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The Economics of Outsourcing

April 21, 2004

The latest political fallout of the current "outsourcing" debate came recently when the Bush Administration's designated "manufacturing czar" turned out to be Anthony F. Raimondo, whose "crime" was to be the head of a firm that recently opened a factory in China. The embarrassed Bushies quickly urged Raimondo to withdraw his nomination, as the Democrats (and a number of Republicans) made hay over the whole thing.

Of course, the idea that the United States needs a "manufacturing czar" continues the misguided policies that gave us a "drug czar" and, during the 1970s, an "energy czar."  (At least the first "energy czar," William Simon, had the good sense to note that the very presence of his office was counterproductive and downright dictatorial and dangerous. Subsequent "czars" have, instead, reveled in their powers and have continued the deception.)

This is not a discussion about the necessity of "czars" to guide public policy – unless the "czar" calls for laissez-faire and closes up shop. (Unfortunately, "czars" labor under the delusion, as do the political classes and the general public, that their labors are the only thing between prosperity and chaos.)

Instead, I directly address the issue of "outsourcing," from an Austrian point of view. Now, in the current political climate, "outsourcing" is bad and is blamed for unemployment and other social evils, and already Congress has jumped into the fray, framing legislation that will deny firms to do business with the federal government if the companies have invested in overseas operations that Congress deems having "cost" American jobs.

Others writers have dealt with the issue, and there is no need to repeat their arguments, as sound as they have been. What I look to do is to point out how Austrian Theory not only debunks the fallacies that the anti-outsourcing advocates have been spawning, but also points out why the process makes sense economically, and not just for the countries where the investment takes place, but also the nations where the final goods are sold.

In defending his company's decision, Raimondo declared that the goods his factory built in China were making were for sale in that country, not the United States. Those who have been beating the anti-outsourcing drum have said that "outsourcing" is harmful when a company located in one country invests in a lower-wage nation, then exports the goods manufactured there back to the home country. As Paul Craig Roberts has claimed, the problem is that whatever savings consumers might gain from the cheaper goods sold here is more than nullified by the loss of income to workers in this country who either have lost their jobs due to the "outsourcing" move or have lost potential income from the investment not made here.

This point of view, not surprisingly, has many adherents in Congress from both parties. When George W. Bush's chief economic advisor Gregory Mankiew said in testimony before Congress that the "outsourcing" practice ultimately would be good for the U.S. economy, the outrage from both Democrats and Republicans forced Mankiew to make a hasty retreat. (For example, Tennessee Republican Congressman Zack Wamp – and old friend of mine – called for Mankiew's immediate dismissal and has been at the forefront of trying to outlaw overseas investment.)

Members of Congress have no problem when firms headquartered in other countries invest in operations located in the United States. For example, Toyota, Mercedes-Benz, and Nissan, among others, have automobile manufacturing plants here, with the products not shipped back to Japan or Europe, but rather are sold in this market. If "outsourcing" were such a harmful practice, then one would expect members of Congress to be introducing bills to close down these factories. That they do not displays either total ignorance of their stated position or rank hypocrisy. I leave it to the readers to decide which is true.

One of the most important contributions made by Austrians and especially the "founder" of the AustrianSchool of Economics, Carl Menger, has been the description of how the various factors of production receive their value. The ClassicalSchool, beginning with Adam Smith, said the valuation of goods runs upward, beginning with the raw factors of land and labor, and continuing to the manufacturing of the final product that is sold to consumers.

From this point of view, the notion of "value added" at each stage of production becomes vital in describing how the final product receives its value. In this way of thinking, value is "added" whenever the factors undergo change. For example, when crude oil comes from the ground, it is in an unusable form until it goes through a refinery, where the petroleum is "cracked" and made into a number of products, from fuel oil to gasoline to an intermediate good used in the making of synthetic threads like nylon and polyester (that are intermediate products for goods as diverse as artificial turf to ready-to-wear clothing.)

Thus, the value of the final good, in this way of thinking, simply is the sum of the various valuations that are made at each production stage. Prices of goods are derived from that summation of previous prices of production. (Thus, we hear advocates of government medicine claim that marketing done by private medical firms simply "drives up" the cost of medicine. Eliminating private medicine, they argue, would lower final costs because government health care providers would not need to engage in marketing. The quality of care, they claim, ultimately would improve.)

If that description of economic processes were true, then the outsourcing critics would be correct, since they argue that whatever savings consumers might gain from cheaper products imported from "cheaper labor" countries overseas are more than offset by the losses incurred by the disappearance of the various stages of "value added."  However, there is a problem in that analysis, one that even the Classicals, including Adam Smith, recognized. It was Smith who noted that the purpose of production is consumption. To put it another way, the only way the anti-outsourcing advocates could be correct would be if production were an activity carried on for its own sake.

One of the (many) fallacies of the communist paradigm was that the centerpiece of economic society was the "worker."  As a production-oriented ideology, communism was based upon the fallacy of production itself being the ultimate purpose of economic activity. Therefore, factories were seen as the logical center for political organizing and activity; what actually was made and how it was made and the quality of the final product took second stage (actually being completely off stage) to the issue of employment – any employment. Apologists for communism in the western nations praised the fact that everyone in communist countries was assigned a job, thus eliminating dread unemployment, which leftists claim is the Achilles Heel of the capitalist system.

Menger's contribution in this particular arena of economic analysis is vital to understanding why the anti-outsourcing crowd is just plain wrong. The value of a final product did not arise from the series of "added value" that occurred at the different stages of production. Instead, the valuation of the factors of production ultimately came from the value that consumers placed upon the final product itself. To put it another way, the imputation of value did not run upward first from the factors and ultimately to the final product; instead it occurred the other way around. Consumers, through their valuation of a good, indirectly determined the value of each factor of production and each intermediate stage of manufacturing.

This insight is the antidote against the claim that "outsourcing" harms the U.S. economy. As I said in an earlier article on this subject, the anti-outsourcing advocates make the claim that the ultimate source of wealth in an economy comes from costs of production. The higher the costs, the wealthier a society becomes.

One manifestation of this fallacy is the notion that Henry Ford, when he doubled the pay to his employees at his Dearborn, Michigan, plant to $5 a day, he instantly created a consumer society. The reasoning goes as follows: Ford doubled the pay of his workers, and by doubling that pay enabled them to become "consumers" by being able to afford to "buy back" the products they were creating. (Henry Hazlitt has a wonderful criticism of the "buy back the product" fallacy in his classic Economics in One Lesson.)

Such a claim, however, is absurd, since what they are actually saying is that by doubling his labor costs, Ford was able to sell more cars. In reality, Ford increased employee pay in order to retain his workers, correctly assessing that the high costs associated with employee turnover and constant training of new employees who were not enamored by the boredom of the conveyor-belt assembly lines,  or at least not enamored with putting up with such boredom for $2.50 per day. Ford's actions ultimately lowered his total production costs, something that the "Ford created the consumer" advocates miss entirely.

Yet, there is something that is seemingly disturbing when a company closes a plant in the United States, which means layoff here, and builds a plant in another country in large part because they can make the same goods there with substantially lower labor costs. Roberts gives the example of one software firm in this country laying off employees making up to $150,000 a year and opening a new operation in India, paying those employees $20,000 (a very high salary in India). As he sees it, the value of the lost income from American software losing their jobs to lower-paid Indians is more than whatever the value that consumers save – and extra profits earned for stockholders – by having these products made more cheaply. Multiply this across an entire economy, from textiles to parts for airliners, and the result is a lower standard of living for all.

As compelling as this argument sounds – and it certainly is going to be compelling to the families of individuals who lose high-paid jobs and cannot find comparable compensation for their skills – it still is based upon the "value added," production for its own sake fallacy. Before they can make their case that the practice of outsourcing is harmful to the U.S. economy as a whole, the anti-outsourcing advocates must be able to demonstrate that the ultimate purpose of production is not consumption, but rather production itself. This is not an arbitrary claim on my part, for unless those who wish to outlaw "outsourcing" can clearly demonstrate why it is that an economy benefits from higher costs of production versus lower costs, then they have no argument at all.

The Mengarian analysis hardly begins and ends with international trade, as one can easily apply it within an economy. For example, I currently live in an area (Allegany County, Maryland) that at one time was a thriving manufacturing center. In the past 40 years, however, almost all of the manufacturing plants that employed thousands of people have closed and the population of the county has fallen substantially. Furthermore, the rate of unemployment here is relatively high and many jobs pay low wages.

When this locality was in its manufacturing heyday, places like Greenville, South Carolina, were considered backwaters of low pay and a relatively low standard of living. Today, the situation is reversed, yet I would argue that because factors of production were freely permitted to move within this country, in the end the absolute standard of living in Greenvilleand AlleganyCounty has risen.

Application of Menger's principle here is that when a less-costly way to make a good is discovered, whether it be through the application of new capital or through lower wages, then the value of the factors used for that good has changed as well. An economy cannot gain when the state attempts for force up the price of some factors so that the owners of those factors of production are able to gain an advantage. We are dealing here with the hoary fallacy of protectionism, period.

For all of the popularity of their arguments at this time – something that is being repeated by both major political parties in this current election season – the anti-outsourcing advocates have not discovered anything new. In the end, they repeat the Classical fallacy of goods deriving their value from the costs of production. Should they succeed in forcing their views into law, we can be sure that the ultimate outcome will that which befalls any society that gives into protectionism: a lower standard of living and, in the end, even more joblessness.

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William Anderson, an adjunct scholar of the Mises Institute, teaches economics at Frostburg State University. Send him MAIL. See his Mises.org Articles Archive. Comment on this article on the  blog.


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