International fragmentation of production and
intermediate goods trade
Sanna-Randaccio Lezione 17
•What is production fragmentation
•What the data show
•What are the drivers
•Effects on income distribution
See KOM (2015) Case study p. 221 “Offshoring and unenmployement
in the United States”.
S. ARNDT “Globalization and the Open Economy” (1997) ( excluding
Offshore Sourcing by both Countries) (see website).
What is production fragmentation
Standard model: focus on trade of final goods (produced in a single
location).
Due to revolutionary progress in ICTs previously integrated production
activities are increasingly fragmented in separate stages or tasks (value
chain) and spread over multiple international production sites.
This leads to trade of intermediate goods/services.
For instance, some stages of production more intensive in low-skilled
labour (such as assembly of components or production stages
characterized by repetitive tasks) may be relocated to low income
countries which are abundant in low-skilled labour.
Firms may take advantage of differences in factor costs and expertise
across countries. Proximity becomes less important.
It implies also additional coordination costs.
DEFINITION
Outsourcing: contracting out some of the firm’s activities.
Offshoring: parts of the production chain is relocated abroad. It groups
together:
- Offshore outsourcing: outsourcing abroad. This takes place via the
market (sourcing from a foreign supplier, with an independent contractual
relationship)
- Vertical FDI: the activity moved abroad is controlled by the firm itself
(generating intra-firm transactions). Offshoring within the boundaries of
the firm.
Arndt (1997) offshore sourcing when some stages of the production
process are undertaken abroad.
Why barriers to fragmentation of production are decreasing:
•Changes in production technologies
•Lower costs of transferring information
WHAT THE DATA SHOW
Helg e Tajoli (2005) studying 20 manufacturing sectors in Italy and
Germany find that offshore outsourcing is concentrated in:
Traditional sectors (textiles, apparel, shoes, furniture) where
production phases have become increasingly diversified in terms of
factor intensity and for which low-skilled labour is the main factor of
production in at least one phase.
Italy: the apparel sector is the most affected by offshore outsourcing.
Most production is relocated in Eastern Europe and the southern
Meditterranean countries.
Relatively advanced industries (office machinery, communication
equipment, precision instruments, and transport equipment). In these
sectors the share of production relocated to Eastern Europe and
southern Mediterranean countries is smaller. Independent firms
specializing in a narrow part of the production process.
WHY FIRMS CHOOSE OFFSHORE-OUTSOURCING
The phenomenon is relatively new, there is no unified theory, no simple
analytical framework. Models are developed for explaining specific
settings. It appears that there are different patterns and drivers.
Offshore outsourcing in order to:
1) exploit comparative advantage generated by differences in factor
endowments, leading to differences in the price of low-skilled
labour across countries. This is the case for traditional sectors
relocating to CEECs (Central and Eastern European countries) and the
Medittaranean area or segments of the electrical machinery sectors
intensive in low-skilled labour. Helg and Tajoli (2005) find that
differences in factor prices, and labor cost differentials especially, are one
of the main driving forces of international production fragmentation.
2) exploit technological differences across countries (associated to
economies of scale).
IMPACT OF INTERNATIONAL FRAGMENTATION OF
PRODUCTION ON INCOME DISTRIBUTION
•There are no general conclusions. The implications as to the labour
market (and welfare) of international production fragmentation depend on
the factor intensity of stages of production relocated abroad, on which
industries are involved, towards which countries relocation takes place,
and how this affects the overall composition of production.
The debate is mainly focused on offshoring from developed to developing
countries, to exploit benefits from lower wages abroad.
Grossman and Rossi-Hansberg (2006) –considering such case- show that
a greater possibility of offshoring low-skilled jobs generate several
contrasting effects. It “also might boost the wages of domestic workers
with skill levels similar to those used in performing the tasks that migrate
offshore”.
Why offshoring not necessarily leads to a worsening in
income distribution
ARNDT (1997): the fact that in a developed country
some production stages intensive in low-skilled labour
are transferred abroad not necessarily leads to a
worsening in income distribution, thus not necessarily
it results in low-skilled labour being made worse off.
Model:
2 production factors K and L (but it could also be high-skilled labour (K)
and low-skilled labour (L))
2 two final goods X (intensive in L) e Y (intensive in K)
Country H relatively K abundant (export Y and import X)
In each sector there are two production stages:
stage 1 (relatively intensive in capital)
stage 2 (relatively intensive in labour)
Assumptions:
X 1 , i.e. stage 1 of sector X (labour intensive good) is more capital
intensive than Y2 , stage 2 di Y (the capital intensive good)
X2 is relocated abroad.
The relative price of the two goods is given
ARNDT (1997) shows that:
If the relocation of X2 (labour intensive production stage of the
labour intensive industry) results in a reduction of the overall
production of industry X (final good which is labour intensive)
and an increase of Y production (final good which is capital
intensive),
production fragmentation contributes to a
reduction in real wages (with a worsening in income
distribution).
However if -thanks to offshore outsourcing- industry X
becomes more competitive, it is possible that the production
stage X1 , which continue to be located in the domestic market,
expands to such an extent that the net effect is an expansion of
the labour intensive industry (X) and a contraction of the capital
intensive one (Y). In such a case, real wages would increase
(with an improvement in income distribution). Considering
skilled and unskilled labour, the wage differential would
decrease.
The initial effect of offshoring from the developed country is
a reduction in demand for low-skilled labour.
But there are further repercussions:
The international relocation of tasks generates cost savings for
the low-skilled intensive industry. According to Grossman and
Rossi-Hansberg (2006) p. 79: “The (low skilled) labourintensive industry has a greater incentive to expand and does
so relative to the skill-intensive industry. The expansion more
than offsets the initial fall in labour demand, so that the
domestic
low-skilled
workers
are
utilized
in
the
economy…………..at a higher marginal product than before”.
There is a productivity effect that has been largely
overlooked.