Review of International Economics, 20(1), 72–80, 2012

DOI:10.1111/j.1467-9396.2011.01008.x

The Impact of Differential Falls in Offshoring Costs

on Welfare roie_1008 72..80

Wanida Ngienthi and Fumio Dei*

Abstract
We highlight the fact that offshoring firms and local firms that do not offshore coexist in the North. Adopting
the O-ring production function approach to offshoring, we demonstrate that a fall in offshoring costs in any
sector makes the South better off and that if offshoring costs in a high-technology sector fall at a faster rate,
the North is worse off, and vice versa.

1. Introduction
The information technology (IT) revolution has facilitated offshoring by drastically
reducing the costs of international communication. In many industries, firms in the
developed countries have offshored their manufacturing operations, service operations,
and other business functions to the developing countries. There is one thing we should
note. Not all the firms in the developed countries are engaged in offshoring. According
to the survey by Wakasugi et al. (2008), 21% of Japanese manufacturing firms under-
take offshoring.1
We highlight the coexistence of offshoring firms and local firms that do not offshore
in the developed countries. Since offshoring is prevalent in many industries,2 we con-
sider the case in which firms offshore tasks in all sectors of two-sector economies as in
the paper of Grossman and Rossi-Hansberg (2008). In this sense, our study is very close
to theirs. However, they do not pay attention to the coexistence of offshoring firms and
local firms in the developed countries.
Adopting the O-ring production function approach to offshoring developed by Dei
(2010), we examine impacts of a fall in the costs of offshoring both in a low-technology
sector and in a high-technology sector. We demonstrate that when there are local firms
that produce a high-technology good in the North, the South is always better off. The
fate of the North depends on how fast offshoring costs fall between sectors. If offshor-
ing costs in a high-technology sector fall at a faster rate, the North is worse off, and vice
versa.
A fall in offshoring costs has been thought of as an engine of offshoring in the papers
of Jones and Kierzkowski (1990), Anderson et al. (2006), Fujita and Thisse (2006), and

* Ngienthi: Martin de Tours School of Management,Assumption University, Bang Na Trad Rd., Samut Prakan
10540, Thailand. Tel: +66-0-2723-2222; Fax: +66-0-2313-4673; E-mail: wNgienthi@au.edu. Dei: Graduate
School of Business Administration, Kobe University, Rokkodai-cho 2-1, Nada-ku, Kobe 657-8501, Japan.
Tel: +81-78-803-6939; Fax: +81-78-803-6977; E-mail: dei@kobe-u.ac.jp.The authors would like to thank Ronald
W. Jones, Yunfang Hu, Kenji Kondoh, Yan Ma, Toru Kikuchi, and two anonymous referees for helpful
comments.An earlier version of this paper was presented at Second Keio/Kyoto International Conference on
Market Quality Economics, at 2009 Pacific Rim Conference of Western Economic Association International,
at Fourth Keio/Kyoto International Conference on Market Quality Economics, at Rokko Forum of Kobe
University, and at KIER-Pacific Economic Review Workshop on Economics and Economic Policies. Financial
support from grant-in-aid for Scientific Research of the Japan Society for the Promotion of Science is gratefully
acknowledged.

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 DIFFERENTIAL FALLS IN OFFSHORING COSTS 73

Grossman and Rossi-Hansberg (2008). They were mainly interested in the domestic
income distribution effect of offshoring between skilled labor and unskilled labor.
Instead, we focus on how welfare changes between the North and the South. To do so,
we assume that there is only a single productive factor, labor, in each country.
In the existing literature, it is common to use a multi-factor model when impacts of
a fall in offshoring costs on welfare are examined. For example, Fujita and Thisse (2006)
showed that the skilled and unskilled in the core are worse off, whereas the unskilled
living in the periphery are better off. Robert-Nicoud (2008) showed that a northern
worker is worse off and a southern worker is better off in the presence of land and
capital. Rodríguez-Clare (2010) showed that in the short run, a worker in the rich
country is worse off and a worker in the poor country is better off. In the model in
which entrepreneurship is required to set up a firm and an individual in the home
country owns labor and entrepreneurship, Kikuchi and Long (2010) showed that the
home country may be worse off if moving costs which an entrepreneur must incur to
become an offshored business service provider are sufficiently high that the net profits
of all entrepreneurs decrease.
The remainder of the paper is organized as follows. Section 2 describes O-ring
production functions of tasks and deals with autarky. Section 3 discusses the case in
which offshoring takes place in all sectors. Section 4 explores impacts of a fall in the
costs of offshoring on the welfare of each country.

2. The Model

Core Tasks and Peripheral Tasks

There are two sectors. Sector 1 produces a low-technology good (good 1) and sector 2
produces a high-technology good (good 2). Firms are price takers in perfectly competi-
tive markets. Before we extend the model of Dei (2010) by allowing offshoring in two
sectors, we first explain the production function of a firm in the absence of offshoring.
Except technology parameters, firms in each sector share the following O-ring produc-
tion function:
2
x = ( q1 ) q2,

where x is a firm’s output and qi is the skill level of a worker who is assigned task i.3 As
in the paper of Kremer (1993, p. 553), the skill level of a worker is defined by the
probability of no mistakes. Every firm employs two workers, one worker at task 1 and
one worker at task 2, so that a firm is a team where two workers coordinate.
As Dei (2010) discussed, task 1 can be thought of as a core task and task 2 as a
peripheral task, because task 1 exhibits a higher marginal product of skill than task 2,
∂ x ∂ q1 = 2q1q2 = 2q12 > (q1 )2 = ∂ x ∂ q2,
if the two workers are of the same skill, q1 = q2. A decrease in skill has a larger negative
effect on the output at task 1 than at task 2. This difference in the marginal product of
skill can capture the difference in the importance of tasks.4

Autarky
There are two countries, the North and the South. Workers in the North have identical
skills, which are denoted by q, and workers in the South have identical skills, which are
denoted by q*. We assume

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74 Wanida Ngienthi and Fumio Dei

1 = q > q* > 0,
which implies that the southern skill level is lower than the northern skill level.
Under autarky, all tasks are undertaken by workers in the same country. A firm’s
output of good 1 in the North is
2
x1 = B1( q1 ) q2 = B1q3 = B1,

while that in the South is

x1∗ = (q1∗ )2 q∗2 = q*3.

Similarly, per firm outputs of good 2 in the North and in the South are

x2 = B2,

x∗2 = q*3,

respectively. We assume that the North has an absolute advantage in producing goods
1 and 2 and that the North has a comparative advantage in a high-technology good,
good 2, that is,
1 < B1 < B2.

Let the northern labor serve as numeraire, so that the northern wage is set at 1. Price
is equal to unit cost in a competitive equilibrium:

p1 = 2 B1,

p2 = 2 B2,

p1∗ = 2w* q*3,

p∗2 = 2w* q*3,

where p1 and p2 represent the northern prices of good 1 and good 2, and w* the
southern wage/the northern wage, respectively. The relative price of good 1 is given by

p1 B2 p∗
= >1= 1 .
p2 B1 p∗2

3. Offshoring
As Dei (2010) showed, northern firms offshore only peripheral tasks to the South.5
Offshoring means that production is executed by an international team of a northern
worker and a southern worker in a firm.6 We introduce costs of offshoring into our
analysis. In this model, we capture the costs of offshoring by assuming that the effective
skill level of a southern worker drops when he works for a northern firm. If a northern
firm in sector i offshores only task 2 to the South, its output, xɶ i, is determined by
Bi(q)2liq* where 0 < li < 1. We assume that
λ1 > λ 2. (1)

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 DIFFERENTIAL FALLS IN OFFSHORING COSTS 75

This reflects the difference in the complexity of communication between sectors.

Firms in sector 2 that produce a high-technology good, good 2, require a complex
communication such as face-to-face communication between two workers, whereas
firms in sector 1 that produce a low-technology good, good 1, require only a simple
communication that can be easily codified.
The technology under offshoring can be rewritten as
xɶ i = γ i q*,

where
γ i ≡ Bi λi.
We assume that
1 < γ 1 < γ 2. (2)
This means that despite offshoring costs, the technology of offshoring firms is superior
to the technology of southern firms and that the ranking of technological superiority
between sectors does not change before offshoring and after offshoring. When IT
developments reduce the costs of offshoring, they raise g i, that is, the effective skill level
of a southern worker in offshoring firms increases. We fix the country-wide southern
skill level, q*, throughout this study.
When offshoring takes place in both sectors,7 we have

1 + w*
p1 = , (3)
γ 1q*

1 + w*
p2 = . (4)
γ 2q*
By totally differentiating these equations, it is easy to get
 * − γ1,
p1 = θ w (5)

 * − γ2,
p2 = θ w (6)

where the hat symbol denotes a relative change, x̂ ≡ dx x , and q the cost share of
southern labor, q ≡ w*/(1 + w*).8 From (5) and (6), we have

p1 − 
p2 = γ2 − γ1,

which states that the greater the rate of technological advance for offshoring in sector
1 than in sector 2, the lower the relative price of good 1.

4. Welfare Effects
Using (5) and (6), we can write a relative change in the real wage of a southern worker
in terms of either good as
* − 
w * + γ1,
p1 = (1 − θ )w (7)

* − 
w * + γ2.
p2 = (1 − θ )w (8)

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76 Wanida Ngienthi and Fumio Dei

Similarly, a relative change in the real wage of a northern worker in terms of either
good is written as

− * + γ1,
p1 = −θ w (9)

− * + γ2.
p2 = −θ w (10)

As we show in the Appendix, if the number of northern workers, L, is less than that
of southern workers, L*, there are no local firms in the North. Because we are inter-
ested in the coexistence of offshoring firms and local firms in the North, we concentrate
on the case in which L > L*. Since every offshoring firm employs one northern worker
and one southern worker, offshoring firms cannot employ all northern workers. To
maintain the full employment of labor in the North, northern local firms that do not
offshore tasks must employ workers who are not employed by offshoring firms.9 As we
show in the Appendix, northern local firms must produce good 2 because we have
assumed that
γ1 γ
≡ λ1 > λ 2 ≡ 2 .
B1 B2
Intuitively speaking, offshoring is relatively easier in sector 1 than sector 2,10 so that all
firms in sector 1 offshore and not all firms in sector 2 offshore.
Because northern local firms produce good 2, the unit cost of producing good 2 is the
same between local firms and offshoring firms:
2 1 + w*
= . (11)
B2 γ 2q*
What matters here is that the presence of local firms locks the unit cost of offshoring
firms. Equation (11) gives

 = 1 γ2.
w* (12)
θ
This shows that w* rises as g 2 rises. Using (7), (8), and (12), it is clear that a southern
worker is better off:

* −  1−θ  
w p1 = γ 2 + γ 1, (13)
θ

* −  1
w p2 = γ2. (14)
θ

A relative change in the real wage of a northern worker in terms of either good is
written as

−
p1 = −γ2 + γ1, (15)

−
p2 = 0. (16)

As (16) shows, the real wage of a northern worker in terms of good 2 is kept constant.
Recall that the northern labor is served as numeraire by assumption. The presence of

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 DIFFERENTIAL FALLS IN OFFSHORING COSTS 77

northern local firms that produce good 2 implies that the unit cost and the price of good
2 in terms of northern labor, i.e. the inverse of the real wage of a northern worker in
terms of good 2 cannot change irrespective of a rise in g 2. It is clear from (15) that the
fate of the northern worker depends on which is greater: γ1 or γ2 . If γ2 − γ1 > 0 , the
budget line of a northern worker rotates in an unfavorable way and he is worse off, and
vice versa.
In summary, the South is always better off. In contrast, the fate of the North depends
on how g 1 and g 2 change.11 We have the following proposition:

Proposition 1. When there are local firms in the North, a fall in offshoring costs in any
sector makes the South better off. If offshoring costs in the high-technology sector fall
at a faster rate, the North is worse off, and vice versa.

Appendix
A northern firm in sector i chooses the minimum unit-cost among the following unit
costs:

2
ci(1, 2 ) = ,
Bi

1 + w*
ci(1, 2*) = ,
γ iq*

1 + w*
ci(1*, 2 ) = , (A1)
q*2

2w*
ci(1*, 2*) = , (A2)
q*3

where ci(1, 2) denotes the unit cost when a northern firm in sector i undertakes task 1
and task 2 at home. The asterisk is attached to a task number whose task is offshored.
For example, ci(1, 2*) denotes the unit cost when a northern firm in sector i undertakes
task 1 at home and offshores task 2 to the South. When a southern firm produces good
i, its unit cost is

2w*
ci∗(1*, 2*) = 3 ,
q*
which is the same as ci(1*, 2*). As (A1) and (A2) show, we assume that a northern firm
loses its technological superiority completely whenever it offshores task 1 to the South.
However, the technological superiority is just partially lost if a northern firm retains
task 1 in the North and offshores only task 2 to the South.
We can obtain the minimum-cost locus in sector 1 as shown in Figure A1. Point E is
the point at which a southern firm and a northern local firm are equally competitive at
wE∗ = q*3 B1 . Similarly, point 1 is the point at which a southern firm is equally competi-
tive with a northern firm offshoring task 2 at

q*2
w1∗ = .
2γ 1 − q*2

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78 Wanida Ngienthi and Fumio Dei

unit costs c (1*,2)

1

c* (1*,2*)
1

c (1,2*)
1
E 2
2/B1 c (1,2)
1 1

O w*
w1* w*E w*2

Figure A1. Unit Cost Lines in Sector 1

Since g 1 > 1 and 0 < q* < 1, we have w1∗ > 0. Point 2 shows that a northern firm
offshoring task 2 and a northern local firm are equally competitive at
2γ q*
w∗2 = 1 − 1.
B1
We assume that w∗2 > 0.
Based on the minimum-cost locus in sector 1, we can identify who is a minimum-
cost producer of good 1 depending on the level of w*. The unit-cost line of a task 1-
offshoring firm, line c1(1*, 2), is ineffective. Because 1/q*2 > 1/(g 1q*), line c1(1*, 2) lies
above line c1(1, 2*). This implies that a northern firm never chooses to offshore task
1 to the South and undertake task 2 at home. On the one hand, if w* < w1∗, the
southern wage is so low that only a southern firm is a minimum-cost producer. A
northern firm never offshores both tasks because, in reality, c1(1*, 2*) would be
greater than c1∗(1*, 2*). A northern firm must control two tasks from a remote place
and then face some frictions that are not captured in this model. On the other hand,
if w* > w∗2 , the southern wage is so high that only a northern local firm is a minimum-
cost producer. Offshoring task 2 is profitable to a northern firm only when the
southern wage is trapped by w1∗ and w∗2 , i.e. w1∗ ≦ w* ≦ w∗2 . Note that 0 < w1∗ < w∗2
implies q*3 - 2g 1q* + B1 < 0.
Similarly, in sector 2, the range of the southern wage that attracts a northern firm to
offshore task 2 to the South is w3∗ ≦ w* ≦ w4∗ where
q*2
w3∗ =
2γ 2 − q*2
and
2γ q*
w4∗ = 2 − 1.
B2
We assume that w4∗ > 0. It is easy to see that 0 < w3∗ < w4∗ implies q*3 - 2g 2q* + B2 < 0.
Because we focus on the case in which offshoring takes place in both sectors, it is
sufficient to consider the following two cases:

w3∗ < w1∗ < w4∗ < w∗2

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 DIFFERENTIAL FALLS IN OFFSHORING COSTS 79

or

w3∗ < w1∗ < w∗2 < w4∗.

Because we have assumed that g 1 < g 2 in (2), we have w3∗ < w1∗. From (1), i.e.
γ γ
λ 2 ≡ 2 < 1 ≡ λ1 , we have w4∗ < w∗2 , so that we can exclude the second case. If L > L*,
B2 B1
the full employment of labor requires that w4∗ ≦ w* ≦ w∗2 . The production pattern is
( x2, xɶ 2, xɶ1 ) and w* = w4∗ when offshoring occurs in both sectors. Since B2 > g 2 > 1 and
0 < q* < 1, we have w4∗ < 1, so that w* < 1. If L < L*, we have w3∗ ≦ w* ≦ w1∗. The
production pattern is ( xɶ 2, xɶ1, x1∗ ) and w* = w1∗ when offshoring takes place in both
sectors. Since w1∗ < w∗2 < 1, we have w* < 1.

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80 Wanida Ngienthi and Fumio Dei

Notes
1. See Table 1 of Wakasugi et al. (2008). The top five industries are apparel (37%), information
and telecommunications (35%), machinery (32%), electric machinery (32%), and electronics and
devices (31%).
2. Japanese manufacturing firms in many industries such as apparel, information and telecom-
munications, machinery, electric machinery, electronics and devices, chemicals, transportation
machinery, textile, and foods offshored tasks like final assembly, production of intermediates,
production of jigs/dies, and customer support to China and the Association of Southeast Asian
Nations’ countries in 2007. See Figure 3, Tables 1 and 2 in Wakasugi et al. (2008).
3. Kremer and Maskin (1996, p. 6) used the O-ring production function of this type.
4. According to Kremer and Maskin (1996, p. 6), a different power in the production function
reflects a different sensitivity to skill: task 1 is relatively sensitive to skill and task 2 is relatively
skill-insensitive. Since (q1/x)(∂x/∂q1) > (q2/x)(∂x/∂q2) implies (∂x/∂q1) > (∂x/∂q2) if q1 = q2, sensi-
tivities relate to marginal products under the condition that q1 = q2.
5. Riezman and Wang (2009) considered the case in which manufacturing is offshored but
research is not. Yomogida (2010) showed that unskilled-labor-intensive production of products is
offshored but skilled-labor-intensive production of blueprints is not in the free trade equilibrium.
Long (2005) showed that when an offshoring firm must train southern workers, not all of its
output are offshored if there are spillovers to the southern rival firms.
6. There are no markets for tasks and no prices of tasks. Tasks can be offshored but cannot be
traded like intermediate goods.
7. In this case, we have w* < 1 in equilibrium as shown in the Appendix.
8. Equation (5), for example, can be rewritten as
1 = (1 − θ ) W
P  + θW
* − γ1,

in terms of nominal variables. This is the same relationship as the one Jones (1965, p. 568) derived
because an offshoring firm uses a northern worker and a southern worker to produce good 1.
9. Since firms are homogeneous, labor endowments play a key role in dividing firms into
offshoring firms and local firms. If firms are heterogeneous in productivity, Antràs and Helpman
(2004), among others, showed that local firms are less productive than offshoring firms.
10. If there were no costs of offshoring, offshoring firms’ production functions would be
xɶ i = Bi q* . In the presence of offshoring costs, their production functions are xɶ i = γ i q* . The ratio
g i/Bi indicates relative ease of offshoring.
11. We have considered how welfare changes as offshoring costs fall. We do not compare the
levels of welfare before offshoring and after offshoring. For this comparison, see the paper of Do
and Long (2008), who showed that offshoring can reduce northern welfare when offshoring
involves fixed costs, or when the North has a minimum wage.

© 2012 Blackwell Publishing Ltd