I was pondering outsourcing yesterday and ran out of pondering time. Now that I have some pondering time, I thought I would continue with my pondering of outsourcing. {“ponder”: interesting word, isn’t it? Perhaps I should look it up… Here is what one source on the web says:

To weigh in the mind; to view with deliberation; to examine carefully; to consider attentively.

Syn: To Ponder, Consider, Muse.

Usage: To consider means to view or contemplate with fixed thought. To ponder is to dwell upon with long and anxious attention, with a view to some practical result or decision. To muse is simply to think upon continuously with no definite object, or for the pleasure it gives. We consider any subject which is fairly brought before us; we ponder a concern involving great interests; we muse on the events of childhood.

End of digression.}

First one point of clarification. Yesterday I wrote

Fun fact #2: Trade occurs only among two dissimilar entities. If I have an excess of peanut butter and you have an excess of bread, then we can trade and both end up enjoying peanut butter sandwiches. But if both of us have exactly the same ratio of peanut butter to bread to start off with, then we could not trade.

The point was that the two trading entities have to be dissimilar. That dissimilarity could be intrinsic or extrinsic. If they are intrinsically dissimilar, then even if their endowments are the same, trade can still take place. For instance, we may start off with the same ratio of peanut butter and bread, but you may have a strong preference for only bread and I may have a strong preference for only peanut butter. In that case, we can trade and end up happier. If we are instrinsically similar — our preferences match — then we cannot trade unless our endowments are different. End of digression number two.

Continuing with the list of fun facts, here is another. Fun fact #5: The world is moving towards increasing specialization since the stone age. Speciation is what happens in the natural world where life evolved in some primal soup and since then from the earliest protozoan to the present day different species have emerged. Evolution is a fact. The theory which explains the mechanism of evolution was given credence through the diligent and brilliant work of Charles Darwin (1809-1882). Darwin got the germ of his idea upon reading Thomas Malthus’ (1766-1834) Essay on the Principle of Population. No doubt Darwin pondered that issue long and hard and then it struck him that speciation occurs through competition for resources and those that are less fit are doomed and this process he called “natural selection”. Darwin explained the mechanism that underlies the question how did all the diversity of life originate.

It is easy to see that specialization in the economic world is a close analog of speciation in the natural world. Once upon a time you used to have people who were jacks of all trades and masters of none. Now you have programmers and playwrites, prostitutes and politicians (ok, I repeat myself), pharmacists and paleontologists. The more advanced the society, the more specialization of its work force.

Hand in hand with the specialization of the work force, we have the specialization of the firms that operate in the society. Firms that used to do all things in a particular sphere (vertically integrated firms) no longer do so. They ‘outsource’. For instance, take a car manufacterer. Once upon a time, at one end steel, rubber, and glass would go in and at the other end of the factory you would have cars rolling out of the assembly lines. All the raw materials would be transformed inside that one plant into cars. That was then. Now a car manufacturer assembles cars from components that are manufactured by other firms. So a firm that manufactures engines will supply these intermediate goods to a host of firms.

{Advanced industrialized countries (or developed countries) trade a lot amongst themselves. Much of that trade is in intermediate goods. Given that, it is hard to tell where something is really manufactured these days. For instance, ponder a complex creature such as a Boeing 777. Engines could come from Europe, parts of the fuselage from Japan, avionics from the US, … by the time you are done enumerating, you would find that practically the whole world was somehow involved in the manufacture of the plane. End of aside #18.}

That is what outsourcing is all about. You don’t do all the stuff that needs to be done. Get someone else to do it because they have a comparative advantage in doing that bit. I outsource ‘jhadu-pocha-bartan’. American firms outsource much of what they need done and a part of that outsourcing happens to be done abroad and of that work done abroad, India has a small share.

So now let’s ponder outsourcing and India. I will ponder outsourcing and the US later because I am fast running out of pondering time.

India appears to be a destination for a specific kind of outsourcing. Business processes and software development. The sort of work that does not require hard infrastructure such as roads and ports and water and power. You just need some kind of connectivity, a bunch of English-speaking graduates who can be easily trained, and a bunch of entreprenuers who would start BPO and software firms to do the ‘jhadu-pocha-bartan’ equivalent for the US firms.

From all indications, the whole business works quite well. India has a huge population. Out of that billion+ population, India graduates around a million every year. Some of these graduates can speak English and of them some are trainable. Firms that initially went into the BPO and software business had an easy time. Lots of unemployed and underemployed graduates to choose from and they had a party. Will the party continue? As more and more firms get into the game, it will become increasingly difficult to find graduates that are trainable and can speak English. Given increase in demand without significant changes in the supply, prices will get bid up. That will drive up the costs of BPO and software in India. India’s competitive advantage in the sector will deteriorate.

So how does one go about avoiding the fate that I just outlined? Simple: increase the supply. India should see that more of the million graduates it produces are capable of being trained and speak English.

For the record, I should state that while I feel happy for the people who get the BPO and software jobs, I do not feel very happy about the fact that India has to be the preferred provider of ‘jhadu-pocha-bartan’ to the Americans.

Via Rajesh Jain, I came to know of NY Times report on Paul Samuelson’s essay in an upcoming issue of JEP. I am probably one of the very few who have not read Samuelson’s celebrated book on introductory economics. That is so because I never studied undergraduate economics. My introduction to economics was at the graduate level and the first books on economics I read were Hal Varian’s Microeconomic Analysis and Bhagwati and Srinivasan’s Lectures on International Trade. I learnt undergraduate economics later while teaching undergraduate classes. OK, enough of this biographical aside.

The issue of outsourcing appears to be a very hot topic. Here is how I think about it. I go back to the basic facts.

Fun fact #1: Trade is good. Whether between two people on eBay or between two countries across an ocean, trade increases welfare. While that is true in general, there are well-known conditions under which trade can be harmful and decreases welfare. If any of those conditions exist, then you need to take corrective measures which may include the extreme measure of banning the trade.

Fun fact #2: Trade occurs only among two dissimilar entities. If I have an excess of peanut butter and you have an excess of bread, then we can trade and both end up enjoying peanut butter sandwiches. But if both of us have exactly the same ratio of peanut butter to bread to start off with, then we could not trade.

Fun fact #3: Increasing the supply of any good or service (all other things being equal) reduces its price. This is not rocket science but the ignorance of this fact is as widespread as the ignorance of rocket science.

Fun fact #4: Most change gives rise to winners and losers. Walmart in your neighborhood helps you and hurts the little stores in your neighborhood. Imported Chinese junk helps the consumers of junk but hurts the domestic manufacturers of junk. Basically, lower prices help those who consume the good or service but hurt those who produce it.

OK, so here is the story about outsourcing, the US, and India. India and US are dissimilar. Wages are lower in India as compared to the US. Why? Because wages depend on the average productivity of the country. India is a low productivity country. Why that is so is another story that we will not go into right now. Because Indian labor is cheap, producers who can use Indian labor will have an incentive to use them. If you are producing goods, you can get the goods produced abroad and sell them in the home country. Winner: the domestic consumers. Losers: the domestic workers who were replaced by cheaper labor. While labor is immobile internationally (immigration laws and all that), labor is said to be embodied in the goods that are produced abroad. Think of it as if the worker is virtually present in the US and is working for a wage much lower than the domestic worker would demand.

In the past, India supplied some goods to the US, mostly commodities. Then when communications technology improved, services could be exported. It was as if a couple of million Indians moved to the US. Increased supply immediately translates into lower prices. Basic economic logic, not rocket science at all. Lower prices help the consumers and hurt those who worked in that sector before the supply of labor increased. Globally, that movement of labor (virtual movement, of course) is welfare improving. It is undoubtedly good for India because the average wage of those workers increases and since Indians are in general not consumers of the stuff these workers produce, Indian consumers are not hurt. But is it good for the US?

What is good for GM is good for America is only true if all Americans work for GM, otherwise it is an open question. So also, if the US workers displaced by the virtual migration of Indian labor move on to more productive jobs, then the change is an unmitigated good for the US. Then of course, one has to consider the question from the temporal angle as well and distinguish between the short- and long-term impact of the change.

In the long-term (not the real long term, of course, in which we are all dead as Keynes astutely observed), Heckscher-Ohlin’s factor price equalization theorem takes effect. Here is a definition from About.com:

Factor price equalization is an effect observed in models of international trade — that the prices of inputs to (“factors of”) production in different countries, like wages, are driven towards equality in the absence of barriers to trade. This happens among other reasons because price incentives cause countries to choose to specialize in the production of goods whose factors of production are abundant there, which raises the prices of the factors towards equality with the prices in countries where those factors are not abundant. Shocks to factor availability in a country would cause only a temporary departure from factor price equality.

The basic theorem of this kind is attributed to Samuelson (1948) by Hanson and Slaughter (1999) who also cite Blackorby, Schworm, and Venables (1993). The context of the theorem is a Heckscher-Ohlin model.

Programmers and call center operators are a factor in the production of many goods and services in today’s global economy. Since barriers to trade have come down both due to free trade agreements and to technological advances in telecommunications, it has led to a “mobile” labor market for those workers. Increased supply implies lower prices for that sort of labor. Lower prices implies winners and losers, as argued earlier.

So is it good for the US and if not, could the US do something about it and if it could, should the US do something about it? Good question. The answer is forthcoming. What we have to remember when it comes to change is the good old theory of the second best which Bhagwati had written about years ago and which I believe throws light on the present debate.