BPO and Kuznet’s Curves

These days one of the dangers of reading newspapers is that one is faced with yet another article on business process outsourcing (BPO) and how there is a backlash from specific sectors in the developed countries. It makes for breathless copy and many of these articles are mere regurgitation of rehashed articles on the same subject. What is the broader context in which to locate all this talk of BPO?

Let’s step back a bit and look at an economy from a macro viewpoint. Economies are usually subdivided into three sectors: agricultural, manufacturing, and services. At the earliest stages of an economy’s development, agriculture is the dominant sector. It is low productivity initially and therefore low wages prevail. Since most of the population is engaged in low wage agriculture, income inequality is low.

Then manufacturing starts to grow, which is high productivity relative to agriculture. Manufacturing wages are therefore high relative to agricultural wages. Income inequality grows in the economy. The mechanism for this income inequality was first explained by Kuznets in 1955 in his paper Economic growth and income inequality. Here is an introduction to the paper from a World Bank site:

The process of industrialization engenders increasing income inequality as the labor force shifts from low-income agriculture to the high income sectors. On more advanced levels of development inequality starts decreasing and industrialized countries are again characterized by low inequality due to the smaller weight of agriculture in production (and income generation).

In other words, there is an “inverted-U” relationship between income inequality and per capita income. At the two extremes of very low and very high per capita incomes, income inequality is low; at intermediate per capita incomes, income inequality peaks.

There is a fractal nature to this “inverted-U” phenomenon in that this relationship holds at different scales of organization. It is definitely true for the rural and urban regions of an economy. The income inequality exists not just at level of an economy, it exists at the global level as well. Early on in the history of the world economy, various parts of the globe had similar income levels, since all were pretty much in subsistence agriculture. Then, as some regions industrialized before others, income inequality grew. In some future time, all regions will become industrialized and once again income inequality will fall. So also, urban regions of a country will initially have higher incomes relative to rural regions. But in time, rural areas will become urbanized and income inequality will fall.

In the long run, income inequality will eventually decrease to zero. But, as John Maynard Keynes observed, in the long run we are all dead. What I understand from that is that the ‘long run’ is really very uninteresting. Interesting things happen in the short- and medium-run time frames. And that’s where we are today — in the intermediate stages where income inequality is high in the global arena.

I will not go into the reason for the differential emergence of industrialization in some regions of the globe. For now, I will take that as a given and thus also take as given the income inequality. It is interesting to ask what accounts for the maintenance of that inequality. Primarily it is the cost of population migration from low income regions to high income regions. By ‘cost’ we mean barriers both natural such as distance, and man-made such as laws against migration. The natural barriers can be lumped together as ‘transportation costs.’ With technological advances, transportation costs come down. However, man-made barriers continue to exist and therefore labor migration is still not possible.

However, since transportation costs have come down, it makes possible what I would call virtual labor migration which is achieved through trade between the various regions. Virtual migration takes place because labor is embodied in the goods that are traded. A Chinese laborer virtually migrates when the goods produced in China are sold in the US. This virtual migration of labor is a factor that puts pressure on wages so as to equalize them across the two regions. To use a mechanical analogy, if the income levels in the two regions were seen as two containers with different levels of liquid in them, then the lowering of transportation costs can be seen as a pipe connecting the two containers: the pipe allows equalization of the fluid levels.

The trade in goods is just a way for labor in the manufacturing and agricultural sectors of low income countries to be available to high income countries. What about the services sector? Services are categorised as tradeable and non-tradeables. In the latter category is included services such as haircuts and house-cleaning and transportation: the production and consumption of which is local. For these, transportation costs are so high that they can almost never be ‘traded’: the cost of haircut in NY is $20 but the cost of a trip to Mumbai is $1000 where a haircut is only $1. Unless transportation costs (and times) come down to $5 (and half hour), haircuts will continue to retain their price differentials.

For those services whose transportation costs have dramatically reduced, trade becomes possible. With the advances in information and communications technologies (ICT), certain services have become tradeable and thus the phenomenon of business process outsourcing. Income inequality between regions is what drives the BPO phenomenon and one can no more wish away the BPO phenomenon than wish away the income inequality underlying it.

Just like the trade in goods, trade in services will tend to equilibrate wage levels across the trading regions. Programmers in the US are paid multiples of wages earned by Indian programmers. With fewer H1-B visas and lower costs of transporting bits, instead of physical movement of Indian programmers to the US, you will have Indian programmers doing work for US firms off-site for lower wages. With perfect substitutability between American and Indian programming skills, the wages will tend to “equalize” after adjusting for average wage levels in the two countries. This adjustment will always keep Indian programming wages lower than American wages and therefore at least in the medium run, programming will continue to get done in India, just as manufacturing will be done in China.

Time to conclude this one. BPO is a consequence of income inequality just as much as off-shore manufacturing is. Both are here to stay until the other end of the Kuznet’s curve is reached.