What Do You (Falsely) Take for Granted Regarding U.S. Outsourcing?

The loss of manufacturing from the U.S. costs American jobs but at least brings big cost savings to American consumers, right?  And anyway, the U.S. is too advanced an economy to do its own manufacturing, right?  Well, not so fast.  That first assumption is false in most cases, and the second is questionable.

What prompted me to devote this evening’s blog post to this topic is an article, “The Human Toll of Offshoring,” that ran in the New York Times on Labor Day.  It in turn was triggered by a new book, Factory Man: How One Furniture Maker Battled Offshoring, Stayed Local, and Helped Save an American Town, by Beth Macy, a longtime reporter for the Roanoke (VA) Times.  An alert reader of this blog called my attention to the NYT article, though I had heard Macy interviewed on NPR a few weeks ago.

Sadly, even the NYT buys into myth that offshoring brings U.S. consumers big cost savings.  Generally, this is not the case.  The typical profit margin for manufactured goods is so small that the savings in labor costs accrued from offshoring make a big difference proportionally to the manufacturer, but the difference in consumer price is small, as the labor costs are a small portion of the overall cost.  More generally, labor cost savings don’t bring big reductions in retail price.  For instance, my UC Davis colleague Phil Martin, an agricultural economist, once calculated that consumers save about a nickel per head of lettuce grown with unauthorized-immigrant labor.  Negligible savings for the consumer, but the growers win big.  Labor is a small part of retail price even in some service industries; Card and Krueger, writing in support of raising the minimum wage, found that a 19% increase in labor costs led to only a 2% rise in fast-food prices.

Of course, the politicians’ and unions’ favorite boogey man in such discussions is China.  Yet an investment analyst estimated that Chinese labor forms only 2-5% of the retail price of an iPhone.  I’ve seen other similar analyses.  A 2011 analysis by the Boston Consulting Group (BCG) stated that “…labor accounts for a small portion of a product’s manufacturing costs.”  Since the NYT article is about the furniture industry, note that the profit margin in that industry is said to be 2%.  If one combines this fact with the BCG statement, one sees that the savings to consumers is very small.  Again, remember that it is the manufacturer who wins from offshoring, not the consumer.

Significantly, a BCG survey found that Americans are willing to pay considerable premiums for products made in the U.S.  In fact, the amount they are willing to pay extra actually exceeds the small savings they actually get from offshoring.  Apple is moving some of its Mac production back onshore, presumably at least in part from this consideration.  BCG claims that this is a coming trend, as does The Economist.

So, the economics professor cited in the NYT article (requoted from the Macy book, and endorsed by the NYT reporter) seems to be rather off base in his statement:  “In reality, we shouldn’t be making bedroom furniture anymore in the United States. Shouldn’t we instead be trying to educate these workers’ kids to get them into high-skilled jobs and away from what’s basically an archaic industry?”  Moreover, his apparent attitude that all Americans should get an education and pursue one of the professions is of course absurd on its face, and  frankly, is amazingly naive.  Should more Americans go into the science research field, for example?  No, they can’t get jobs as it is, as a National Institutes of Health study found a couple of years ago.

Moreover, the NIH stated that foreign-worker programs were part of the problem.  Importation of foreign labor is just like offshoring, really; whether cheap labor is used abroad or brought to the U.S., the losers are U.S. citizen and permanent resident workers.  UC Berkeley economics professor Clair Brown and her coauthors have found that the H-1B work visa program negatively impacts American engineers, and the congressionally commissioned NRC report found that H-1B was adversely impacting IT wages.  (See references on NIH, Brown and the NRC in my Migration Letters paper.)

Apologists for offshoring, such as the NYT’s Tom Friedman, try to excuse all this not only by the old “the labor costs savings are passed on to the consumer” canard, but also by saying that the workers abroad will be enabled to afford American products, thus creating U.S. jobs.  That is true to some extent, but the benefit is probably not as great as the loss.  Friedman, for instance, has noted that software development work offshored to India is compensated by the fact that the Indian software “factories” use Carrier brand air conditioners.  But the extra Carrier sales arising from this are probably not going to result in Carrier hiring more engineers; the engineering is largely a fixed cost.  So, we are losing engineering jobs in this scenario but MAYBE gaining some manufacturing jobs (assuming those are not in India, which would be counter to Carrier’s best interests)–not a very good trade, is it?

Is the solution to place restrictions on globalization, in the form of imposing tariffs on goods and tightening policy on importing foreign labor?  As I’ve emphasized before, those questions should be for the American people to decide–based on full information, not on misleading NYT articles.

 

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10 thoughts on “What Do You (Falsely) Take for Granted Regarding U.S. Outsourcing?

  1. >Yet an investment analyst estimated that Chinese labor forms only 2-5% of the retail price of an iPhone.

    But if it were made in the US and labor cost $20/hr instead of $1/hr, then labor would cost up to 100% of the current price of the phone – the price would double, or more to preserve a percentage profit, anyway the labor would look like 50% or more of the (increased) price.

    And so if it were made in the US then labor would be replaced by automation. Voila, the labor percentage would go down again, but the price not so much, labor might look like 25% of the cost and the price up by only 80% instead of doubling.

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    • Apple’s profit margins are extremely high, 40 or 50%, not the 2% or less that is common. (Plug “iphone profit margin” into Google for numerous references.) Also, the Boston Consulting Group group that I cited puts Chinese labor cost savings for the manufacturer at only 55%, i.e. about 2-to-1 instead of your 20-to-1 figure; this apparently factors in productivity, shipping costs and so on. So again, the savings to the consumer are pretty modest.

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      • Chinese “labor costs” often include many externalities other than labor, and no doubt my 20x was a convenient high side, but I daresay BCG’s 55% is far too low as well, even including shipping and some very healthy bribes. They may use a bigger factor for automation savings too and then lose track of them, as I suggested US “labor” would be reduced but replaced with other significant expenses. Indeed there might be very little US labor at all, and then the savings would indeed look minimal – but only when replaced by huge automation expenses that dwarfed the Chinese labor numbers.

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  2. In economic theory the relationship between the market price and cost of production is only indirect. The price of a product or service is what the market will give. What it cost to produce impacts that price only in that it tells the producer whether of not he can be in that market. If the full cost of production exceeds the price the firm can get from the market then the firm must abandon that market. When a firm abandons a market because its cost are too high then those firms still in the market can command a higher price because the supply is reduced. That is the only impact cost of production has on market price. Lower price means that when the firm takes the market price profit is higher.

    For example, years ago I was in an airline executive’s office discussing the details of a program I was writing for him. The phone rang and he excused himself to answer it. He did not hear well so the volume of his phone was set high enough that I heard both sides of the conversation. The caller was a hotel near a large airport served by the airline. They wanted to bid on supplying hotel rooms to flight crews overnighting there. The airline averaged near 100 rooms a night there. The executive listened to their offer then pulled out a file did some calculations and told the caller he was not interested because the annual savings offered was only $25,000 a year and since both the pilot union and the stewardess union would have to approve the change the minimum savings would have to be $50,000. The caller said his cost structure would not allow him to do that. The phone call came to an end and we resumed our talk. About five minutes later the phone rang again. It was the hotel with a new lower bid. It was accepted.

    In economic theory as in the real world the firm takes the price offered by the market regardless of the cost of production.

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    • Excellent points, illustrating in various ways why the classical free market “marginal revenue = marginal cost” theory fails to account for various important factors.

      But even that simple theory shows that the whole notion of “pass the savings on to consumers” (or “pass the cost of the new tax or increase in minimum wage on to consumers” is wrong. The effect of the change in costs will be shared between the seller and the buyer, with the proportion for each depending on the setting.

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    • @James H. Murphy: ‘If the full cost of production exceeds the price the firm can get from the market then the firm must abandon that market.’

      That firm has at least 2 other alternatives: externalize costs sufficient to restore profitability, or internalize benefit(s) sufficient to restore profitability. “Market fundamentalists” often (seek to) forget that, even in “market economies,” Σmarkets << "the economy." Interestingly for this example, in order for Σmarkets ~= economy, firms (which are internally command-and-control institutions which *remove* transactions from markets[1]) could not have anything like their present significance in our economy.

      [1]: https://en.wikipedia.org/wiki/Theory_of_the_firm#Overview

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  3. [BTW: your link to the Nocera piece is broken. You have 2 w’s but need 3:

    http://ww.nytimes.com/2014/09/02/opinion/joe-nocera-the-human-toll-of-offshoring.html

    should be

    http://www.nytimes.com/2014/09/02/opinion/joe-nocera-the-human-toll-of-offshoring.html?_r=0
    ]

    @matloff: ‘[Bruce Blonigen said, “]Shouldn’t we instead be trying to educate these workers’ kids to get them into high-skilled jobs and away from what’s basically an archaic industry?” [The claim] that all Americans should get [a tertiary] education and pursue one of the professions is of course absurd on its face, and frankly, is amazingly naive.’

    Really? It sounds like a *great* way to sell university tuition 🙂

    IMHO the single greatest cognitive bias of US history/politics is the search for individual solutions to collective problems (err … non-1% problems, that is 🙂 and the single greatest cognitive bias of US “progressives” is the belief that more education will (c.p.) solve all individual and collective problems. (I work on global environmental degradation, and particularly global warming, and could pay *my* tuition easily if I got a dollar everytime someone talked about we just need to *explain* it better to the deniers.)

    Sounds like Blonigen knows suckers when he sees them; but what will Blonigen et al do when the US university bubble pops?

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  4. Some time ago The Wife was looking in the fabric department at Wal-Mart so went to the kitchen appliance department and at every product on the shelves. The only product made in USA was Anchor-Hocking and one other brand glassware. Nothing that required electricity was made in USA. No non-mechanical or mechanical items were made in USA.

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  5. When it comes to free trade and outsourcing most economist find themselves between a rock and a hard place. Upton Sinclair described their dilemma this way

    “It is difficult to get a man to understand something, when his salary depends on his not understanding it.”

    Most economist work for organizations that benefit from free trade and outsourcing. If the Pope is not Catholic and wants to keep his job I suggest hekeep quiet about it. Likewise economist who do not believe in free trade need to keep quite about it.

    I suspect that a lot more of them see the harm than talk about. In my view our economic problems today are primarily due to free trade. Jobs lost to outsourcing and imports that kill jobs where in the past those jobs were protected by tariffs. It is the 800 pound gorilla in the room that nobody wants to talk about. When asked economic generally avoid the question by saying that it is mixed. They then make the almost obligatory comment about lower consumer prices. Over the last few months I have noticed that most economist add the phrase “on imported goods” to that comment.

    The reason that phrase is significant is that consumers may (I do not believe it but I have no data to support that belief) indeed be getting lower prices on such goods but that is not the whole story on consumer prices. Free trades impact prices other than import prices.

    First, consider mirror image of lower import prices. American consumers pay higher prices on the domestic consumption of exported goods because of free trade. Free trade increases exports which increases demand which increases price. American consumers of those goods exported must pay that higher price.

    Second, our government is trying to increase exports by devaluing the dollar to make them cheaper for foreigners to buy. But a devalued dollar means American consumers pay more dollars for goods imported. The dramatic increase in a gallon of gasoline is in part due to the devaluation of the dollar.

    Third, the largest impact on American workers is not in what they have lost but in what they have failed to gain. From 1947 to 1972 average real wages rose to a peak and since declined. Blue collar workers in this country have not seen an economic recovery from the 1972-73 recession. If we had continued the real wage increase of the period 1947-72 workers would be making about $1290 a week. They are making $690. This is the real cost of free trade.

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