Working Paper, Department of Economics, Johannes Kepler University of Linz 0020
A distinctive feature of the present wave of economic globalization is that the principle of world-wide arbitrage is increasingly applied to individual components of value added chains, rather than final goods. The result is a phenomenon called outsourcing, or international fragmentation. Economists have investigated this phenomenon with a focus on welfare and factor price effects, mainly using Heckscher-Ohlin-type trade models. Existing studies emphasize a positive welfare effect of international fragmentation, but reveal ambiguous effects on factor prices. This paper first reviews existing literature, identifying the crucial modeling differences that drive the differing results. It then presents an alternative view on international fragmentation based on the specific fators model, instead of the Heckscher-Ohlin model. The analysis explicitly deals with the cost of international fragmentation, emphasizing that there will typically be a fixed cost element, with important consequences for the welfare efect of outsourcing. Moreover, the paper highlights a crucial distinction between outsourcing that takes place in an environment where firms may entertain foreign direct investment, and international fragmentation without capital mobility where firms must rely on arms-length trasactions. The results are as follows. a) With foreign direct investment, outsourcing which is driven by a low foreign wage unambiguously depresses the domestic wage rate. Outsourcing of a single fragment is sufficient to drive the domestic wage rate to the foreign level, adjusted for the cost of fragmentation. This holds irrespective of the factor intensity ranking of fragments. b) If outsourcing takes place without foreign direct investment, then the factor intensity ranking matters. Domestic labor loses if a labor intensive fragments moves offshore, and vice versa. c) In both cases, international fragmentation may cause awelfare loss if te costs of fragmentation includes a fixed element.