Foreign Offshoring

7
of Goods and Services

1. Consider an offshoring model in which the labor hours of four activities in the
United States and Mexico are as follows:

Hours of Labor Used in Each Activity (Per Unit of Output)

Assembly
Production Services Component Office R&D

Low-skilled labor Mexico: 20 Mexico: 12 Mexico: 8 Mexico: 4

U.S.: 5 U.S.: 3 U.S.: 2 U.S.: 1
High-skilled labor Mexico: 4 Mexico: 4 Mexico: 8 Mexico: 40
U.S.: 1 U.S.: 1 U.S.: 2 U.S.: 10
High-/Low-skilled ratio 1/5 1/3 1/1 10/1
R&D, research and development.

Note that labor hours in Mexico are four times those in the United States, reflecting
Mexico’s lower productivity. Also note that the ratio of high-skilled to low-skilled
labor used in each activity increases as we move to the right, from 1/5 in assembly to
10/1 in R&D.
Suppose that the wage of U. S. low-skilled workers is $10 per hour and that of high-
skilled workers is $25 per hour and that the wage of Mexican low-skilled workers is
$1 per hour and that of high-skilled workers is $5 per hour (these values are made up
to be convenient, not realistic). Also suppose that the trade costs are 25%, 30%, or
50%, which means that an additional 25%, 30%, or 50% is added to the costs of off-
shoring to Mexico.
a. Fill in the blank cells in the following table by computing the costs of produc-
tion of each activity in each country (two cells are filled in for you).

S-55
S-56 Solutions ■ Chapter 7 Foreign Offshoring of Goods and Services

Answer: In italics in the following table:

Component
Assembly Production Office Services R&D

Mexico $40 $32 $48 $204

United States $75 $55 $70 $260
Imported by U.S. from Mexico, $50 $40 $60 $255
Trade costs ⫽ 25%
Imported by U.S. from Mexico, $52 $41.6 $62.4 $265.2
Trade costs ⫽ 30%
Imported by U.S. from Mexico, $60 $48 $72 $306
Trade costs ⫽ 50%
R&D, research and development; U.S., United States.

b. With trade costs of 50%, where is the value chain sliced? That is, which activities
are cheaper to import from Mexico and which are cheaper to produce in the
United States?
Answer: With trade costs of 50%, assembly and component production are done
in Mexico because the gross costs of importing these activities are lower than
their respective costs in the United States. On the other hand, office services and
R&D activities are done in the United States.
c. With trade costs of 30%, and then 25%, where is the value chain sliced?
Answer: With trade costs of 25%, all activities are offshored to Mexico, whereas
with trade costs of 30%, assembly, component production, and office services are
done in Mexico (R&D is still done in the United States).
2. Consider an offshoring model in which Home’s high-skilled labor has a higher rela-
tive wage than Foreign’s high-skilled labor and in which the costs of capital and trade
are uniform across production activities.
a. Will Home’s offshored production activities be high or low on the value chain
for a given product? That is, will Home offshore activities that are high-skilled-
labor-intensive or low-skilled-labor-intensive? Explain.
Answer: The high relative wage of Home high-skilled labor makes high-skilled-
labor-intensive activities more expensive at Home relative to Foreign. Equiva-
lently, the low relative wage of low-skilled labor makes low-skilled-labor-
intensive activities less expensive at Home relative to Foreign. As a result, Home
will undertake production activities lower on the value chain while offshoring
higher value activities to Foreign.
b. Suppose that Home uniformly increases its tariff level, effectively increasing the
cost of importing all goods and services from abroad. How does this affect the
slicing of the value chain?
Answer: A uniform increase in the tariff level causes fewer activities to be off-
shored. The slicing of the value chain reflects this increased cost as a rightward
shift; Home expands the set of activities that it does at Home to include incre-
mentally higher value activities, whereas the set of high value offshored activities
shrinks.
c. Draw relative labor supply and demand diagrams for Home and Foreign show-
ing the effect of this change. What happens to the relative wage in each coun-
try?
Answer: An expansion in the set of production activities done at Home (to in-
clude higher value ones) increases the average skill intensity of Home produc-
tion. This increases the relative demand for high-skilled labor at Home. Simi-
larly, because Foreign ceases to do its least skill-intensive activities, the average
 Solutions ■ Chapter 7 Foreign Offshoring of Goods and Services S-57

skill-intensity in Foreign increases and hence the relative demand for high-skilled
High-/Low-skilled Wages,WH / WL labor increases. See the following figure.

High-/Low-skilled Wages, WH* / W L*

Home supply
Foreign supply

B B*

A A*

Home demand Foreign demand

High-/Low-skilled Labor, H / L High-/Low-skilled Labor, H* / L*

(a) Home (b) Foreign

3. Consider a U. S. firm’s production of automobiles, including R&D and component

production.
a. Starting from a no-trade equilibrium in a PPF diagram, illustrate the gains from
offshoring if the United States has comparative advantage in component pro-
duction.
Answer: See the following figure, where the offshoring equilibrium is B and C.

R&D

Slope = (PC / PR) A

U.S. firm
imports of R&D
A Y1
Y0

B
Slope = (PC / PR) W

Components

U.S. firm exports of

components
S-58 Solutions ■ Chapter 7 Foreign Offshoring of Goods and Services

b. Now suppose that advances in engineering abroad decrease the relative price of
research and development. Illustrate this change on your diagram and state the
implications for production in the United States.
Answer: See the following figure, where the new equilibrium is B⬘ and C ⬘.

R&D

C⬘

Slope = (PC / PR)A

U.S. firm
imports of Y2
R&D
A Y1
Y0

B Slope = (PC / PR) W1

B⬘ Slope = (PC / PR) W2

Components

U.S. firm
exports of
components

c. Does the U. S. firm gain from advances in research and development abroad?
Explain why or why not.
Answer: Because the United States imports R&D and exports components, a
decrease in the relative price of R&D abroad represents an improvement in the
U. S. terms of trade; as a result, U. S. output increases to Y2 so there are gains for
the United States.
4. Consider the model of a firm that produces final goods using R&D and components
as inputs, with cost data as follows:

Components: Total costs of production ⫽ PC ⴢ QC ⫽ 100

Earnings of high-skilled labor ⫽ WH ⴢ HR ⫽ 10
Earnings of low-skilled labor ⫽ WL ⴢ LC ⫽ 40
Earnings of capital ⫽ R ⴢ KC ⫽ 50
Share of total costs paid to high-skilled labor ⫽ 10 / 100 ⫽ 10%
Share of total costs paid to low-skilled labor ⫽ 40 / 100 ⫽ 40%
R&D: Total costs of R&D ⫽ PR ⴢ QR ⫽ 100
Earnings of high-skilled labor ⫽ WH ⴢ HR ⫽ 40
Earnings of low-skilled labor ⫽ WL ⴢ LR ⫽ 10
Earnings of capital ⫽ R ⴢ KR ⫽ 50
Share of total costs paid to high-skilled labor ⫽ 40 / 100 ⫽ 40%
Share of total costs paid to low-skilled labor ⫽ 10 / 100 ⫽ 10%
 Solutions ■ Chapter 7 Foreign Offshoring of Goods and Services S-59

a. Which factor(s) is(are) components intensive? Which factor(s) is(are) R&D in-
tensive?
Answer: Component production is intensive in the use of low-skilled labor, be-
cause the cost share of low-skilled labor in components (40%) exceeds the cost
share of low-skilled labor in R&D (10%). Similarly, R&D is intensive in the use
of high-skilled labor, because the cost share of high-skilled labor in R&D (40%)
exceeds the cost share of high-skilled labor in components (10%). Notice that
capital is used equally in both activities, so it is not intensive in either one.
b. Suppose that due to the opening of trade, the price of components falls by
⌬PC / PC ⫽ ⫺10%, and the price of R&D remains unchanged, ⌬PR / PR ⫽ 0.
Using the hint below, calculate the change in the wage of high-skilled and low-
skilled labor.

Hint:
We follow a procedure similar to that used in Chapter 4 when calculating the
change in factor prices in the Heckscher-Ohlin model. First, write the total costs
in each activity as consisting of the payments to labor and capital:

PC ⴢ QC ⫽ R ⴢ KC ⫹ WH ⴢ HC ⫹ WL ⴢ LC, for components

PR ⴢ QR ⫽ R ⴢ KR ⫹ WH ⴢ HR ⫹ WL ⴢ LR, for R&D
Because we assume that 50% of costs in components or R&D are always paid to
capital, then R ⴢ KC ⫽ 0. 5(PC ⴢ QC ) and R ⴢ KR ⫽ 0. 5(PR ⴢ QR ), so we can
rewrite the above two equations as:

0. 5(PC ⴢ QC ) ⫽ WH ⴢ HC ⫹ WL ⴢ LC, for components

0. 5(PR ⴢ QR ) ⫽ WH ⴢ HR ⫹ WL ⴢ LR, for R&D
Taking the change in these equations:

0. 5(⌬PC ⴢ QC ) ⫽ ⌬WH ⴢ HC ⫹ ⌬WL ⴢ LC, for components

0. 5(⌬PR ⴢ QR ) ⫽ ⌬WH ⴢ HR ⫹ ⌬WL ⴢ LR, for R&D
Dividing the equations by (⌬PC ⴢ QC ) and (⌬PR ⴢ QR ), respectively, we can re-
write the equations as:

⌬PC ⌬WH WH ⴢ HC ⌬WL WL ⴢ LC

冢 PC 冣 冢
0. 5 ᎏ ⫽ ᎏ
WH 冣冢 ᎏ
P ⴢ Q 冣 冢 W 冣冢 P ⴢ Q 冣
C
⫹ ᎏ ᎏ , for components
C L C C

⌬PR ⌬WH WH ⴢ HR ⌬WL WL ⴢ LR

冢 PR 冣 冢
0. 5 ᎏ ⫽ ᎏ
WH 冣冢 ᎏ ⫹ ᎏ
PR ⴢ QR WL冣 冢 冣冢 冣
ᎏ , for R&D
PR ⴢ Q R
Use the cost shares and price change data in these formulas to get:

⌬WH 10 ⌬WL 40
⫺5% ⫽ ᎏ
WH 冢 冣冢 冣 冢
ᎏ ⫹ ᎏ
100 WL 冣冢 冣
ᎏ , for components
100

⌬WH 40 ⌬WL 10
0⫽ ᎏ
冢
WH 冣冢 ᎏ
100 冣 冢 W 冣冢 100 冣
⫹ ᎏ ᎏ , for R&D
L

Now solve these two equations for the change in the high-skilled wage, (⌬WH
/ WS ), and the change in the low-skilled wage, (⌬WL / WL ).
S-60 Solutions ■ Chapter 7 Foreign Offshoring of Goods and Services

Answer: There are many ways to solve the last two equations for the change in
the wages (⌬WH / WH ), and (⌬WL / WL ). One method is to eliminate the term
for the percentage change of the high-skilled wage; this can be done by multi-
plying the first equation by 4 and subtracting the second equation from it, to get:

⌬WH 40 ⌬WL 160

⫺20% ⫽ ᎏ
冢
WH 冣冢 ᎏ
100 冣 冢 W 冣冢 100 冣
⫹ ᎏ ᎏ , for components
L

⌬WH 40 ⌬WL 10
Minus: 0 ⫽ ᎏ
冢
WH 冣冢 冣 冢
ᎏ ⫹ ᎏ
100 WL 冣冢 冣
ᎏ , for R&D
100

⌬WL 150
Equals: ⫺20% ⫽ 0 ⫹ ᎏ
WL 冢 冣冢 冣ᎏ , answer
100
It follows that (⌬WL / WL ) ⫽ ⫺20% ⴢ (100 / 150) ⫽ ⫺13. 3%, so that the wage
for low-skilled labor falls by 13. 3% when the price of components falls by 10%.
To find the change in the high-skilled wage, we can take this solution, and plug
it back into the equation for the change in wages in R&D, to get:

⌬WH 40 10
0⫽ ᎏ
冢
WH 冣冢 ᎏ
100 冣 冢 100 冣
⫺ 13. 3% ᎏ ,

so it follows that (⌬WH / WH ) ⫽ 13. 3% ⴢ (10 / 40) ⫽ 3. 3%. The wage for high-
skilled labor increases by 3. 3% when the price of components falls by 10%.
c. What has happened to the relative wage of high-skilled/low-skilled labor? Does
this match the predictions of the offshoring model in this chapter?
Answer: With the wage for high-skilled labor going up, and the wage for low-
skilled labor going down, it follows that the relative wage of high-skilled labor
(WH / WL ) also rises. Equivalently, the relative wage of low-skilled labor, which
is (WL / WH ), falls. This is as predicted by our model in this chapter, where a fall
in the relative price of components or a rise in the relative price of R&D bene-
fits high-skilled labor.
5. Consider the model of a firm that produces final goods using R&D and components
as inputs, with cost data as follows:

Components: Total costs of production ⫽ PC ⴢ QC ⫽ 100

Earnings of high-skilled labor ⫽ WH ⴢ HC ⫽ 25
Earnings of low-skilled labor ⫽ WL ⴢ LC ⫽ 25
Earnings of capital ⫽ R ⴢ KC ⫽ 50
Share of total costs paid to high-skilled labor ⫽ 20 / 100 ⫽ 25%
Share of total costs paid to low-skilled labor ⫽ 25 / 100 ⫽ 25%
R&D: Total costs of R&D ⫽ PR ⴢ QR ⫽ 100
Earnings of high-skilled labor ⫽ WH ⴢ HR ⫽ 30
Earnings of low-skilled labor ⫽ WL ⴢ LR ⫽ 20
Earnings of capital ⫽ R ⴢ KR ⫽ 50
Share of total costs paid to high-skilled labor ⫽ 30 / 100 ⫽ 30%
Share of total costs paid to low-skilled labor ⫽ 20 / 100 ⫽ 20%
 Solutions ■ Chapter 7 Foreign Offshoring of Goods and Services S-61

a. Which factor(s) is components intensive? Which factor(s) is research intensive?

Answer: Component production is intensive in the use of low-skilled labor, be-
cause the cost share of low-skilled labor in components (25%) exceeds the cost
share of low-skilled labor in R&D (20%). Similarly, R&D is intensive in the use
of high-skilled labor, because the cost share of high-skilled labor in R&D (30%)
exceeds the cost share of high-skilled labor in components (25%). Notice that
capital is used equally in both activities, so it is not intensive in either one.
b. Suppose that due to the opening of trade, the relative price of R&D in-
creases, ⌬PR / PR ⫽ 10%, whereas the price of components stays unchanged,
⌬PC / PC ⫽ 0. Calculate the change in the relative wage of high-skilled and
low-skilled labor.
Answer: Following the same hint that was given for problem 4, we end up with
the following two equations:

⌬WH 25 ⌬WL 25
0⫽ ᎏ
冢
WH 冣冢 冣 冢
ᎏ ⫹ ᎏ
100 WL 冣冢 ᎏ
100 冣
, for components

⌬WH 30 ⌬WL 20
10% ⫽ ᎏ 冢
WH 冣冢 冣 冢
ᎏ ⫹ ᎏ
100 WL 冣冢 冣
ᎏ , for R&D.
100
Multiplying the components equation by 4 and the R&D equation by 5, and
subtracting them, we get:

⌬WH 100 ⌬WL 100

0⫽ ᎏ
冢
WH 冣冢 冣 冢
ᎏ ⫹ ᎏ
100 WL 冣冢 冣
ᎏ , for components
100

⌬WH 150 ⌬WL 100

Minus: 50% ⫽ ᎏ
WH冢 冣冢 ᎏ
100 冣 冢 W 冣冢 100 冣
⫹ ᎏ ᎏ , for R&D
L

⌬WH 50
Equals: ⫺50% ⫽ ⫺ ᎏ
WH 冢 冣冢 冣
ᎏ ⫹ 0, answer
100
It follows that (⌬WH / WH ) ⫽ 50% ⴢ (100 / 50) ⫽ ⫺100%, so that the wage for
high-skilled labor rises by 100% when the price of R&D rises by 10%. To find
the change in the low-skilled wage, we can take this solution and plug it back
into the equation for the change in wages in components, to get:

25 ⌬WL 25
冢 冣 冢
0 ⫽ 100% ᎏ ⫹ ᎏ
100 WL 冣冢 冣
ᎏ ,
100
so it follows that (⌬WL / WL ) ⫽ ⫺100%. The wage for low-skilled labor falls
by 100% when the price of R&D rises by 10%.
c. What has happened to the relative wage of high-skilled/low-skilled labor? How does
this result compare with problem 4, and explain why it is similar or different.
Answer: With the wage for high-skilled labor going up, and the wage for low-
skilled labor going down, it follows that the relative wage of high-skilled labor
(WH / WL ) also rises. Equivalently, the relative wage of low-skilled labor, which
is (WL / WH), falls. The change in the relative wages is the same as what we found
in problem 4, because a fall in the relative price of components or a rise in the
relative price of R&D has the same effects: to benefit high-skilled labor. Wage
changes found in this problem are larger because the cost shares in the two ac-
tivities are more similar than those in problem 4.
S-62 Solutions ■ Chapter 7 Foreign Offshoring of Goods and Services

6. The diagram below shows what happened to the relative wage and relative demand
for high-skilled labor in the U. S. manufacturing sector during the 1990s. These
points are plotted using the data from Figures 7-5 and 7-6.

1.80

1.78 2000
2001
1.76 1999
Nonproduction/Production Wage

1998
1.74 1997

1.72
1996

1.70 1995

1.68
1994
1.66 1993 1992

1.64 1991
1990

1.62

1.60
0.2 0.25 0.3 0.35 0.4 0.45 0.5 0.55 0.6

Nonproduction/Production Labor

a. What must have happened to the demand and supply curves to explain this
change in relative wage and relative employment?
Answer: The relative nonproduction wage increased significantly in U. S. man-
ufacturing between 1990 and 2001 but the relative employment of nonproduc-
tion labor did not change much. This pattern is consistent with an outward shift
in relative demand and an inward shift in relative supply for nonproduction
workers. As such, relative demand for high-skilled labor has increased (shifted
right) and the relative supply of high-skilled labor has decreased (shifted left). See
the figure on the next page.
b. Why do you think the demand and supply curves shifted this way? (Hint: Think
about where the workers who leave manufacturing might be going. )
Answer: The increase in relative demand is a continuation of what we already
saw in the 1980s, due to high-skilled-biased technologic change and offshoring.
The reduction in relative supply is new, however. One explanation for this is that
high-skilled workers were pulled out of manufacturing and into services (because
many high-skill-intensive service sectors have been expanding).
 Solutions ■ Chapter 7 Foreign Offshoring of Goods and Services S-63

1.80 Supply, 2001

1.78 2000

1.76 2001
1999
Nonproduction/Production Wage

1998
1.74 1997
Supply, 1990
1.72
1996

1.70 1995

1.68
1994
1.66 1992 Demand, 2001
1993
1.64 1991 1990

Demand, 1990
1.62

1.60
0.2 0.25 0.3 0.35 0.4 0.45 0.5 0.55 0.6

Nonproduction/Production Labor

7. Read the article about offshoring by General Motors located online at:
http://www. businessweek. com/technology/content/feb2006/tc20060202_578175.
htm and answer:
a. What goods or services are being offshored by GM?
Answer: GM is offshoring its information technology (IT) services (this article
is not talking about the offshoring of manufacturing).
b. What company was named a “tier-one” supplier by GM? What do you already
know about this company from Side Bar: Offshoring Microsoft Windows
in this chapter?
Answer: The Indian company Wipro was named a tier-one supplier to GM.
Wipro already manages Microsoft’s computer resources during Seattle’s evening
hours, as described in a Side Bar in this chapter.
c. Why do you think that GM was willing to spend this money on offshoring?
Answer: GM’s decision may reflect the decreasing costs to high-tech offshoring
(relative to the costs of doing the same functions “in-house”) due to increased
international competition from countries such as India. Even though GM is los-
ing money right now, it still makes sense to offshore IT services if these can be
done cheaper abroad. By doing so, GM will save money and hopefully restore
its profitability.
8. Read the following excerpt, and using what you have learned in this chapter, discuss
how offshoring creates opportunities for the countries involved.
Source: Excerpted from Steven Pearlstein, “Still Short of the Offshoring Ideal,” The Wash-
ington Post, March 12, 2004.
Sudhakar Shenoy, chief executive of Information Management Consultants in Reston, makes an ef-
fective pitch for “offshoring.”
Several years ago IMC saw a market developing for software that would allow biotech companies to
make better and faster use of the new human genome research. Doing it here, Shenoy calculated, would
S-64 Solutions ■ Chapter 7 Foreign Offshoring of Goods and Services

cost several million dollars, which he figured would have priced the product too high for most customers.
But by having a small group of engineers at IMC’s Indian subsidiary do much of the coding work, he
was able to bring the project in at $500,000. The result: IMC now has a thriving line of business in
bioinformatics, with major clients and a growing payroll of six-figure PhDs here. And there are more
engineers than ever—six here for every one in India.
But that’s only part of the good-news story. In Pune, where IMC’s Indian operations are located,
an airport under construction will require lots of U.S. engineering, design and electronics. At the same
time, IMC’s Indian engineers, who earned annual salaries of $3,500 a decade ago, now command up
to $12,000—enough to buy all manner of imported consumer goods.
Answer: By offshoring software in India, IMC is able to pass the cost savings to
biotech companies researching the human genome. Moreover, the derived de-
mand from Indian engineers by successful companies like IMC attributes to
higher salaries for the local talents. In addition, the need for reliable infrastruc-
ture resulting from a growing economy boosted by companies such as IMC has
led to the demand for U. S. engineering, design, and electronics.
9. The quote from the 2004 Economic Report of the President at the beginning of the
chapter generated a lot of controversy that year, as discussed at the beginning of sec-
tion 3 in the chapter. The chairman of the Council, N. Gregory Mankiw, made the
following additional comments in a speech while presenting the report: “Outsourc-
ing is just a new way of doing international trade. More things are tradable than were
tradable in the past, and that’s a good thing. ”
Those statements quickly led to reactions from both Democratic and Republican
members of Congress. Tom Daschle, a Democrat and the Senate minority leader,
said, “If this is the administration’s position, they owe an apology to every worker in
America. ” Dennis Hastert, a Republican and speaker of the House, said, “Outsourc-
ing can be a problem for American workers and the American economy. ” John
Kerry, the Democratic presidential candidate, referred to businesses that offshored as
“. . . Benedict Arnold corporations. ” In response, Mankiw clarified his earlier com-
ments: “My lack of clarity left the wrong impression that I praised the loss of U. S.
jobs. ”
Although you might believe that these statements are just a squabble between
politicians trying to score points during the presidential campaign, it is still worth try-
ing to sort out who gains and who loses from offshoring.
a. Why does Mankiw say that “outsourcing [is] . . . a good thing”? Who is it good
for in the United States? Are there overall gains for the United States? Explain
with a diagram.
Answer: Mankiw says that offshoring is “a good thing” because there are over-
all gains from the trade of production activities relative to autarky. As seen in
Figure 7-10, both countries benefit by specializing in certain production activi-
ties and offshoring others. Trade in production activities allows for higher levels
of output employing the same amount of domestic inputs. However, within each
country these gains may not be spread evenly across workers of different skill lev-
els, as changes in the number of tasks offshored lead to changes in the relative
wage of high-skilled workers.
b. Later in this chapter, Paul Samuelson is quoted as saying that there is no “neces-
sary surplus of winning over losings” due to offshoring. Use Figure 7-12 to care-
fully explain why Samuelson says this.
Answer: Samuelson points out that loss due to offshoring may occur as a result
of the deterioration in a country’s terms of trade. That is, from one offshoring
equilibrium to another there are not necessarily gains since an increase in the rel-
ative price of a production activity hurts the importer of that activity. Of note,
 Solutions ■ Chapter 7 Foreign Offshoring of Goods and Services S-65

though, gains from offshoring are always greater than the situation with no-
trade.
10. In Figure 7-11, we saw that a fall in the relative price of components leads to an in-
crease in the amount of components imported, but that the amount of R&D ex-
ported from Home does not necessarily increase. To explore this further, complete
the following:
a. Let the relative price of components continue to fall in Figure 7-11, and show
in a graph what happens to the equilibrium point on the isoquant for the final
good.
Answer: As the relative price of components continues to fall, the use of com-
ponents in the final good increases. Imports of components increase as the equi-
librium production point moves out to the flatter portion of the final good iso-
quant, and the level of final good output increases (but at a diminishing rate due
to diminishing returns in production). See the following figure.

R&D Slope = (PC / PR) A

Y2

B⬘
B

C⬘

A C
Slope = (PC / PR) W2
Y1
Y0
Slope = (PC / PR) W1

Components

b. Now draw another graph that has the relative price of components on the ver-
tical axis and the imports of components on the horizontal axis. Start at the no-
trade relative price of components, where imports are zero. Then label the var-
ious world-relative prices of components on the vertical axis, and graph the
quantity of imports at each price. Can we be sure that the import demand curve
slopes downwards?
Answer: As the relative price of components decreases from the Home autarky
level, Home components imports as well as the final goods produced increase.
As long as incremental components are still useful in final good production, com-
ponents imports will increase as their relative price decreases, which is guaran-
teed by the shape of the isoquants. See the following figure.
S-66 Solutions ■ Chapter 7 Foreign Offshoring of Goods and Services

PC / PR

(PC / PR) A

(PC / PR) W1

(PC / PR) W2

Home Components Imports

c. Now draw a new graph that has the relative price of R&D on the vertical
axis and the exports of R&D on the horizontal axis. Start at the no-trade rela-
tive price of R&D, where exports are zero. Then label the various world-relative
prices of R&D on the vertical axis, and graph the quantity of exports at
each price. When the relative price of R&D is high enough, what do you no-
tice about the export supply curve?
Answer: See the following figure:

PR / PC

(PR / PC)W2

(PR / PC) W1

(PR / PC) A

Home R&D Exports

As the relative price of R&D increases from its autarky level, Home specializes
further in R&D services and exports increase. However, for a sufficiently high
relative price, import demand in the rest of the world diminishes as countries
abroad substitute components for R&D in final good production. As a result, as
Home approaches full specialization in R&D, exports of that activity approach
zero.
 Solutions ■ Chapter 7 Foreign Offshoring of Goods and Services S-67

11. Why might it be relatively easier for an undeveloped country like India to export ser-
vice activities through offshoring than to participate in the global economy by pro-
ducing manufacturing components?
Answer: Because offshoring of manufactures involves the trade of intermediate in-
puts across several borders, there is an extra cost associated with transporting the
goods. Therefore, a country must have good infrastructures such as developed road-
ways to participate in the global economy. In India, for example, communications
technology developed rapidly whereas transportation developed more slowly, which
allowed the South Asian country to partake in service offshoring.
12. It is widely noted that even though China is the favored destination for manufactur-
ing offshoring, it is far behind India in the business of offshored services. What are
some differences between these two countries that may account for this causal ob-
servation?
Answer: Although wages are also low in India, due to its weak transportation infra-
structure it is unable to successfully compete against China in manufacturing off-
shoring. However, it has an advantage over China in service offshoring because the
country has developed an advanced communication infrastructure. Moreover, as a
former British colony, India has a proficiency in the English language. The workforce
in India is well educated and highly skilled in information technology. In addition,
Tarun Khanna, a professor at the Harvard Business School, notes that India has a
thriving entrepreneurial effort unhampered by government bureaucracy, unlike
China (The McKinsey Quarterly, 2004). These include a low level of government in-
tervention in the Indian capital markets and no regulations in industries such as
software.
13. Why is the offshoring of white-collar or high-skill-intensive jobs a concern for many
Americans?
Answer: Traditionally, white-collar workers have been relatively insulated from for-
eign competition in comparison with blue-collar workers. For decades the unem-
ployment rate of high-skill-intensive jobs, such as computer programming, was well
below the national average. However, with the trend reversing between 2001 and
2002, the expected job security associated with advanced training and experience
came into question. Although the loss of white-collar jobs was offset by the increase
in service employment, many Americans fear that it is unclear how job opportunities
will adjust to the new labor challenges.