Outsourcing vs Offshoring: What’s the Difference?
“Outsourcing” and “offshoring” used to be some of the trendiest buzzwords in business: if you weren’t offshoring to India or China, you were regarded by America’s business elites as a country bumpkin.
You were a rube.
But then offshoring got IBM into hot water with its investors and the public alike.
And then Boeing had some serious problems.
Before you knew it, the tides turned. Now Americans are more skeptical than ever of the so-called “benefits of offshoring”.
Should they be?
Yes. Offshoring’s done a ton of damage to America’s economy, and key industries, over the last 40 years.
In this article, I’ll explain what the terms outsourcing, offshoring, and offshoring-outsourcing mean, and what’s the difference between them; then I’ll let you know why offshoring has, as a whole, been bad for America’s economy.
So let’s start: what’s the difference between outsourcing and offshoring anyways?
What Is Outsourcing? A Definition & Example.
Outsourcing is when one company hires another (domestic) company to perform a specified process for them (that they would otherwise do themselves). Why? To save money, or because the other company will do a better job.
That’s it, pretty simple.
Here’s an example of outsourcing: Acme Inc has an office building that they need to keep clean, because their tenants won’t pay rent if there’s garbage on the floors. In this case, Acme can either:
(1) hire a janitor, and clean the building themselves, or
(2) hire Bingo Ltd (who specializes in cleaning services) to do it for them.
In the first option, Acme would have total control over the janitor, which could be a good thing (it depends upon the complexity of the task, and how much loyalty you need).
However, Bingo Ltd might be cheaper, and better, since they specialize in cleaning, and have all their own equipment.
Basically, it frees up workers and money to do other, hopefully better, things.
Here’s a picture to make it crystal clear:
What Is Offshoring? How Is It Different From Outsourcing?
Offshoring is when a company creates a foreign-based subsidiary company (eg. in China) to perform a specified process for them (in the foreign country). Basically, the company opens up a branch in another country to do something for them—usually because it’s cheaper.
An example of offshoring would be when IBM moved programming jobs from the US to India, because Indian coders will work for less than Americans—everyone still worked for IBM, just in 2 different countries.
Now, offshoring is a bit of a double-edged sword: often labor and capital are allocated more efficiently globally, but this does not necessarily mean it benefits either country (although it does benefit the corporation).
There could be winners and losers here.
Let’s look at 2 examples. First, suppose the American company McDonald’s opens up a restaurant in Shanghai; this benefits America, since money flows to the US, who loses no jobs, capital, or technical know-how.
However, pretend a US company opens up a subsidiary Research & Development lab in India. This may benefit the company, but it’ll hurt the US in the long run, because it contributes to brain-drain (or at least diminishes our intellectual magnetism), hollows out our specialized supply chains, and denies the US the spin-off benefits that research brings.
Basically, we lose out on scientists and their discoveries, while India gains them.
The below infographic sums up how offshoring works.
What Is Offshore Outsourcing?
How Offshore Outsourcing Works In Theory:
This brings us to the big ticket item: offshore outsourcing, which is just a combination of the two.
Essentially, offshoring outsourcing can be defined as when a domestic company hires a foreign company to do something for them in the foreign country.
For example: the American company Acme Inc. hires the Chinese company China Corp to build laptops for them—China Corp builds the laptops in China, and then Acme Inc imports them to, and sells them in America.
This is usually a bad thing if you’re in America’s position. I’ll explain why shortly.
That being said, from now on when I say offshoring, I actually mean offshore outsourcing, for the sake of brevity.
Here’s what offshore outsourcing looks like in a handy picture:
How Offshore Outsourcing Works In Practice:
Like pretty much anything else, theory and practice often don’t match up very well. This tension often leads to absurd results, which is happening with offshoring.
On the one hand, it’s supposed to grow the economy by increasing economic efficiency, while on the other, the signs of America’s economic collapse are everywhere.
Here’s an infographic explaining how offshoring works in practice (more details will follow):
If you’re still not convinced, let’s conduct a thought experiment, and see if offshoring still makes sense. This way we will be able to tinker with the logic, and be sure we don’t miss out on any key points:
1. Assume there are 10 companies that make widgets in the US, each employ 10 people. They all make equally good widgets, and all sell their widgets for $1 a piece.
2. One of the companies, Shillcorp, discovers that it can save money by building widgets in Japan and importing them to the US. It builds a factory in Japan and does so, selling its widgets for $0.80.
In doing so it retains 1 designer in the US, and lays off 9 factory workers. This benefits Shillcorp, who gains market share and becomes more profitable (people love cheap widgets).
The overall impact on the economy is relatively benign: together, the companies still employ 91 people in the US (9 people are now unemployed) who continue buying the cheap(er) widgets.
3. In order to compete with Shillcorp, the other companies, one by one, must move their production to Japan. After all, who would buy a widget for $1 when they can get an equally good widget for $0.80? This results in cheaper widgets, but also fewer jobs, and therefore fewer people who can afford the widgets.
Logically this results in only 2 scenarios: either (a) all of the production moves to Japan, and the US consumers buy the widgets by selling assets or debts for as long as possible, before they can no longer afford even the cheapest widgets; or (b), an equilibrium point is found where the widgets are built in Japan, but are designed in the US.
In (a) the US economy will inevitably collapse, in (b) inequality in the US grows until the equilibrium point is found, whereby this increased inequality becomes the new baseline (a few designers replaced many factory workers).
Neither of these outcomes is good for the average American.
Now, we both know that the economy is not contained to a single industry (widget-making), so let’s expand our example to include the condition that US widget-makers are able to pursue alternative employment in doohickey building.
4. Assume that doohickey building employs 100 people: the first 9 widget-makers have just been laid off.
Those unemployed workers now have to compete with the doohickey-builders for jobs, which means that there is more competition for doohickey-building jobs, and wages will decrease in doohickey-building. Now if the industry cannot absorb more labor, then the average wages will still decrease due to competition, but 9 people will still be unemployed.
Either way, wages are lower.
5. Now assume that those 9 unemployed people are able to find service jobs which are supported by the 1 designer.
In this case the designer would have to make an order of magnitude more money than any of the displaced 9 workers in order to support them. First, he probably does not; second, if he does, all this system has done is create inequality.
Even if it generates a wealth surplus, this accrues wholly at the top and trickles downwards, rather than the wealth being more evenly dispersed among the average worker.
6. Since wages are depressed, and more people are unemployed, Shillcorp realizes that it must make the widgets even cheaper, so it moves its factories to Taiwan. This process is repeated and the others follow. Shillcorp then moves to China; the process is repeated and the others follow.
This occurs until there is nowhere cheaper to make widgets. This means that when widgets are made artificially cheaper due to trade, the process is necessarily finite (it ends when you run out of cheap labor). The only way to make widgets cheaper over the long term is to increase productivity (ie. ensure that it takes fewer people to make the widgets).
However, by relocating widget factories to cheaper locations, Shillcorp and friends have removed the natural incentive (high labor costs) to innovate and increase productivity—why invest in productivity-boosting technology when you can employ the same technology abroad for much cheaper?
As a result, real economic growth (making more widgets with less labor) is retarded by artificially cheap labor (There is a reason why the Industrial Revolution happened in tiny England, as opposed to big France or China).
7. In the end, the US widget-making industry is hollowed out, inequality has increased, and the cost of labor has decreased in tandem with the cost of widgets (widgets are cheaper, but workers are poorer too, so no one is better off).
Worse still: Japan, Taiwan, and China now build their own widgets rather than importing ours.
In a final ironic twist, the foreign widget-making companies eventually expand into the weakened US widget market, since their widgets are cheaper than US-designed widgets (it is cheaper to design and make them abroad), and they are of comparable, if not higher quality (they learned how to build good widgets from us).
Of course, this process is not limited to the making of widgets: doohickeys are also being offshored, so are gizmos, and whatchamacallits.
Anything that can be done abroad for cheaper is subject to this logic (which as it turns out, is a sizable portion of America’s key industries—widgets being the first among equals, naturally).
In the end, any short term gain is swamped by long term pain.
And to make matters worse, it’s our rivals that benefit.
Computer Models Prove Offshoring Harms America’s Economy
Computer simulations run by economist Joseph Stiglitz corroborate this logic, and show that offshore outsourcing can harm advanced economies, and undermine economic growth in the long run.
His experiment ran as follows: there are 2 model nations, A and B; A has a short term consumption preference (they want cheap goods now) and B does not; A is rich and B is poor (B makes goods cheaper).
If there are no trade barriers between the two nations, A will buy as many goods as possible from B (selling assets and debts to do so), and for a time, both nations are happy (A gets cheap goods, B gains wealth). However, after a number of cycles A runs out of assets and debts to sell, and A’s economy contracts—there is a consumption boom, then a massive bust.
If we run this against a baseline simulation, we find that the baseline outperforms the free trade simulation in the long term.
In fact, it is a “mathematical certainty” that consumption (a proxy for the standard of living) is worse in the long run when nation A adopts a free trade position (ie. It is also true that there is less volatility in this baseline model (there is no cataclysmic boom or bust fueled by the conspicuous consumption).
Too much offshoring (and giant trade deficits) leads to economic ruin in the long term.
Asymmetrical trade has asymmetrical outcomes—it’s win-lose, not win-win.
Trade does not always equal to growth, and free trade doesn’t always work: the benefits are smoke and mirrors when dealing with asymmetrical, yet competitive, partners.
How Does Offshore Outsourcing Impact America?
1. Offshoring Costs America Jobs
In 2015, America’s trade deficit was $736 billion, or 4% of our GDP. Since GDP is simply the total output made by America’s working population, and since 4% of America’s GDP is imported, then it follows that 4% of America’s workers are displaced by these imports.
This means roughly 6 million workers are replaced by imports.
Worse yet, this probably lowballs the actual numbers, because labor-intensive jobs are more likely to be offshored.
Looking specifically at manufacturing paints a grimmer picture.
American manufacturing contributes $2.2 trillion dollars to our economy. And since 78% of our trade deficit is in manufactured goods, this means that we’ve offshored $573 billion worth of production. That’s one-third of our manufacturing industry. Finally, since manufacturing employs 12.3 million Americans, then we know that roughly 4 million more are displaced by imports.
But it’s higher than that.
Manufacturing brings wealth into a region, and therefore supports local services and supply chains. For example, a car factory supports hairdressers and accountants, but not the other way around. This “job multiplier” has been studied extensively.
As it turns out, each manufacturing job usually supports 1.58 other service jobs. This means that since 4 million manufacturing jobs are displaced by imports, then about 6 million service jobs were also lost.
According to this method, the trade deficit costs America at least 10 million jobs.
This makes sense, especially when you consider how many Americans are truly unemployed.
And no, this job loss hasn’t been caused by automation.
Let’s stop blaming robots for inept policies.
2. Offshoring Causes Increased Income Inequality & Wage Stagnation For US Workers
Offshoring replaces demand for domestic output with demand for imports (rather than make it, we buy it). In turn, this replaces demand for domestic labor with demand for foreign labor (we hire foreigners, not Americans).
This increases income inequality because it lowers American wages.
When a business is offshored, people lose their jobs. Some of these people cannot find new work, and drop out of the labor force; the rest find other work, but usually earn less (since manufacturing jobs pay so well).
In fact, the average wage cut for a worker who lost his job in an exporting industry (America’s largest exports are manufactured goods) was 17.5% (you used to make $50,000 a year, now you make $40,000).
Additionally, people who are laid off compete with everyone else for (fewer) jobs. This shifts bargaining power from workers to employers, who can pay less to attract the same number and quality of employees.
How much are wages impacted?
From 1950 to 1973 worker’s productivity gains were reflected in wage gains on a nearly 1:1 basis (the more work you did, the more you were paid). However, since then productivity increased by 72%, but average wages stagnated.
If wages had continued to rise with productivity, the current median wage would be $33.60 an hour, as opposed to $21.00. Most of this divergence is caused by the trade deficit, although immigration (especially illegal immigration), higher taxes, and superfluous regulation also helped murder the American dream.
3. Offshoring Lowers America’s Standard Of Living
The offshoring and the attendant trade deficit also lowers most American’s standard of living by boosting foreign demand for America’s assets (this is on top of wage stagnation, of course).
Foreigners are furiously buying US stocks and property, which inflates their prices.
Most Americans are being squeezed—particularly by increasing housing costs.
In fact, the primary reason why the median household has less disposable income today than in 1985 is because the cost of housing has increased so dramatically (by a multiple of 3.5), while wages have not.
Not to mention the fact that offshoring hasn’t brought down the cost of goods, when you account for product quality. For example, household appliances are twice as expensive today as they were 40 years ago.
This is made abundantly clear in the graph below, which shows the change in US disposable income over time. You can clearly see the regression in the median, not the mean, which means that most of the gains are going to a small portion of the population.
Offshore Outsourcing Is Bad For America—We Should Invest In Ourselves
The problems America faces today are an echo of ages past—at the end of the 19th century, Britain underwent a very similar economic decline, with disastrous results.
That being said, we’re in a better position than they were, because we can learn from their mistakes.
It’s time we learned from history, and embraced the only trade policy that’s stood the test of time: economic nationalism.
You can read about it in that article, or in my book on the subject, Bobbins, Not Gold.
Bivins, Josh, and Lawrence Mishel. “Understanding the Historic Divergence Between Productivity and a Typical Worker’s Pay: why it matters and why it’s real.” Economic Policy Institute Report, 2015.
Federal Reserve Bank of St. Louis, “All Employees, Manufacturing.” Accessed Nov 20, 2016. https://fred.stlouisfed.org/series/MANEMP
Fletcher, Ian. Free Trade Doesn’t Work: What Should Replace it and Why. Washington DC: US Business & Industry Council, 2010.
Frank, Robert. “Wealthy Foreigners Bought $100 Billion in US Real Estate.” CNBC, June 22, 2015. http://www.cnbc.com/2015/06/22/wealthy-foreigners-bought-100-billion-in-us-real-estate.html
Prestowitz, Clyde V. Three Billion New Capitalists: The Great Shift of Wealth and Power to the East. New York: Basic Books, 2005.
Reinert, Eric. How Rich Countries got Rich and Why Poor Countries Stay Poor. New York: Carroll & Graf, 2007.
Townhall.com “The Major Trends in US Income Inequality Since 1947.” Accessed June 10, 2016.
United States Census Bureau. “Income and Poverty in the United States: 2014.” Accessed May 28, 2016. http://www.census.gov/library/publications/2015/demo/p60-252.html
United States Census Bureau, “Median and Average Sales Prices of New Homes Sold in the United States.” Accessed May 22, 2016. https://www.census.gov/construction/nrs/pdf/uspricemon.pdf