Outsourcing

An Economic Analysis of "Outsourcing"

by : Vipin Manuel

Prepared for ECO 500

FALL 2004

Dated: 15th December 2004

Outsourcing can be termed as shifting of major functions (production, back office processing and call centers) of a firm from one area to other which in return gets them more profit. Usually large firms base their head offices in developed countries and operate their productions from other developing countries where they can produce the goods at a cheaper cost. One of the main reasons for outsourcing of jobs from US to other developing countries like China and India is the low cost of production due to cheap labor available which in turn reduces the variable costs (6) involved. Some economists look upon it as a threat to US while others think of it as a way for its progress.

The outsourcing of jobs from United States of America is becoming a major threat to the American economy. Despite the substantial benefits of outsourcing, the increase in unemployment and the economy decline causes a major concern to the US government. But economists have cited many points that support outsourcing of jobs based on certain facts. If US companies do not outsource their jobs then foreign firms will produce cheaper goods and sell it to the US market. The demand curve is negatively sloped, so as the price of the substitute goods (3) that are outsourced gets low, the demand for the costlier US goods will come down. The demand curve for this can be said as elastic (5). This paper notes how outsourcing can be said to be as a "progress of the country" or "a major economy break down". China and India are among the major countries that US outsource its jobs.

The outsourcing of jobs from US flourished after the "North American Free Trade Agreement" which moved many jobs in US to Mexico. The wages paid to the Mexicans were 10 to 20 times lower than those paid to the Americans. Companies that outsourced learned the fact that they had to invest only a little in order to get more profits. Since labor was cheap they recruited more and increased productivity (6) and get more sales which helps to lower the variable cost involved (6) and increase the profit margin. But during the mid 90's US companies saw that China was offering wages much lower than Mexico, so they began to focus on China. In the beginning monopolistic competitors (11) began move to China and earn huge profits which caught the attention of Oligopolists. They began to invest huge amounts in capital to build factories and start manufacturing products in China. They concentrated for profits earned in the long run. They knew that since wages are low the cost involved in this can be transferred to increasing the production, charge a low price and maximize sales revenue.(11) They made tie-ups with local companies which helped them to study more about doing business in China. Most of the jobs that were outsourced were unskilled jobs which demanded low wage rates while the skilled jobs still remained here.

The wage rate compared to the US Dollars is very low in Countries. For example the average salary of a software programmer in US is about $60,000 to $80,000 while that of India is just $5,880 to $11,000 (Kansancityfed.org - "Off shoring in the service sector: Economic Impact and Policy Issues"). Taking into consideration this fact as the main reason for companies to go offshore; when they can get the same labor with the same skill for such cheap cost why should they be paying 10 to 20 times more to an employee in US when they can make use of the cost difference for other productive issues of the firm. The firms took the decision to outsource the jobs based on the opportunity cost involved (2).

The article also mentions that; "History of progress is a history of job destruction. Jobs destroyed in one sector of economy are often destroyed by the expansion of other sectors". Even though outsourcing brings about unemployment it can also do well to the country. Since the production cost involved is very low when outsourced, these goods can be sold at a cheaper price to the customers, which balance the whole situation. Take the case of Wal-Mart which sells goods cheaper than any retailer in the country. As the price of these products is lowered the quantity demanded increased (3). They tried to raise sales revenue instead of profit. The company which began selling in small towns sold outsourced goods to the public at the cheapest price. They knew the consumer choices and the total utility (4) of the goods being sold. Wal-Mart turned out to be one of the leading retailers in US.

But according to the law of comparative advantage (1) even in extreme cases, two nations can still benefit by trading and that each can gain as a result. Even though US out source a large no of jobs overseas it can still gain profits by concentrating in areas it has an absolute advantage in (33). Like even though if US out source's most of its unskilled labor to China and India, it can still concentrate on its skilled labor which are used in areas such as space research, aircraft manufacturing and advanced defense systems. US should divide the labor(2), train and build them in those areas in which it is good at and produce it more than what it wants. These new technologies developed can be exported to other countries for a much bigger price and still keep the economy up. Instead concentrating areas that need unskilled labor which can be out sourced, the country should concentrate on what it is best at and still make profits.

IT related jobs (software development, customer service jobs) in US are mainly outsourced to India. The main reason for this is the large number of English speaking population. India also has a very large number of students graduating from top universities (Indian Institute of Engineering) which give extensive training in both technical and problem solving aspects. Every year an average of around 2500 students graduate from these colleges ("The Journal Report - The Wall Street Journal"- Sep 27 2004).

India is the hub of Customer Service call centers of many companies. The main