As featured in the November 2005 edition of WSA newbytes

The WSA is an alliance focused on helping Washington state technology innovators succeed. WSA is a catalyst for sharing expertise, delivering key business services and leading the advocacy of issues necessary to keep Washington a leader in the digital economy.

Article written by:

Daniel Kah, Research Director

AngelouEconomics

Feature: The Economic Impact of Offshore Outsourcing

There is growing concern among American workers that the economy is being hollowed out by offshore outsourcing. American firms have begun to employ foreign workers and subcontractors for a wider variety of white-collar and service-sector jobs. While outsourcing white-collar jobs is not materially different from trends in the manufacturing industry, it is a relatively recent phenomenon. In the past, geographic barriers made service jobs, especially in the technology field, difficult to outsource. Geography is no longer a limitation because the advent of the Internet, global adoption of the personal computer, and advances in telecommunications. These advances have allowed large amounts of data to be sent virtually anywhere in the world instantaneously and cost-effectively. New technology enables workers located anywhere to compete effectively for a wider variety of jobs, including those in the service sector.

This competition has reduced costs for a wide variety of service-sector tasks, and these cost savings and productivity enhancements are driving companies to outsource more non-core functions. Outsourcing allows companies to focus on their core competencies and reduce operating expenses. This is particularly true in the software industry. Mature software firms can spend less than one-third of their research and development budgets on new-product development. Much of the rest is increasingly absorbed simply maintaining existing software. Updating security programs, fixing bugs and creating fixes for viruses is a contractual obligation for firms. Developers at large software companies are now performing mundane tasks, rather than focusing on innovation.

Outsourcing programming and support for maintenance efforts provides more funding and staff resources for true research. Recent case studies indicate that a large outsourcing program can save 25 percent, allowing the company to increase investment in traditional research and development.

Outsourcing can also improve quality. A U.S. software firm can view basic programming and technical support as a cost, not a profit center, and will focus resources in other areas. An outsourcing firm focused on testing code or providing technical support will perform that task with excellence. Making your back office another company’s front office tends to improve quality and cost.

The technology hardware industry provides a roadmap many service-sector firms, including software firms, are likely to follow. As the hardware industry matured, fierce global competition ensued, and the price of hardware fell dramatically. Price declines lowered barriers to entry, allowing a wide group of companies, both large and small, to adopt these new technologies. Savings from lower hardware prices was also spent on software to increase hardware efficiency. Today, software spending is growing much faster than hardware, and now prices for many software components are falling. As segments of the software industry become more mature, competition ensues, firms lose pricing power, and prices fall. These price declines allow for capital to be spent on advanced software and services. IBM followed this path closely, moving from a manufacturer, to a software company, and now a services firm. Offshore production of technology hardware created growth opportunities for the software industry. Outsourcing in software is creating opportunities in services and custom software.

Outsourcing – often to foreign countries – played a big part in the declining prices at every step of this process. The productivity gains in the software industry vastly outpaced economic losses resulting from outsourcing aspects of hardware manufacturing. The gains from outsourcing aspects of software production will be in higher value-add software and services.

The economic effect of these trends was mostly positive. The flexibility of the American economy and labor market is one of the country’s greatest assets. As employment declined in manufacturing, job opportunities expanded in software and services. U.S. firms are able to react to external economic opportunities and shocks in a timely manner, which is not the case in many other developed nations. This flexibility enables the American economy to capitalize on opportunities in advance of competing nations. This is evidenced by strong GDP growth and low unemployment, particularly when compared to Western Europe and Japan. During the previous 20 years, as outsourcing and offshoring expanded throughout manufacturing U.S. economic growth remained strong, as did employment and wage growth.

Many fear that service-sector outsourcing and offshoring will reverse these trends, and begin to cause unemployment to rise. This does not appear to be the case. Outsourcing creates jobs by freeing up money for investment; this leads to job creation in other sectors of the economy. The U.S. is at the forefront of outsourcing, and Washington State firms are leaders domestically. Our analysis of corporate outsourcing patterns indicates an industry that has adopted outsourcing will see a decline in low-wage positions, and a greater increase in high-wage positions.

From 2002 to 2004, U.S. employment expanded by 0.5 percent, a rather anemic rate of growth. During the same time employment in software occupations grew by five percent. Further examination of the industry shows job losses in computer programming and database administration positions, but significant gains in all other areas. The fastest job growth is occurring in the highest wage positions. Nationally, software occupations are growing faster than the overall economy, and wage growth is higher. Job losses in programming are replaced by employment gains in software engineering positions.

The State of Washington provides a very similar story. Job creation is faster than the national average, and software jobs continue to grow. Job losses in the software industry are limited to computer programming, computer support specialists and database administrators, positions that are prime candidates for offshore outsourcing. But overall, more software jobs are created than lost, and wages continue to grow faster than the national average, from an already impressive base.

The traditional economic argument for free trade, briefly stated, is that all parties can raise living standards if economic activity is focused on what each country does best (often called comparative advantage). Even if one country is more efficient at producing every good and service needed, the country still benefits from focusing on areas where the advantage is greatest. Economic theory and real-world experience have proven this theory to be true, but recent trends in service-sector trade raise new questions. Research from two of the world’s most respected economists, Nobel Laureate Paul Samuelson and Jagdish Bhagwati, indicates that trade in services, including offshore outsourcing, is no different than trade in manufactured goods. Although possible, it remains very unlikely that a country will lose from trade in the long run – whether focusing on trade in goods or in services. The cost savings and productivity benefits are simply too great.