Wednesday, March 23, 2005

Easing Fears over Outsourcing

One of the biggest fears that people have about globalisation and free trade concerns outsourcing - when domestic industries start manufacturing goods abroad, and then selling them at home. Over at Liberty ForumI got in a discussion concerning exactly this issue. The result is the essay below:

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Why using labour saving machines doesn't create unemployment.

Imagine a clothing manufacturer learns that a newly invented machine will make men's and women's trousers for half as much labour as he previously uses. For this reason he installs the new machine and lays off half his work force.

Now, at this stage it looks obvious that there has been a clear loss of employment - half the people in his company are now unemployed. There is the fact that the machine required labour to produce, and so here the unemployment the manufacturer appears to cause is slightly offset by the fact that the introduction of the machine itself created jobs that would not have otherwise existed.

However, this is clearly not a sufficient response to the problem of the apparent unemployment that the introduction of the machine causes. The manufacturer would have introduced the machine only if it had either made better suits for half as much labour, or if it had made the same suitts at a lower cost. Assuming the latter, we can't assume that the labour reuired to make the machine is as much, in terms of the payroll, as the amount of labour that the manufacturer hopes to save in the long run by adopting the machine. So there is still a net loss of employment that needs to be accounted for.

After the machine has produced sufficient economies to offset it costs, the clothing manufacturer is left with a profit. So at this point it would seem that labour has suffered a net loss in employment, whilst the manufacturer, and only he has gained - an apparently clear case of one side benefitting at another's expense.

However, it is from these profits that the benefits come, since the manufacturer has to use these profits. And he can only use these profits in one, or all of three ways. (1) He will use these extra profits to expand production by buying more machines to make more coats; or (2) he will invest the extra profits in some other industry; or (3) he will spend the extra profits on increasing his own consumption, buying a new car, or house, or something. The point is that each of these three courses of action increases employment.

In other words, because he introduced the labour saving machine, the clothes manufacturer has profits he previously didn't have. Every penny of the amount he saved by no longer having to pay the wages of his former workers, is a penny he now has to pay out indirect wages either to the makers of new machines (if he chooses option (1)), or to workers in another capital using industry (if he chooses option (2)), or to the builders of his house or makers of his car, etc. (if he chooses option (3)). Whatever the case, he gives indirectly as many jobs as he ceased to give directly.

However, the matter doesn't rest here. The process goes on to create even more jobs. If the manufacturer makes great economies compared to his competitors, then either he will expand his production at their expense, or they will also start using the machines (further increasing the demand for people to work to make the machines). But in this case the competition and increased production will drive the prices of the trousers down. The rate of profit available to manufacturers will fall, so that the saving of introducing the machine will be passed along to those that buy the trousers - the consumers.

Now, because the trousers are cheaper, more people will buy them. In other words, even though it takes fewer people to make the trousers as before, more trousers are being made than before. If the demand for over coats is elastic - that is, if a fall in the price of trousers causers a larger amount of money to be spent on them than before - then more people will be employed in producing the trousers than were employed in producing them prior to the introduction of the labour saving machine. This is what has occurred in reality, for instance, whilst the luddites smashed up new stocking frames under the claim that their introduction in the stocking industry at the beginning of the nineteenth century would result in unemployment, by the end of the century the industry employed one hundred men for every single man it employed at the beginning of the century.

In 1760 Arkwright invented new cotton spinning machinery that could do the job of many people. At that time it was estimated that there were 5,200 spinners and 2,700 weavers in England, and the introduction of Arkwright's machines was greatly opposed as a threat to people's livelihoods. However, in 1787, twenty-seven years later, a parliamentary inquiry found that the number of person's employed in spinning and weaving cotton had increased from 7,900 to 320,000. That is an increase of 4,400%!

However, new employment does not depend on this elasticity of demand for the product - in our case, trousers - involved. Imagine that the price of the trousers dropped from £60 to £40, but not a single additional pair of trousers were sold. In this case each buyer of the trousers would be provided with the trousers they would have got before, plus £20 left over that they didn't have before. In effect, they would have made a profit just as the clothing manufacturer in our example did earlier. Like the manufacturer, this customer would have to use the money they saved, and could only use it by (1) investing it in his own industry, (2) investing it in some other capital using industry, or (3) by using it to increase his own consumption. Just as with the manufacturer, in each of these three ways the consumer is paying the wages of workers that he would not have paid before.

So, on net balance machines, techonlogoical improvements and automation, economising and making a firm efficient, do not throw people out of work. It is important to remember, though, is that machines are good, not for making more jobs, but for bringing more products. What machines do is to increase production and increase the standard of living in two ways. They do it by making goods cheaper for consumers (as in our example), or buy increasing workers' wagers because they increase workers' productivity. In short, they either increase money wages, or, by reducing prices, they increase the number of goods and services that that money wage will buy. Sometimes they can do both. In any case, machines increase real wages.

What does this have to do with free trade and outsourcing?

What this has to do with free trade and outsourcing is that outsourcing in a way of economising in a firm just as introducing a machine can be. Take our same example of the trousers manufacturer in the example above. Now, imagine that what he discovered was not that introducing a new machine will make clothes for half as much labour as previously. Suppose, instead, that he learns that workers in another country will make as many clothes for him as before but for half the cost. So the manufacturer lays off half his workforce and employs the people in the foriegn country instead.

In exactly the same way as with the machine, the manufacturer again is left with a profit. Again, this profit can only been in one or all of three ways. (1) He can use the profits to expand production, hiring more of these foreign workers; or (2) he can invest it in other industries; or (3) he can spend it increasing his own consumption. Any of these three ways means taking money he saved by no longer paying wages to half of his original workforce and using it to indirectly pay the wages of other workers.

Moreover, again, if the demand for these goods is elastic, by gaining the economies of introducing foreign labour into his firm, coupled with the activity of his competitors, his industry may well end up employing more poeple than it did prior to switching to cheap foreign labour.

And even if the demand is not elastic, his customers save money, and so have more money to spend on other things, increasing demand for those other thinngs, and so increasing demand for workers to produce those other things.

The effects of Outsourcing in the real world: What prospects for the future

The concern over outsourcing is a coherent one. It is said that, if developing countries can pay lower wages to their workers, aren't constrained by environmental regulations or workplace regulations, and can make their workers work long hours, then their cheap output will eliminate our well-paid jobs and force us to lower our wages and working conditions. Firms, it is held, will migrate to places where they can pay the lowest wages and have the worst conditions. And so we get the "race to the bottom," as it is called.

The trouble is that this argument is plainly rooted on fallacious beliefs. It is wrong for the same reason that arguments for a minimum wage are wrong: If it is the nature of firms to naturally drive down to there barest minimum necessary to survive (as the "Iron Law of Wages of classical economic held), then all employers would pay no more than minimum wage. They don't. If it was the nature of firms to always drive work conditions down to the worts possible, then all employers would offer a working environment that was barely within the legal constraints. They don't.

The explaination is fairly simple. The fact is that consumers are not above all interested in buying goods from people who are poorly paid. What consumers want above all is to obtaining products that are as good and as cheap as possible. Ther reason that wages are low in developing countries is because workers in these countries are less productive than we in the west, producing less per employee.

If wages rose as a result of increased productivity, then there would be no problem, and consumers would have no reason for invariably choosing the products of cheaper labour. For instance, in thrity years - since becoming more globalised - Japanese wages rose from an average of one tenth of the American level to a level higher than the average American's. However, this did not make the Japanese less competitive - as many an American protectionist will testify - because output capacity rose at the same rate.

As Johan Norberg says, "Firms are not primarily looking for cheap labour. If they were, the world's aggregate production would be concentrated on Nigeria." What firms are interested in is getting as much as they can out of the capital they invest. Wages in developing countries are so low because, relatively speaking, manpower is worth less to business unertakings, because it is less skilled and there is little access to machinery. As investments and education and prosperity increase, so too do wages.

The facts prove this, as Norberg shows:

In 1960 the average Third World worker had about 10 per cent of an American industrial worker's wage. Today this has risen to 30 per cent, in spite of the American wage level also having risen. If compettition had kept wages down in affluent countries down in affluent countries, the proportion of the national income going on wages ought to diminish, but it is not doing so.


Likewise, echoing the fears behind the "race to the bottom" belief, Ross Perot claimed that the NAFTA free trade agreement would cause a "great sucking sound" as all American jobs are vacuumed up in Mexico. However, since NAFTA came into force in 1995, employment in the USA has risen by ten million job opportunities. The US workforce is one of the world's best paid, so if American firms were solely interested in paying low wages, they would all have relocated to Africa where wages are lowest (not Mexico!). However, 80 percent of all investments go to high-wage countries, not low wage countries. The investment goes to countries like the UK and Canada, the Netherlands and Germany, where living conditions, social standards, incomes and regulatory levels are all comparable to US ones.

Conclusion

Fears about economising by outsourcing are essentially the same as fears about economising by introducing labour saving machinery and automation. They rest on the same fallacy. This fallacy is that of looking only at the immediate effects on some persons or groups. A firm introduces a new machine or hires a cheap Indian and Joe Smith gets laid off. The fear-mongers tell us to keep an eye on Joe Sith, but make the mistake of only keeping an eye on Joe Smith, and ignoring Tom Jones who got a job making the machine, or working for the Indian's new higher wages, or to Mary Miller, who now has a job operating the machine, or on Ted Baker, who now has more money to spend as a result of being able to buy his trousers more cheaply, or Henry Tyler, who now has a job pulling the beers that Henry spends his savings on, etc. etc.
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After posting this article, a chap asked me about my claims that 80% of US investment goes to "to countries with workers paid pretty much the same as US workers" and asked for evidence that so little world investment actually goes where wages are lowest. So I made the following post:

The percentage of investment in the third world economies is rising. In 1970 it was about 23%, 1977, almost 25%, and 1981, about the same, and in 1985 it actually fell to about 21%. However, by 1991 it was up to more than 25%, in 1995 it was 32%, and in 1997, about 37%. So that is still less than 40% of world investment going to the Third World (source Ajit K Ghose, Trade Liberalisation and Manufacture Employment, Geneva: International Labour Office, 2000).

Note that in this time, between 1975 and 1998, employment in countries like the USA, Canada, and Australia rose by 50%, and in Japan by 25%. Between 1983 and 1985 in the USA, 24 million more job opportunities were created than disappeared. Moreover, these jobs were not low paid, low skilled ones, with 70 % of these new jobs paid a wage above the American median level. Almost half these new jobs belonged to the most highly skilled, and this figure has risen since 1995. (Rojas Mauricio, Millenium Doom: Fallacies About the End of Work. London Social Market Foundation)

The average length of time that an American spends in a job rose between 1983 and 1995 from 3.5 years, to 3.8. Nor have these jobs been created because wages are falling. A large proportion of wages are paid in non-monetary forms, like health insurance, company shares, personal savings contributions, and day care places, etc. in order to avoid taxes. Including these benefits in American wages, US wages have increased in line with productivity. Moreover, the proportion of consumption among poor Americans that is devoted to food, clothes, or housing has fallen since the 70s from 52% to 37%, showing that poor Americans have more to spend on the bare necessities in life. (Michael W Cox and Richard Alm, Myths of Rich and Poor: Why We're Better Off than We Think, New York: Basic Books, 1999).

So, yeah, most investment does not go to the Third World, because Third World workers are less productive. More of it has been going to the Third World, though, since Third World productivity is rising. However, since Western productivity has not declined, incomes in the developed world are also rising, and employment is increasing.

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