Offshoring

You believe in the power of the free market and its maximization of efficiency? Well, then, you should have no issue if your employer lays you off and hires someone in a developing country for half your pay?

Would you work for a foreign company for a wage less than they can legally provide their workers domestically? Would you accept that illegally low wage if it was double your country's average wage?

The globalization of markets has led to a multitude of shake-ups in our normal understanding of how an economy works. Read this explanation to learn more about a part of globalization, offshoring!

What is Offshoring?

What exactly is offshoring? As economies expand and become interconnected globally, offshoring is a natural consequence that can easily be explained in economic theory. Offshoring refers to businesses that hire laborers in a different country than where the company is located domestically. Read this example below for an easy demonstration of offshoring.

In the example above, we see that the bread baker hired foreign laborers to perform financial services. This example may arouse reasonable questions such as. Why does a bread baker in France not hire french workers? Why would they hire someone in Bangladesh?

France has a high standard of living, and thus high wages compared to developing countries. Additionally, competition for financial services within France may drive the cost up. Bangladesh provides a cost-effective alternative as the standard wage rates are much lower than french ones. Additionally, the global supply of financial services is much, much larger than the supply of financial services within France.

So the bread baker hires a Bangladeshi financial firm to run their finances, allowing the baker to save money and focus their resources on their production side.

Fig. 1 - Advertisement to offshore accounting. Source: Wikimedia Commons¹

Offshoring vs Outsourcing

What is the difference between offshoring vs outsourcing? Offshoring may not be the term you are most familiar with. In some places, it's referred to almost exclusively as outsourcing. This can be a bit confusing, as they share some similarities but aren't exactly the same.

Outsourcing refers to hiring an external company to perform services. This external company can be within the same country or in a different one.

Offshoring refers to a specific type of outsourcing that hires an external company in another country.

Due to this, not every situation involving outsourcing leaves the country, but every instance of offshoring is also outsourcing.

Fig. 2 - President Trump's policy goal to reduce outsourcing Source: Wikimedia commons²

The image above shows congressional representatives speaking about former president Trump's initiatives to stop offshoring and bring back American jobs. This seeks to improve working conditions for Americans by punishing firms that offshore their production. This is a positive policy for working-class and low-income citizens. However, this policy is anti-free market and hurts businesses. Free-market labor would settle at the most efficient location, no matter how many American jobs are lost.

Offshoring Definition

So what is the definition of offshoring and what forms does it take in the modern world? Offshoring occurs when a business entity hires services from another country's laborers. Offshoring is a result of what economists call comparative advantage, by minimizing opportunity costs. Comparative advantage is when one player has a lower opportunity cost than the other player. Other countries' economic layouts may provide significant comparative advantages, most commonly low cost of labor. Offshoring according to economic theory is just the natural course of an efficient market.

That is the textbook definition of offshoring, but in the chaos of the real world, it can mean many things. For example, you may have heard any variation of the following statements about offshoring.

• I'd call tech support but it's impossible to talk to someone in the same country as me.

• That other country is stealing all of our jobs! ("they took our jobs" is a popular joke phrase).

• Multinational corporations are exploiting developing countries' labor forces.

• Taxing the rich is pointless, they have all their money offshore.

• Offshoring provides economic opportunities to developing countries they wouldn't get otherwise.

• All our manufacturing jobs were sent overseas!

• Offshoring has bolstered domestic profits.

So what exactly does offshoring imply then? Well, all of these statements are true to some degree about offshoring.

The statement that is the least true is that country X is stealing jobs, foreign countries can't steal jobs. They can however accept your job when your employer willingly gives it away to foreign laborers.

Why is it that when you contact tech support the worker who answers the phone is working from another country? The effect can be followed easily. It's likely the labor cost for the tech support employee is much lower in other countries than domestically. This cuts down on client management costs, saving the business money. Additionally, if the business is saving money, then it can charge less, if they don't its competitors will charge less and you can switch to them. So the net result is a lower price for customers, lower cost for employers, new jobs for the foreign country, and lost jobs in the domestic country.

It's important to understand what effects offshoring has on the country if the job is outsourced. Are they being exploited or given opportunities as stated above? Every scenario will be different, but likely all will have a mixture of both depending on your views.

The profit motive is how we assume all businesses are to operate. To produce the most, at the lowest cost. To get the lowest cost of production, businesses want to pay as low as possible, not have to deal with costly regulations, and pay the least amount of tax. These three ingredients to profit maximization are inherently bad for workers.

Despite the negative tone above, simultaneously occurring to those are also positive effects of offshoring. Bad wage rates domestically may be many times greater than the standard wage in developing countries. Countries that receive offshoring jobs have more investment and currency than flowing through their economy, which can increase growth across the whole economy.

A major source of scrutiny is offshore accounting, most popularly touted by those who believe the rich are keeping their money out of the system to avoid taxation. We will discuss the full range of its effects below.

Offshoring Accounting

Offshoring accounting refers to a few kinds of financial tricks that global markets enable. On a small scale, for example, you could open a bank account in a foreign country and keep some of your savings there. The incentive to do this is that other banks may provide better quality services or higher interest rates. Additionally, if the currency appreciates from your domestic currency then you'll make even more money.

It can be a smart financial decision to take your business, as is said where it's treated best. This takes the shape of businesses being held by holding companies and trusts. By doing this one can protect assets if a business falls into bankruptcy.

It is illegal for businesses to create offshore accounts to avoid taxes, so you better make up a different reason when you are asked. This may sound like a joke, but it is indeed the reality. In recent years a data leak known as the Panama papers has revealed billions of dollars that weren't properly taxed from citizens all across the world. This loss of potential tax revenue consolidates wealth at the top and restricts the government's funding it uses to help citizens.

Offshoring Pros and Cons

What are the pros and cons of offshoring?

How does offshoring shape the economy?

On a small scale, offshoring is quite simple, a domestic job is sent to another country. However, in a massively interconnected economy, how does the cumulative effect of each instance of offshoring change economic conditions?

We can follow the effects step by step:

Low-wage jobs that don't require specialized skills are the easiest to offshore, as the training requirements for foreign workers are easier. Picture manufacturing and assembly line jobs.

The exodus of low-wage jobs from the domestic country creates a gap in the economic ladder. Manufacturing jobs provide an important step for workers to acquire skills and develop their careers. The ramifications of this can be noticed in the explosion of service jobs throughout the United States. Domestic jobs become predominantly jobs that can't be offshored, such as in-person service. Previously domestic workers would manufacture the goods, but now that they are imported, domestic workers can only deliver them or stock the shelves where they sit.

To have a complete understanding of offshoring, two separate pro and con lists must be made, one of the country offshoring jobs, and the country receiving the jobs.

As you can see in the example above it is a mixed bag of benefits and costs that offshoring provides, depending on who you are in the scenario can control which of those you receive.

Now let's consider the other side, the foreign country receiving jobs.

Between both examples above, it's clear there is a wide range of benefits and costs for both countries in the scenario. To do a full comparison of whether it's a net positive or negative would require a financial estimation of gains and losses for each of the pros and cons.

One of the cons listed above is the cutting of regulation and other protective policies to be the most appealing for foreign investment, read the deep dive below to find out more!