Trade Theoretic Perspective on Outsourcing: Efficiency Gains & Income Transfers

1. Efficiency gains and income transfers in outsourcing : a trade-theoretic perspective John Quiggin Schools of Economics & Political Science University of Queensland Paper will be available at http://www.uq.edu.au/economics/johnquiggin/

2. Outsourcing and competitive tendering • Growing importance in both public and private sectors • ‘Steeering not rowing’ • ‘The virtual corporation’ Outsourcing, efficiency and transfer

3. Efficiency gains and income transfers • Normally outsourcing will take place only if outside supplier has a cost advantage • This cost advantage may arise from • Greater efficiency • Implies net efficiency gain from outsourcing • Lower wages • Implies cost reduction is mainly an income transfer Outsourcing, efficiency and transfer

4. Economic significance • Industry Commission estimates gains from government CTC ranging from 0.3 to 1.7 per cent of GDP • Crucial issue is whether cost savings arise from efficiency improvements or wage reductions • Total benefit of mid-90s productivity surge (relative to trend) was 4.8 per cent of GDP • Data suggests outsourcing played a major role Outsourcing, efficiency and transfer

5. A trade-theory perspective • Shift from full vertical integration to outsourcing/competitive tendering is like shift from autarky to free trade • Efficiency gains and comparative advantage • Factor price equalisation Outsourcing, efficiency and transfer

6. Comparative advantage • With equal factor prices, comparative advantage coincides with absolute advantage • Benefits from specialisation • Firm/country-specific technology • Economies of scale vs economies of scope Outsourcing, efficiency and transfer

7. Factor price equalisation • Stolper-Samuelson theorem - relatively abundant factor gains from trade • In firms controlled by capital, but with effective shortage of labour due to unions or contracts, outsourcing will be attractive • In presence of distortions, need not be welfare-improving Outsourcing, efficiency and transfer

8. Welfare implications • General presumption of potential Pareto-improvement • Need not apply in the presence of pre-existing distortions • Net gains are second-order Outsourcing, efficiency and transfer

9. Applying trade theory models to outsourcing • Dixit-Norman dual approach • Krugman-Helpman on scale economies Outsourcing, efficiency and transfer

10. Formal modelling of outsourcing • Outsourcing defined as purchase of intermediate outputs • Profit functions • Convex case - relative and absolute advantage • Nonconvex case - specialisation Outsourcing, efficiency and transfer

11. Specialisation and diseconomies of scale • Consideration of outsourcing suggests an explanation in terms of agency theory • Unobservable contingencies in the production of intermediate goods increases severity of principal’s problem Outsourcing, efficiency and transfer

12. Transfers • Arise from trade between firms facing different factor prices or wage-employment bargains • Simplest case is that of high-wage firm outsourcing to low-wage suppliers Outsourcing, efficiency and transfer

13. Concluding comments • Income distribution is crucial • This fact has been • Long-recognised in debate about trade • Largely ignored in economic discussion of outsourcing Outsourcing, efficiency and transfer