Intermediate good sourcing, wages and inequality: From theory to evidence

• Published date: 01 November 2019
• DOI: http://doi.org/10.1111/roie.12400
• Date: 01 November 2019
• Author: Philip Luck

Rev Int Econ. 2019;27:1295–1350. wileyonlinelibrary.com/journal/roie

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1295

© 2019 John Wiley & Sons Ltd

Received: 4 December 2017

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Accepted: 29 January 2019

DOI: 10.1111/roie.12400

ORIGINAL ARTICLE

Intermediate good sourcing, wages and inequality:

From theory to evidence

PhilipLuck

Economics,University of Colorado Denver,

Denver, Colorado

Correspondence

Philip Luck, University of Colorado

Denver, 1380 Lawrence Street, suit 470,

Denver, CO 80204.

Email: philip.luck@ucdenver.edu

Abstract

This paper examines the consequences of offshoring and

outsourcing on domestic wages and wage inequality. I high-

light the role of labor market frictions in impacting firms’

outsourcing and offshoring decisions; specifically, how dif-

ferential costs of matching with workers affect the location

of production (onshore or offshore) and how differential

costs of assessing worker quality affect the ownership of

intermediate production (intra‐firm or inter‐firm). I demon-

strate how firm sourcing decisions can depend crucially on

the industry skill intensity, which reflects the importance

of worker–firm match quality, and as a result, the effect of

offshoring on domestic labor depends on occupation and

industry characteristics, as well as the ownership regime

of trade. Bringing the theory to the data I rely on plausibly

exogenous variation in the cost of inter‐ and intra‐firm off-

shoring to identify the effects of a change in each type of

offshoring on domestic wages. I find strong evidence that

the effect of offshoring on domestic wages—both on the av-

erage and on the wage distribution—is governed by the type

of offshoring (inter‐ vs. intra‐firm), the skill intensity of the

industry, and the offshorability of the occupation.

JEL CLASSIFICATION

F12; F14; F16

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LUCK

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INTRODUCTION

In recent years global supply chains have become increasingly complex, crossing the borders of both

countries and firms. Moreover, globalization of supply chains has led to rapid growth in the interna-

tional trade of intermediate goods. From 1972 to 1990, the share of imports in the total purchase of

intermediate inputs in the United States more than doubled, increasing from 5% to 11.6% (Feenstra &

Hanson, 1999) and within manufacturing industries, from 2002 to 2011, this share grew by an addi-

tional 30%.1

At the same time, the growth of multinational firms has also made intra‐firm trade an

increasingly important component of United States trade. In 2012, intra‐firm imports made up 50.3%

of the U.S.$1.13 trillion in total United States imports of goods.2

Intra‐firm imports in manufacturing

accounted for half of the overall growth of total purchase of imported intermediate inputs from 2002

to 2011, outpacing the growth of inter‐firm imports. This paper investigates how the increased access

to imported intermediate goods, sourced both from foreign affiliates and nonaffiliate, affects the be-

havior of firms and the returns to domestic labor.

I propose a model of global production wherein the incentives for firms to source intermediates

from abroad and the incentives for firms to engage in intra‐firm trade are driven by matching and

screening frictions in labor markets, which generates testable predictions regarding the impacts of off-

shoring on domestic wages and inequality. Specifically, I develop a framework for understanding how

labor market frictions affect firm sourcing and ownership decisions, and I demonstrate theoretically

and empirically how offshoring differentially affects labor depending on offshoring regime (intra‐firm

or inter‐firm trade), as well as the type of industry (skill intensive or not) and the type of occupation

(offshorable or not).

The model builds on the random search literature employed by Helpman, Itskhoki, and Redding

(2010a, 2010b), and incorporates a model of firm intermediate good sourcing similar to Antràs

and Helpman (2004, 2006). In the model, the productivity of worker–firm pairs are heterogeneous

and match specific. This fact along with firm productivity heterogeneity leads to firms screening

their workers with varying intensity and therefore hiring labor forces with different average skill.

Additionally, since the cost of screening depends on ownership, this provides incentives for firms to

take on different organizational forms. The importance of firm heterogeneity is well established in

the international trade literature, and in this paper I additionally emphasize the role that labor plays

in shaping observed dispersion in firm outcomes, which is supported by Irarrazabal, Moxnes, and

Ulltveit‐Moe (2013) who argue that worker heterogeneity is an important source of firm observed

productivity. In the theoretical model, intra‐ and inter‐firm offshoring have differential effects on

productivity, which in turn allows for differential effects on domestic wages. This model also im-

plies that offshoring has differential effects on wage inequality by affecting different parts of the

wage distribution.3

The idea that labor market frictions may motivate trade has recently gained prominence in academic

circles as well as the popular press. The New York Times recently described the role labor market

frictions play in determining the location choice of multinational firms as follows: “Apple’s executives

believe the vast scale of overseas factories as well as the flexibility, diligence and industrial skill of

foreign workers have ... outpaced their American counterparts.”4

This quote captures the motivation

for and mechanisms behind my model in two ways. First, I model the incentive to source intermediates

from abroad as driven by a lower marginal cost of filling vacancies abroad, hence a more “flexible"

workforce.5

In addition to shedding light on firm sourcing location decisions, the theoretical model

incorporates a firm’s incentive to own their intermediate goods suppliers as being driven by the im-

portance of obtaining a skilled workforce, which is easier with direct control of labor force hiring and

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LUCK

screening. However, in order to realize these lower marginal costs of hiring and screening labor, firms

must pay the higher fixed costs associated with international and internal production, respectively.6

Guided by the theoretical predictions of the model, this paper is the first to separately identify the

differential effects of intra‐ and inter‐firm offshoring on domestic earnings. Utilizing a unique dataset

that separates United States imports into related party (RP) and nonrelated party (NRP) trade flows,

along with an instrumental variables strategy to identify cost‐driven changes in intra‐ and inter‐firm

offshoring, I causally identify the effects of inter‐ and intra‐firm offshoring on domestic earnings. I

find evidence that supports the predictions of the model: the impact of offshoring on labor markets

critically depends on industry skill intensity, occupation offshorability and firm organizational form. I

find that intra‐firm offshoring has a large and positive effect on earnings of those employed in nonoff-

shorable occupations, while having a smaller, yet still positive, effect on earnings of those employed

in offshorable occupations. This difference across occupations appears to be independent of industry

skill intensity. I find that nonrelated party offshoring has a substantial negative effect on earning of

those employed in nonskill intensive industries, yet this is independent of the occupation in which a

worker is employed.

The estimated heterogeneous effect of intra‐ and inter‐firm offshoring are both statistically and

economically significant; a one standard deviation increase in intra‐firm offshoring is predicted to

increase annual earnings by as much as U.S.$15,000, while a one standard deviation increase in inter‐

firm offshoring is predicted to decrease earnings by as much as U.S.$8,000.7

This is consistent with

the model that predicts intra‐firm offshoring will be done by the most productive firms who, due in

part to labor market frictions, pay the highest wages. I find additional evidence that the effect of intra‐

firm offshoring on domestic earnings is consistent across industry groups, skill intensive vs. nonskill

intensive, however it is significantly different across occupations, offshorable vs. nonoffshorable.

Conversely, the effect of inter‐firm offshoring on earnings appears to be independent of occupational

offshorability, while depending critically on industry characteristics.

Due in part to data limitation, previous work has traditionally either focused on the effect of total

offshoring or intra‐firm offshoring on domestic labor market outcomes. The effect of total offshor-

ing on domestic earnings was first investigated by Feenstra and Hanson (1999, 1996). More recently

there have been many studies investigating the wage and employment effects of intermediate goods

trade on domestic labor Krishna and Sethupathy (2011), Geishecker (2006), Amiti and Davis (2012),

Ottaviano, Peri, and Wright (2013), and Wright (2014). Alternatively, studies such as Ebenstein,

Harrison, McMillan, and Phillips (2014) and Sly, Oldenski, and Kovak (2017) have measured off-

shoring using employment by foreign affiliates of multinational companies, which limits their analysis

to apply only to intra‐firm offshoring.8

My results reaffirm the findings of Ebenstein etal. (2014);

exposure to offshoring is dependent on occupation characteristics. Additionally, I am able to make

the future contributes to the literature by developing independent measures of intra‐ and inter‐firm

offshoring for a broad set of manufacturing industries, which allows me to demonstrate that exposure

also depends on industry skill intensity and the type of offshoring (intra‐ vs. inter‐firm). This is the

first paper to evaluate the effect of intra‐ and inter‐firm offshoring independently in a single empirical

framework. Doing so I find that the empirical model does a better job fitting the data than work that

disregards the role of ownership.

The remainder of the paper is organized as follows: Section 2 presents a model of production with

outsourcing under labor market frictions, then Section 3 introduces offshoring which allows the model

to make predictions about how offshoring affects domestic wages and wage inequality. Section 4 intro-

duces the datasets employed to test the model and develops empirical tests guided by the model, and

Section 5 summarizes my findings.