Outsourcing and Offshoring

I hear hearts beating loud as thunder
I saw the stars crashing down
--David Bowie

Outsourcing, or 'contracting out,' is purchasing goods and services on the market instead of producing those items internally. All people and all firms face the 'make or buy' decision--i.e., whether it is economically best to insource or outsource.

Insourcing is typically motivated by desires to achieve better control over quality, access, cost, or other aspects of operations. Outsourcing is typically motivated by desires to specialize on a core set of activities; the repetitive learning-by-doing associated with specialization is prone to lead to efficiency gains.

Often, people observe firms electing to outsource particular functions, and the layoffs that may result, and conclude that there has been a net loss of jobs in the economy. These people are likely mistaken. Work no longer being performed inside the firm must be performed by the contractor. There is likely to be little net effect on jobs in the near term. In the long term, outsourcing may increase real returns from work because of positive spillovers gained from the productivity of specialization and trade.

Many people mistakenly associate outsourcing with job loss because of today's pervasive practice of 'offshoring.' Offshoring comes in one of two flavors: a) outsourcing done with suppliers from other countries, b) insourcing done by relocating internal units to other countries. Similar to the general practice of outsourcing discussed above, there should be no appreciable net effect on jobs. Work is merely being shifted elsewhere.

What many people see, of course, is that the work is being shifted to another country. In the here and now, domestic jobs appear lost. Offshoring, therefore, earns a black eye among people those focused on domestic employment.

That focus may be misplaced. Like the decision to outsource, offshoring is generally done because managers view it as favorable for profits. For producers that operate in unhampered markets, profits only come by way of satisfying customer needs. To the extent that offshoring projects generate profits, then these projects have advanced the interests of buyers.

Stated differently, in free markets it is buyers who motivate offshoring, not producers.

Over time, the general effect on domestic employment is likely to be positive as well. If offshoring projects are profitable due to efficiency gains, then lower prices of consumer goods extend purchasing power which in turn, stimulates demand for other goods and the jobs that produce them. Producers that profit from offshoring now possess capital that can be reinvested to build more capacity for customer satisfaction in the future or distributed to owners who can invest or spend on their own. It is also likely that the wages of offshore workers will rise with their productivity which will reduce the attractiveness of future offshoring projects from a labor arbitrage perspective.

Lack capacity for economic logic, many people myopically embrace the domestic job loss story. This makes them easy pickings for politicians with the power to redistribute resources in exchange for political favor.

We'll consider the political angle of offshoring in a future post.