Two-Country General Equilibrium Model

Offshoring domestic jobs/ Hartmut Egger, Udo Kreickemeier, Jens Wrona/2015 JIE.

Abstract

We develop a two-country general equilibrium model, in which heterogeneous firms offshore routine tasks to a low-wage host country. In the presence of fixed costs for offshoring the most productive firms self-select into offshoring, which leads to a reallocation of domestic labor towards less productive uses if offshoring costs are high. As a consequence domestic welfare may fall. The reallocation effect is reversed and domestic welfare rises if offshoring costs are low. The aggregate income distribution, comprising wages and entrepreneurial incomes, becomes more unequal with offshoring.

Introduction

Public opinion in high-income countries has been very critical of this phenomenon, and much more so than of traditional forms of international trade, since it seems obvious that offshoring to low-wage countries destroys domestic jobs.

As pointed out by The Economist (2009), “Americans became almost hysterical” about the job destruction due to offshoring,when Forrester Research predicted a decade ago that 3.3 million American jobs will be offshored by 2015. Using survey data from Germany, Geishecker et al. (2012) find that offshoring to low-wage countries explains about 28% of the increase in subjective job loss fears over the period from 1995 to 2007.

• The academic literature points out that the effect of offshoring on workers in the source country is ambiguous ex ante: On the one hand, offshoring has indeed the obvious international relocation effect emphasized in the public discussion, as tasks that were previously performed domestically are now performed offshore, thereby harming domestic workers. On the other hand, however, there is a productivity effect, as the ability to source tasks from a low-wage location abroad lowers firms' marginal cost, thereby increasing overall domestic income, which benefits domestic workers, ceteris paribus.

• The offshoring-induced reallocation of employment shares is at the heart of our paper, and we show that this effect can be important for aggregate welfare in the source country of offshoring. The mechanism leading to the reallocation of employment from high- to low-productivity firms is straightforward: Falling trade costs, starting from their prohibitive level, lead to offshoring among the most efficient firms, which frees some domestic labor and lowers domestic wages. As a consequence, the least productive firms hire more domestic labor and thus expand.

• Offshoring allows firms to hire foreign workers to perform routine tasks at a lower wage, and this provides an incentive for firms based in the source country to shift production of these tasks abroad. This incentive is not unmitigated, since firms relocating their routine tasks abroad have to Offshoring allows firms to hire foreign workers to perform routine tasks at a lower wage, and this provides an incentive for firms based in the source country to shift production of these tasks abroad. This incentive is not unmitigated, since firms relocating their routine tasks abroad have to pay a fixed offshoring cost, and shipping back to the source country the intermediate inputs produced in the host country is subject to iceberg trade cost pay a fixed offshoring cost, and shipping back to the source country the intermediate inputs produced in the host country is subject to iceberg trade cost.

• We consider an economy with two sectors: A final goods industry that uses differentiated intermediates as the only inputs, and an intermediate goods industry that employs labor for performing two tasks, which differ in their offshore ability. One task is non-routine and requires face-to-face communication, and it must therefore be produced at the firm's headquarters location.

• The other task is routine and can be either produced at home or abroad. Each firm in the intermediate goods industry is run by an entrepreneur, who decides on hiring workers for both tasks. We embed the economy just described into a two-county world, where the second country differs from the first in only one respect: The second country does not have any entrepreneurs. Given our production technology, the country without entrepreneurs cannot headquarter any firms, and therefore ends up being the host country of offshoring. The other country is the source country of offshoring. Trade is balanced in equilibrium, with the source country exporting the final good in exchange for the tasks offshored to the host country. In the remainder of this section, we discuss in detail the main building blocks of our model and derive some preliminary results.

The final goods industry

The final output is assumed to be CES-aggregate of differentiated intermediate good [pic 1]:

[pic 2]         

The intermediate good:

[pic 3]        

The intermediate goods industry

[pic 4]under monopolistic competition. Each firm is run by a single entrepreneur who acts as an owner-manager and combines a non-routine task, which must be performed at the firm's headquarters location in the source country, and a routine task, which can either be produced at home or abroad

[pic 5]