International outsourcing: An open-economy model with intermediate goods and economies of scale

A key current trade controversy concerns the impacts of international outsourcing on wage disparities and employment. To generate new insights into this debate, we develop a more relevant framework by extending the traditional trade model in two main directions.;First, a pure intermediate good exhibiting a positive externality at Home is introduced to the traditional two-sector two-factor framework. We show that a normal output response to price in final goods is a sufficient but not necessary condition to ensure the concavity of the PPF. When Home opens to free trade, the technology difference across countries prevents equalization of factor returns, which provides an incentive for outsourcing to occur.;For a large country with flexible wages and full employment, although there is always a cost saving, outsourcing could lead to either an improvement or a deterioration in the terms of trade. Then the net impact on social welfare is ambiguous as are the effects on the wage rates. However, it is possible for outsourcing to boost both countries' welfare because the production processes are allocated across borders more efficiently. The cost saving and the expansion of the industry with the positive externality lead to a net gain to a small open economy despite the fact that wage disparity is enlarged against unskilled labor.;Second, in order to examine the possible effects of free trade and outsourcing on employment, a binding minimum-wage constraint is introduced. We show that the domestic output response to price now becomes perverse. Relative to autarky, free trade leads to an increase (a decrease) in employment when Home exports (imports) the good which embodies the economies-of-scale intermediate input. Moreover, we find that outsourcing actually raises rather than threatens employment, but it aggravates another distortion by further contracting the industry exhibiting the positive externality. In contrast to the implications of free trade, these impacts on production and employment are independent of trade patterns. Welfare outcomes are also identified in each case. Due to distortions being present in both intermediate good and factor markets, outsourcing may yield a net welfare loss to the home country.