â€“ something that is being repeated by both major political parties in this current election season â€“ the anti-outsourcing advocates have not discovered anything new. In the end, they repeat the Classical fallacy of goods deriving their value from the costs of production. Should they succeed in forcing their views into law, we can be sure that the ultimate outcome will that which befalls any society that gives into protectionism: a lower standard of living and, in the end, even more joblessness.
These companies are not locating plants in the US because wages in the US are cheaper than in Japan or Germany, but in order to gain cost advantages from logistical and political proximity.
America's problem is not caused by jobs outsourced to Sweden, France or Australia but rather to India, China and Asia-Pacific.
The presence of this argument undermines the rest of the article.
Rather than showing how this assumption is incorrect, the article sidesteps this and goes on to something else.
Public medicine would in fact lower consumer costs not only due to the elimination of marketing costs but also because profits could be eliminated as well. How is this not true?
How can a consumer decide the value of each factor of production? If this were true, then it would mean that all companies would have the same cost structure for commodity products. We know this not to be true because some companies are more profitable than others. That alone shows that companies have different cost structures. How would consumers dictate one costs structure to a company and then dictate a different cost structure to another company making the same product for the same price?
If this is not so, then it should be straightforward to provide examples of how value returns to the country doing the outsourcing. Where are such examples?
What? He just said that "Today, the situation is reversed." so standard of living followed manufacturing. How is this an argument for outsourcing???
The only reason Allegany didn't suffer greater misery is because populations are allowed to move from state to state. This is not true of national populations where if nothing else there is a barrier to going to nations like China and India due to language differences alone.
Nobody is trying to "force up" the costs of labor when they are against outsourcing. Capital should not be allowed to exploit the gap between high consumer prices in advanced industrialized nations and low labor costs in underdeveloped third world countries because doing so undermines the very purchasing power of the advanced industrialized nations that drive the world's economy!
Banning outsourcing has nothing to do with propping up wages. The argument is solely based on the health of the economy. The economy will simply not support outsourcing for long before price deflation erodes company profits, decimates consumer demand in the nation outsourcing its jobs and currency pressures slashes that nations purchasing power. Since demand drives supply, it ultimately drives economic growth. No demand, no growth.
Finally, outsourcing is made even worse by China fixing its renmibi yuan to the American dollar. Under normal circumstances a rising yuan would make outsourcing less attractive as labor costs in China would start to go up, but a fixed yuan insures that no matter how low the dollar falls, China continues to maintain its competitive advantage over the US.
There are other negatives. Outsourcing makes trade imbalances worse. It lowers the dollar's value causing US energy prices to rise and increases the national debt. It lowers federal and state tax revenues while increasing federal and state expenditures at the same time. Undermining the US economy also undermines national defense.
All I need to believe in outsourcing is an example of how world product is increased. That's all. Very simple. Show me how wealth is created through outsourcing!
I don't believe that's the case. If it were indeed more cost advantageous to have automobile factories in the U.S. as opposed to a third-world country, why have companies like General Motors moved to countries like Mexico? Of course they moved to take advantage of the lower labor cost environment. The foreign-owned automobile manufacturers did not set up factories in the U.S. for cost advantageous reasons.
It would be far more advantageous to outsource the factories to regions where production costs are lower.
This would be true if the entire system was funded exclusively on income generated directly from the services rendered. And, if this were the case, it would indeed need to invest in marketing.
What is being proposed in the United States (at least) is not such a system. Public medicine in the U.S. would entail a medical system which is funded by taxpayer subsidy money, and not directly from income from service charges.
One of the major problems with subsidized, government-owned institutions is that they are horribly plagued with inefficiency. They just can't allocate funds effectively and efficiently. There is always massive amounts of waste. For example, the United States Postal Service was subsidized by taxpayer money up until the 1970's. The USPS is now funded completely by the income it generates from its services. Productivity, efficiency, and customer satisfaction increased drastically after this occurred. In fact, since 1995 the USPS has reported over $5 billion in profits! And yes, it does invest extensively in marketing.
Also, if it were true that public medicine would be so much less expensive, efficient, and would cover a far larger number of people, why would we not do this with all industries and service companies? Why not go for 100% full-on socialism, since government-owned industry is so much more efficienty and cost-effective? The reason is simple: because it just ain't so!
This is not true. Different companies produce very nearly the same products have different cost structures because of demand and consumption. For example, why is it that Mercedes automobiles sell for much more than Ford automobiles, even though the cost in factors of production are very nearly identical. The reason is because of demand. Cars like Mercedes and BMW are similar to a Veblen good.
A Veblen good is something whose demand is decreased as price decreased, the opposite of most goods. In other words, the price elasticity of demand is positive instead of negative.
The costs of factors of production in such goods (also see Giffen goods) has almost nothing to do with the actual market value of the good. The market value is not set by factors of production as much as they are determined by the consumer.
Ultimately, the market value and the costs of factors of production are determined by consumers. What is it that determined that McDonald's workers should be paid $6.50/hr and their products cost $X, instead of their workers getting paid $13.00/hr and their products costing double $x? It is the collective demand of all of the consumers in that market which determine both the market price and the cost of factors of production.
Here I agree with you.
Wealth is not created through outsourcing. General Motors didn't move manufacturing jobs to Mexico because they thought it might increase the world's net wealth. Wealth is still created, however, despite manufacturing jobs being outsourced. Wealth is created by outsourced companies in the same way that it is created strictly within the borders of a single nation: consumption generates a demand which is met with production of the supply. Of course the process is a lot more complicated than this. I would recommend Adam Smith's The Wealth of Nations.
"The property which every man has in his own labour, as it is the original foundation of all other property, so it is the most sacred and inviolable. The patrimony of a poor man lies in the strength and dexterity of his hands; and to hinder him from employing this strength and dexterity of his hands; and to hinder him from employing this strength and dexterity in what manner he thinks proper without injury to his neighbour is a plain violation of this most sacred property. It is a manifest encroachment upon the just liberty both of the workman and of those who might be disposed to employ him. As it hinders the one from working at what he thinks proper, so it hinders the others from employing whom they think proper. To judge whether he is fit to be employed may surely be trusted to the discretion of the employers whose interest it so much concerns. The affected anxiety of the law-giver lest they should employ an improper person is evidently as impertinent as it is oppressive."
- Adam Smith
You disagree with me in the first sentence, but then support my argument in your second sentence only to disagree with me in your fourth sentence but then you negate that in the last sentence.
I'm confused. What are you saying exactly?
In order for the article to strengthen its point through this example the following would have to be true: "Japanese and German auto manufacturers moved fabrication to the US because of low wages."
But if that is true then why are US companies outsourcing? Why didn't the Germans simply outsource to the same countries to which the US is outsourcing.
That would be the problem of outsourcing jobs.
Cars are not exactly commodities since a BMW is not interchangeable for a Dodge so they can't be used for this example.
I don't see how the Veblen good tangent helps here. The existence of Veblen goods is very questionable.
One commodity which has numerous layers of added value production in it and yet is completely interchangeable is computer memory. The market is quite diverse with European, American, Japanese and Korean corporations as the major players. They have completely different cost structures and yet for any given memory chip their spot prices are identical. If consumers set costs of individual added value steps that it takes to produce a memory chip, then it would figure that every company would have the same cost structure and yet this is not so.
First of all, the cost of labor does not account for the full price of a product. Therefore increasing labor cost by a factor of 2 is not guaranteed to increase the price by a factor of 2. The new price depends on the shape of the new supply curve and the shape of the existing demand curve. Second, market price must eventually exceed the cost of materials, labor and overhead in order for the business not to lose money on a product regardless of what consumers would like to pay. If nobody is willing to pay this minimum, then supply will dwindle to zero. Initially if labor were made to cost twice as much, there would be a glut of supply at the new price and businesses would have to downsize or close until only enough business existed to satisfy the new demand.
The question boils down to this, "Does an economy produce more wealth when outsourcing is possible than one where outsourcing is not possible?"
I would say that, under certain circumstances, economies with outsourcing can produce greater wealth than those without but under other circumstances economies with outsourcing can slow down wealth production or even start eliminating wealth. America is in the latter stage now. Ricardo's comparative advantage no longer applies because transportation costs are low enough to facilitate manufacturing anywhere and capital can go anywhere to experience the same labor productivity levels. Nations with the lowest cost of labor hold absolute advantage.
This was not true in Smith's time and was still not true in Ricardo's time. It has become true only very recently, within the past several decades.
Given that nations with the lowest cost of labor hold absolute advantage, then how can outsourcing create wealth faster? Or how can it even create wealth at all when the demand of advanced nations is being undermined and low cost countries are creating a glut of supply? Who will buy all these gizmo's that low cost nations are producing without growing demand in proportion to the loss of demand in advanced countries?
You said that the European automobile manufacturers have factories in the U.S. for cost advantageous reasons. I simply disagreed by saying if they were really after cost advantages, they would have outsourced to a third-world nation, where costs of production are much less, just like General Motors has done.
That was the point I was trying to make in the paragraph you were confused by. It's obvious that the Germans didn't outsource to the U.S. for cost reasons, because it would be far better to outsource to, say, Mexico, and obtain a far greater cost advantage.
I don't see it as a problem for the U.S., or (in long run) for the nations where manufacturing is being insourced.
I'm fully aware of this, it was simply an example.
Really? Perhaps you can explain how America is eliminating wealth by outsourcing.
It most certainly does!
It is true that transportation costs are low enough to facilitate manufacturing anywhere, and it is also true that capital can be invested anywhere. However, just because this is possible, does not mean that it is so in every case. We were talking about German automobile manufacturers setting up factories in the U.S. earlier.
They have the option to outsource to the nation with the lowest costs of production, or the absolute advantage, yet they have not (yet anyway). Just because products can be produced more cheaply elsewhere, does not necessesarily mean that they indeed will be produced there.
Supply and demand are constantly "trying" to match eachother. These nations with absolute advantage will not be able to continue overproduction that far exceeds the demand. Sooner than later the companies will realize that they are wasting capital in this process of overproduction and they will cut back on production to better equal the demand.
I agree, but now we both disagree with the article.
For every $10 an hour job you replace with a $0.10 an hour job, you destroy $9.90 worth of demand. This is OK if the person previously earning $10 an hour is able to re-employ because if he gets another job for $10 an hour then overall world product has risen by the amount of the outsourced job, $0.10, and this is a net gain for everyone. If the person retrains and re-employs at a higher wage, then America benefits as well for the small price of retraining. The problem starts when re-employment occurs at a lower wage and the shit really hits the fan when no re-employment occurs.
In the past, when low skill jobs were being outsourced and Americans retrained, this actually worked in their favor because for the cost of retraining, world product rose as low skilled employment went abroad but low skilled employment in the US was replaced by higher skilled employment for the one time cost of retraining. This is pretty simplified but can under other conditions generate economic growth on both sides.
The problem now is that jobs of all skill and educational levels can be outsourced. This means that a factory worker earning $20 an hour can be replaced for $0.50 an hour and any potential job that this person could have retrained to can also be replaced for a lower cost job overseas. This is not a growth engine. It is simple job substitution. Companies profit as long as the price difference between US jobs and overseas jobs allows for a greater profit margin, but profits return to normal once outsourcing has been tapped and prices have been deflated. At that point however American consumer purchasing power has collapsed and world demand for all those outsourced products has been decimated since populations in nations participating in outsourcing don't earn anywhere near what American consumers who are now jobless earned. There's no force that could adjust this back to normal because no company is going to be willing to be the first to start hiring Americans back to get demand started again. This can only happen after Americans have suffered enough hardship to legislate against such practices.
This would be an inefficiency in a free market. You can't seriously believe that free markets work and then turn around and say that it is a market's inefficiency that is keeping jobs in the US.
The fact that you admitted absolute advantage completely undermines your stand that Ricardo's theory of comparative advantage still applies.