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Globalization and the widening inequality in developed countries.

INTRODUCTION

In the past thirty years, the world saw two important changes: first, with the end of the ideological war, two gigantic economies--China and India, joined the international market; second, the advancement in information technology removed obstacles in communication and made the world a global village. Meanwhile, in developed countries, the wage gap between high skilled and low skilled workers enlarged, which can be seen on Figure 1. The prices of education and medical care skyrocketed. The discontent of the middle class escalated. Figure 2 shows the wages of high school graduates and bachelor's degree holders against the price index of medical care service. There is an obvious decline in this variable for high school graduates.

[FIGURE 1 OMITTED]

[FIGURE 2 OMITTED]

The coincidence of what happened in the world and in the developed countries evoked hot debates on the effect of globalization, especially offshore outsourcing, on developed countries. Some of the issues in these debates include: (1) Whether offshore outsourcing or skilled-biased technical change (SBTC) is responsible for what happened in the developed countries; (2) Whether the discontent is over the inequality, namely, some people get a larger share of the gain from outsourcing and others get a smaller share, or the absolute loss in welfare; (3) If the middle class actually loses due to outsourcing, then is the loss long-lasting or just the inevitable temporary transition cost predicted in traditional models on international trade?

The confusion over offshore outsourcing indicates a lack of theoretical models on it. The nature of international trade is changing. Traditional international trade mostly entailed an exchange of goods. There are abundant studies in economics which could be traced back to Adam Smith and David Ricardo. Offshore outsourcing involves bits of value being added in many different locations, or what might be called trade in tasks (Grossman & Rossi-Hansberg, 2008). The purpose of our paper is to provide some theoretical findings on the welfare impact of offshore outsourcing. First, we prove that offshore outsourcing will widen the wage gap, which is supported by the empirical studies by Feenstra and Hanson (1996, 1999). Second, the welfare of low skilled workers could be hurt by outsourcing. Third, the loss is not the same as the transition cost in international trade, such as job displacement, which will disappear as losers find new jobs in other industries. It is caused by the increase in certain service prices and is long-lasting.

We set up a model with two countries--the North, or developed country and the South, the developing country. In the North, there are two types of labor--high skilled and low skilled labor. There are three sectors--high quality services, such as health care and education; low quality services, such as housekeeping and baby-sitting; and goods. To our best knowledge, no other papers has divided the service sector into two different sectors as we do in our paper. The introduction of high quality service sector permits a useful decomposition of the impact of outsourcing on workers. Since workers consumer goods, low quality services and high quality services, the price change in any sector has an impact on their welfare. However, in the existing literature, not enough attention was paid to the rising price in high quality services, despite the fact that people have been complaining about college tuitions and health care costs for a long time. We address this issue and show that the rising prices in high quality services indeed hurt low skilled workers.

Among the three sectors, offshore outsourcing can only occur in the goods' sector. The wage of low skilled workers in the South is lower than that in the North. Firms in the North will exploit the wage difference between the two countries and ship the labor intensive segments of the production to the South. When that happens, the cost of production decreases. The drop in the price of goods leads to an increase in the real wage (in terms of the amount of goods it can buy) of both high and low skilled workers in the North. However, the wage gap between them widens. Offshore outsourcing causes a greater inequality. The reason is as follows. Low skilled foreign workers are complements with U.S. high skilled workers (Hanson, Mataloni, & Slaughter, 2003). Increased employment of low skilled workers by overseas affiliates of U.S. firms or independent foreign firms is associated with increased demand of high skilled workers in the U.S. The increased demand leads to more employment and higher wage level. Low skilled workers move to the low quality service sector and the wage level decreases. Therefore the wage gap widens.

The increase in the demand for high skilled workers has another effect. With the increase in the employment in the goods' sector, the supply of high skilled workers in the high quality service sector shrinks. The wage level increases until it equals to that of high skilled workers in the goods' sector. Consequently, the price of the high quality service also rises. Low skilled workers lose since they need to pay more for high quality services, such as health care and education. When the wage level in the South country is sufficiently low, so that low skilled workers' gain from the lower goods' price outweighs the loss from higher service price, the low skilled workers are better off. As the South country's economy grows and the wage level increases, the relationship may reverse and the low skilled workers are worse off.

The paper is organized as follows. The next section reviews the related literature on the impact of offshore outsourcing on the wage inequality. The basic elements of the model and the equilibrium without outsourcing are presented in Section 3. In section 4, we study the impact of outsourcing on the North Country. Section 5 offers some discussion based on our findings. The last section concludes.

RELATED LITERATURE

Offshore outsourcing is not only a hot topic in politics, but also in economics. There are both theoretical and empirical studies on its effect on wage inequality and welfare. Theoretical studies suggested ambiguous effects on the relative wage (or income distribution as used in many papers). They established conditions under which the low skilled workers (analogously labor in their models) benefited and lost, respectively (See Jones & Kierzkowski , 2001, for example).

Deardroff (2001) studied the impact of fragmentation on the national welfare and showed that even when a country gained from fragmentation, some factor owners might lose. Deardorff (2004) used a single-sector model to study the welfare impact of skilled-labor outsourcing. He found that this outsourcing could cause the wage of low skilled labor in North to fall below that in South. However, if the factor endowments differ enough, both the high and low skilled labor in North could gain. Kohler (2001) analyzed the impact of the cost of international fragmentation on the welfare effect of outsourcing. In the presence of a positive cost of international fragmentation, outsourcing might be welfare reducing for the domestic economy. He also found that if foreign direct investment was impossible, then labor lost if a labor-intensive fragment moved "offshore". Venables (1999) argued that fragmentation reduced wage-rental ratio (or the relative wage between low and high skilled workers) in the Home country.

In the explanation of the widening wage gap between skilled and unskilled workers in the U.S. and elsewhere, there is a debate among economists as to which one is more important--the skilled-biased technical change (SBTC) or outsourcing. Feenstra and Hanson (2001) did a comprehensive survey and argued that "trade ... has much the same impact ... as does skill-biased technical change." They mentioned a similar finding in Sachs and Shatz (1998) where the price of skilled-labor intensive nontraded goods rose and that of unskilled-labor intensive nontraded goods fell. However, in that case, the price of the traded goods was assumed to be constant. Askenazy (2005) is by far the closest model to ours. He studied the impact of international trade on wage inequality in developed countries. The economy was divided into three sectors: innovative R&D, employing only high skilled workers; manufacturing, employing both high and low skilled workers and personal services, employing only low skilled services. His R&D sector and our high quality service sector are similar in that both of them employ only high skilled workers. The fundamental difference between them is whether the outputs in these sectors are tradable. R&D in Askenazy (2005) produces the designs for manufacturing equipment and is tradable. In our paper, we consider this as part of the high skilled workers' job in the goods' sector, same as management. On the other hand, high quality service must be produced and consumed locally.

Empirical tests also confirmed the prediction by theoretical studies that outsourcing had quantitatively similar effects as SBTC on the increase in wage inequality between skilled and unskilled workers (see the survey by Crino, 2009).

THE MODEL

The Setup

There are two countries in this world: the developed, or the North Country and the developing, or the South Country. We analyze the economy in the North while taking the economy in the South as exogenously given. In the North Country, there are two types of labor: high skilled labor (H) and low skilled labor (L) and three distinct sectors: goods (X), high quality services ([S.sub.H])--such as education, health care, consulting and legal services and low quality services ([S.sub.L])--such as haircuts, housekeeping and baby-sitting. High skilled labor can produce all types of output. Low skilled labor can only be used to produce low skill service and goods. The total numbers of high skilled and low skilled workers are fixed. We assume that goods are tradable and services are not. Services can only be produced and consumed locally (7).

All three sectors and the labor markets are perfectly competitive. Workers move freely among sectors and firms within a country, so that all workers of each type receive the same wage. We tried the monopolistic competition for the three sectors but the results do not change. For the labor market, there will be frictions in the short run. We look at the long run effect so an assumption of perfect competition is appropriate. Moreover, the friction in the labor market will only strengthen our finding since the low skilled labor finds it more difficult to transfer to another industry once the jobs are outsourced in the manufacturing sector. Low skilled workers' welfare will decrease even more.

The Technology

The high quality service is produced by high skilled labor with the production function

[MATHEMATICAL EXPRESSION NOT REPRODUCIBLE IN ASCII]

and the low quality service is produced by high skilled and low skilled labor with the production function

[MATHEMATICAL EXPRESSION NOT REPRODUCIBLE IN ASCII]

which implies that the productivity of high and low skilled workers is the same in the production of low quality service. The good X is produced by the high and low skilled labor together with a Cobb-Douglas production function

X = [mu][H.sup.[alpha].sub.g][L.sup.1-[alpha].sub.g], [mu] > 0, [alpha][member of](0,1)

[MATHEMATICAL EXPRESSION NOT REPRODUCIBLE IN ASCII] and [H.sub.g] denote the numbers of high skilled workers in high quality service, low quality service and goods sector, respectively. Analogously, [MATHEMATICAL EXPRESSION NOT REPRODUCIBLE IN ASCII] and [L.sub.g] are the numbers of low skilled workers employed in the low quality service and goods sector, respectively.

The Preference

Households in the North consume high quality services, low quality services and goods. A typical household's problem is to maximize the utility subject to its budget constraint.

[MATHEMATICAL EXPRESSION NOT REPRODUCIBLE IN ASCII]

where I is the household's income, [w.sub.i] is the wage and [pi] is the dividend from firms.

[p.sub.x] [equivalent to] 1

therefore X is the numeraire.

The Equilibrium in Autarky

In the equilibrium, the marginal cost must be equal to the price in a perfectly competitive market.

[MATHEMATICAL EXPRESSION NOT REPRODUCIBLE IN ASCII]

The marginal productivity is equal to the wage so that

[MATHEMATICAL EXPRESSION NOT REPRODUCIBLE IN ASCII]

Solving household i's problem, we get

[MATHEMATICAL EXPRESSION NOT REPRODUCIBLE IN ASCII]

We can pin down the equilibrium wage levels (due to the space limit, the proof here and for the three propositions below are omitted and are available upon request).

[MATHEMATICAL EXPRESSION NOT REPRODUCIBLE IN ASCII]

no high skilled labor will work in low quality service sector.

The Impact of Outsourcing

Suppose that due to the technological advancement, Northern firms can outsource the labor intensive segments of the good's production process to the South country with much lower wage for low skilled labor, [w.sub.o] [much less than] [w.sub.L]. In reality, there will be a positive cost associated with outsourcing. The cost may include transportation cost and increased complexity of management. In this paper, we assume that the cost saving from the low wage exceeds the additional cost from outsourcing so all firms decide to outsource the labor intensive segments. After this decision is made, the outsourcing cost does not affect our analysis. Without loss of generality, we set the cost equal to 0. As a result, the low skilled labor in the north country floods to low skill service industry, [L.sub.s] = L. We can find the equilibrium in this new situation.

Proposition 1 With outsourcing, the employment of high skilled workers in the goods' sector increases. In the goods' sector, the production cost falls due to outsourcing. The supply curve shifts out. Goods become relatively cheaper and quantity demanded rises. To produce more, firms need to hire more high skilled workers. The demand for high skilled worker increases.

Proposition 2 Although both high and low skilled workers' wages increase, the wage gap widens.

The labor intensive segments of the good's production are shipped to the South country. The demand for low skilled workers in the North Country decreases. On the contrary, the demand for high skilled workers increases. Although the real wage of low skilled worker, measured in the amount of goods it can purchase, increases because of a substantially low goods price, the wage gap between low and high skilled workers widens. The increase can be seen from Figure 3, which shows the wages against the price index of commodities less food and energy. The wage gap is shown in Figure 1.

[FIGURE 3 OMITTED]

This explains why outsourcing was welcomed at the early stage but becomes more and more controversial later on. In the 1980s and 1990s, the destination countries of outsourcing, such as China, had a very low wage in comparison to that in the US. For example, in 1999, the hourly compensation in China was only equal to 3 percent of the U.S. level (8). At such a low level, both high and low skilled workers in the US benefited from outsourcing. Over the past decade, the compensation in manufacturing in China surged. In 2007, the ratio of China's compensation to the US rose to 9.2% (9). In this case, the low skilled workers in the US might start suffering from outsourcing. The increase in [w.sub.L], measured in terms of the goods' price, cannot cover the loss from more expensive high quality services. The low skilled workers' welfare is actually lower than that in autarky. Therefore, the complaints by low skilled workers are not just about the inequality, a cry for a larger share of the gain from outsourcing. They indeed lose from outsourcing.

DISCUSSION

In this section, we discuss the implications of our findings on public policies.

When talking about the impact of offshore outsourcing, economists agree that the nation as a whole will gain. However, efficiency does not mean equality. There will be winners and losers in this process. The government should design some policies to help the losers.

One suggestion is investment in education programs. Education can increase human capital, which is a source of productivity growth. Meanwhile, education creates more high skilled workers. The increase in the supply of high skilled workers can narrow the wage gap. The other suggestion is policy tools to combat inequality, such as the earned income tax credit.

Such policies are necessary and will work well if the South country is static, meaning, the wage level there does not change. In that case, the inequality can only be reduced by the government intervention. However, in reality, the South country's economy is growing and the wage level is increasing. If the outsourcing is done gradually, not instantly as we assumed in our paper, then we will see a gradual increase in the wage gap in the early stage of outsourcing, when more and more firms take advantage of the lower wage in the South. As the wage level in the South starts to rise due to its own economic development, the trend will reverse. More and more firms will find outsourcing not cost saving, especially when there is a cost associated with outsourcing. The wage gap will shrink.

If left alone, the wage inequality will decrease with the growth of developing countries. Government intervention could overshoot the problem. There is a time lag between the education investment and its economic return. By the time low skilled workers finish the education and become high skilled workers, the wage gap may already be too small that the investment does not pay off. Taxes have similar problems. It is reasonable to tax the winners and help the losers to reduce the hardship now. The difficulty is the flexibility, or inflexibility of government policies. When the situation changes, it is not easy to repeal the tax. At that time, winners will become losers.

CONCLUSION

We have developed a three-sector, two-factor model to study the widening of the wage gap between high and low skilled workers and the welfare change in the developed countries due to offshore outsourcing. The introduction of the non- traded high quality service sector helps us better understand the impact of outsourcing on workers', especially on low skilled workers' welfare. In contrast to the findings of many existing papers on outsourcing, we find that the welfare of low skilled workers might decrease even when their real wages increase. This finding provides a justification for some people's decrying of outsourcing. At the same time, our model also shows that the remedy does not come from more investment in education nor from other public policies. It comes from the economic development thus the increase in the wage level in the developing countries. With higher and higher wage level, which is already seen in the developing countries, the outsourcing may stop and the problems disappear.

REFERENCES

Askenazy, P. (2005). Trade, services, and wage inequality. Oxford Economic Papers, 57, 674-692.

Blinder, A. S. (2005). Fear of offshoring. CEPS working paper 119.

Crino, R. (2009). Offshoring, multinationals, and labor market: A review of the empirical literature. Journal of Economic Surveys, 23 (2), 197-249.

Deardorff, A. (2001). Fragmentation in simple trade models. North American Journal of Economics and Finance, 12 (2), 121-137.

Deardorff, A. (2004). A trade theorist's take on skilled-labor outsourcing. University of Michigan, Ford School of Public Policy, Discussion Paper 519.

Feenstra, R. C., & Gordon H. (1996). Foreign investment, outsourcing and relative wages. In R.C. Feenstra, G.M. Grossman & D.A. Irwin (Eds.), The political economy of trade policy: Papers in honor of Jagdish Bhagwati, (pp.89-127). Boston: MIT Press.

Feenstra, R. C., & Gordon H. (1999). The impact of outsourcing and high-technology capital on wages: Estimates for the U.S., 1979-1990. Quarterly Journal of Economics, 114 (3), 907-940.

Feenstra, R. C., & Gordon H. (2001). Global production sharing and rising inequality: A survey of trade and wages. In K. Choi & J. Harrigan (Eds.), Handbook of international trade, (pp.146-185). Oxford: Blackwell.

Grossman, G. M., & Esteban R. (2008). Trading tasks: A simple theory of offshoring. American Economic Review, 98 (5), 1978-1997.

Hanson, G. H., Raymond J. Mataloni,Jr., & Matthew J. S. (2003). Expansion abroad and the domestic operations of U.S. multinational firms. mimeo.

Jones, R., & Henryk K. (2001). A framework for fragmentation. In S. Arndt & H. Kierzkowski (Eds.), Fragmentation: New production patterns in the world economy, (pp.17-34). New York: OUP.

Kohler, W. (2001). A specific-factors view on outsourcing. North American Journal of Economics and Finance, 12(1), 3153.

Vanderweerdt, G. (2006). Analyzing the debate over offshore outsourcing in the service industry: Is there a reason for concern? Major Themes in Economics. University of Northern Iowa, 1-15,

Venalbles, A. (1999). Fragmentation and multinational production. European Economic Review, 43(4-6), 935-945.

Xiaojing (Joanne) M.A., Holy Family University

Qiang P.A.N., University of Pennsylvania

(7) With the technological advancement, there is a trend for service outsourcing in the U.S recently, such as calling centers and radiology services. We believe the majority of services are still produced and consumed locally. In this paper, we will focus on the impact of offshore outsourcing in goods' sector. Outsourcing in Business, Professional and Technical services "is small compared to U.S trade in goods or even compared to U.S trade in services such as travel and transportation ..." (Mankiw & Swagel, 2006).

(8) In 1999, the average monthly compensation in China was around 650RMB, which was about $78.6 given the exchange rate then, 1USD=8.27CNY. In the US, the average monthly compensation for workers was $2436 in the same year. Data sources: China Statistical Yearbook 2008; www.socialsecurity.gov.

(9) From the same data sources.
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Author:Xiaojing, M.A. "Joanne"; Qiang, P.A.N.
Publication:Competition Forum
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Date:Jun 1, 2011
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