Vertical Offshoring with Heterogeneous Firms: a Story of Employment Inequality in Europe

Transcription

1 December 2012 Vertical Offshoring with Heterogeneous Firms: a Story of Employment Inequality in Europe Marco Antonielli Fondazione Luigi Einaudi Abstract This paper shows how in a two-countries model with heterogeneous firms vertical offshoring can raise employment inequality within sectors. The model matches the empirical findings of the heterogeneous firms literature as well as characteristics of the offshoring waves occurred between Western Europe and Central and Eastern Europe in the 2000s. I would like to thank Fondazione Einaudi for the unique opportunity of writing this work. I also wish to thank Prof. Gino Gancia, Prof. Rosario Crinò, Prof. Alessandra Bonfiglioli and Prof. Giorgio Ricchiuti for their precious suggestions 1

2 to the making of this work during my studies at Barcelona GSE. I would also like to thank Alexander Ballantyne for his accurate feedbacks to the introduction. All errors remain mine. 1 Introduction In the last thirty years the world economy has experienced economic integration between different regions and a contemporaneous increase of withincountry inequality in many countries. These phenomena have been criticized under the presumption that the benefits of economic integration are not evenly distributed among citizens. While skill-biased technological change has been recognized as the main driver of rising wage inequality in advanced countries, international trade and offshoring are lately gaining more attention. The focus has often been towards the liberalization of world trade, like the constitution of NAFTA in 1994 and of Mercosur in More recently, the integration of several Central and Eastern European countries into the European economy, fostered by accession to the European Union in the 2000s, also raises questions regarding the distribution of its benefits. Since the Hecksher-Ohlin-Samuelson theorem, the economic literature has attempted to explain how the relative wages of skilled versus unskilled labor, or the wage gap for short, could be linked across economies heterogeneous in productivity and the relative endowment of skills. In this abundant literature, a recent challenge has been posed by data regarding the performance of firms engaging in international trade and offshoring: we discovered that the heterogeneity in characteristics and dynamic behavior of firms, which are ultimately the agents trading in the real economy, can modify the predictions over the movement of the wage gap resulting from trade liberalization. Indeed, heterogeneity in productivity and skill composition of the workforce turn out to be determinants. How can offshoring within Europe be a cause of rising wage and employment inequality in all the EU countries? In this paper I develop a model matching the existing evidence on the offshoring waves of the 2000s to find an innovative answer to this question. The fundamental finding of this model is that when firms start to offshore they also expand their headquarters activities in the home country: since offshoring firms use relatively skill-intensive technologies, the demand of skills can rise in both the home and the host country. In order to guide the theoretical work, in Paragraph 1.1 I analyze the available evidence on the extent of offshoring and wages differentials in several countries within the two zones, as well as recent studies on firm-level data and behavior. The model is framed in the literature on wage inequality in Paragraph

3 FDI stock in $, billions 1.1 Firm-level productivity, wage gaps and offshoring in Europe The offshoring wave from Western to Eastern Europe started in the late 1980s but it reached a substantial dimension in the 2000s. In particular, over the late 1990s and 2000s the EU10 countries 1 attracted substantial foreign direct investment, especially from EU15 countries 2. As shown in Graph 1, the stock of FDI in Poland, Hungary and Czech Republic, the three biggest EU10 economies, more than doubled over the period and more than tripled over the period The EU15 countries firms contributed for most of the new FDI in the period, respectively 83% of the total in Poland and Czech Republic and 55% for Hungary. 3 Graph 1 Inward FDI stock in EU10 selected countries OECD data own composition World Total EU15 World Total EU15 World Total EU15 Poland Hungary Czech Republic The offshoring wave towards Eastern Europe was also significant from the perspective of Western European economies: while the total outward FDI stock of the EU15 soared between 2000 and 2008 by 2.7 times, the share of FDI stock in Poland, Hungary, Czech Republic and Slovakia rose from 2% to 5% (OECD data). The advantages of offshoring production in Central and Eastern Europe were geographical closeness, low labor costs and the presence of educated workforce (Gausellman, Kneel and Stephan, 2011). While the boom of FDI crucially characterizes an offshoring wave, the identity of the offshoring firms could be crucial to evaluate its implications on the Slovenia. 1 Cyprus, Czech Republic, Estonia, Hungary, Latvia, Lithuania, Malta, Poland, Slovakia, and 2 Austria, Belgium, Denmark, Finland, France, Germany, Greece, Ireland, Italy, Luxemburg, Netherlands, Portugal, Spain, Sweden, and UK. 3 Similar trends are observed for other EU10 countries: the FDI stock originated in the EU15 countries increased by 11 times in the Slovak Republic over the period and by 2.5 times in Estonia over the period (OECD ). 3

4 labor market (Yeaple, 2005, Altomonte, Barba Navaretti, di Mauro and Ottaviano, 2011, Pflüger, Blien, Möller and Moritz, 2012). The basic intuition is that trade and offshoring liberalizations lead to labor reallocations across firms of the same industry. As different firms may operate under different skill intensities, the relative demand for skills could shift. In literature the identity of firms is often associated with the intrinsic productivity of the firm, to which many other dimensions of firm performance are associated (e.g., size, skill and capital intensity). With respect to internationalization, the empirical literature has established that within sectors only the most productive firms engage in international trade and offshoring (see e.g. Mayer and Ottaviano, 2007). The motive is that internationalizing the firm means higher variable costs i.e. tariffs and transportation costs and higher fixed costs i.e. start up and integration costs that can be sustained only by the most productive firms (see e.g. Helpman, 2006, Antras, 2003, Greenaway and Kneller, 2007, Hayakawa, Machikita and Kimura, 2011). Starting from this fundamental observation, the performance of the offshoring firms has been empirically studied under other key dimensions: Hayakawa et al. (2011) review recent papers drawing attention to the selection into internationalization, learning (broadly defined as the causal effects of globalizing activities on productivity, p.336), and the impact of trade and investment liberalization. For the present context, the survey shows that offshoring firms tend to increase their productivity in Italy (Navaretti and Castellani, 2006) but not in France (Navaretti, Castellani and Disdier, 2010); when vertical and horizontal types of offshoring are considered separately, the results show that horizontal offshoring helps French firms learning, but vertical offshoring does not (Navaretti et al., 2010, and Hijzen, Jean and Mayer, 2006). This is the opposite of what is predicted in theory: on the one hand, vertical offshoring should decrease the total cost of production by locating tasks in countries owning a comparative advantage; on the other hand, horizontal offshoring should have an ambiguous effect as it also implies a loss of economies of scale. In addition, Castellani et al. (2008) and Hijzen et al. (2006) do not find a positive link between skill-upgrading and vertical offshoring. This result is also shared with Wagner (2011), which analyses data collected in different years ( ) from surveys about German firms in the manufacturing industry. Again, the prediction is different: by offshoring unskilled tasks, the skill-intensity of the home production should increase. Another important finding of Wagner (2011) is that the offshoring firms are more skill-intensive than the non-offshoring firms. Therefore at present we cannot infer that offshoring spurs within firm skill-upgrading. 4

5 1.2 Wage and employment inequality in Europe The rise in wage and employment inequalities is common trend for several advanced and emerging countries in the recent past (for recent surveys, see Van Reenen, 2011, and Chusseau and Dumont, 2012). From a review of several empirical papers concerning advanced countries, Crinò (2009) concluded that the shift in the relative skilled labor demand has taken place within industries. Following this trend, skill-upgrading occurred within sectors, or even within firms. In addition, Crinò (2009) concluded that material offshoring represented one of the main causes of rising wage inequality in advanced countries in the recent past. 4 Also, integration of developing countries into the world economy has often coincided with widening wage gaps (Goldberg and Pavcnik, 2007). There is a point in which these trends show an inconsistency with the firmlevel evidence described above: we have seen that only the most skill-intensive firms offshore and within-firm skill-intensity and productivity dynamics appear not to be linked to offshoring activities. This is apparently puzzling as skill premium and employment inequality in an advanced country should respond negatively to the offshoring of the most skill-intensive production in each manufacturing towards low wage countries. Indeed, the firms keeping production at home are relatively low skilled in respect to the offshoring firms. A possible explanation could be that firms engaging in offshoring go on to skill-upgrading the activities they keep at home. However, at present no empirical study concerning European firms finds that within-firm skill-upgrading takes place in offshoring firms. 5 To explain this apparent puzzle we can compare the new evidence with the literature providing justification for the wage gap increase as caused by offshoring. The most convincing explanations follow the pioneering contribution of Feenstra and Hanson (1999). 6 In their model the final good is produced with a continuum of inputs ranked according to skill intensity; when offshoring inputs production is not prohibitively costly, the high-skilled inputs are produced in the skill-abundant country, labeled as North, and the low-skilled inputs are produced in the skill-scarce country, labeled as South. If production capacity increases in the South, also offshoring opportunities expand and new inputs in the middle of the range are relocated to the South; however, these inputs are low-skilled for the North 4 The other great cause was skill-biased technological change. 5 Bustos (2011, 2012) shows that in Argentina trade liberalization stimulated within firm skillupgrading by firms trading with abroad. 6 Notice that offshoring can raise low skilled wages in real terms, as highlighted by Grossman and Rossi-Hansberg (2006; 2008). Their analysis shows that outsourcing unskilled tasks improves the productivity of home skilled tasks to which they are complementary in production of the final good. 5

6 standards, but high-skilled for South standards, so that the wage gap rises in both countries. Whereas this is a convincing proof of how within industry wage inequality can be fostered by offshoring, the Feenstra-Hanson mechanism is rather unsatisfactory in solving our puzzle. The main reason is that in the Feentra-Hanson world the expanding offshoring opportunities affect all firms the same way while we now know that heterogeneous firms respond differently to cheaper offshoring opportunities: virtually all firms should transfer some input production abroad in the Feenstra-Hanson world, but in reality only the most productive can sustain the fixed costs of offshoring activities abroad. 7 This makes a difference for our puzzle which is based on different ex-ante skill-intensity between offshoring and nonoffshoring firms. In the original form, the Feenstra-Hanson mechanism only highlights skill-intensity across inputs and is thus silent on the solution of our puzzle. The Feenstra-Hanson mechanism could be strong enough to offset a possible downward pressure to wage inequality arising from the offshoring of skill-intensive production. Nonetheless, the within industry labor reallocations characterizing an heterogeneous firms world could still move up the relative demand of skills: competitive pressure from offshoring firms would force the least productive firms to exit, and resources would move towards the new offshoring firms, which run skillbiased technologies with respect to the least productive firms. 8 In this work I develop a theoretical mechanism that displays this result: firms from an advanced country engage in offshoring keeping at home the production of fixed services like headquarters, research & development, legal services, marketing services, while relocating the production task in a low wage emerging country. To distinguish from the Feenstra-Hanson world, the model runs under two simplifying hypotheses: first, skill intensity is correlated with firm-level productivity and not with the inputs/tasks performed (within each firm, the skill intensity is the same across fixed cost and variable cost production, as in Bernard, Redding and Schott, 2007); second, wages are exogenously determined so that the wage gap is identical in the two countries, but the advanced country has higher skilled and unskilled wages. This is the only source of ex-ante asymmetry between the two countries. 9 for this feature. 7 The Melitz model, as for example used in Grossman, Helpman, Szeidl (2006), can account 8 In consistency with the empirical findings, within the set of surviving firms the fraction of 9 In a general equilibrium model with endogenous wages, the asymmetry between advanced and emerging countries could arise from ex-ante technological backwardness of emerging countries 6

7 With firms heterogeneous in productivity, only the most productive make enough operating profits to sustain the fixed costs of offshoring. This way, an offshoring wave takes place from a reduction in offshoring fixed costs: 10 more firms in the advanced country decide to locate production in the emerging market in order to save on labor cost. These firms run skill-biased technology with respect to the other firms operating in the emerging country. 11 Thus, the relative demand of skills in the emerging country shifts up. As wages are given, within-industry skillintensity increases in the emerging country. In the advanced country three factors contribute to the movement of the relative demand of skills: firstly, offshoring skill-biased production tends to decrease the relative demand of skills, that would be a formalization of our puzzle; secondly, also the reduction in fixed cost production by already offshoring firms tends to decrease the relative demand of skills; thirdly, the new offshoring firms get more labor to work in the fixed cost production, thus boosting up the relative demand of skills. I show that the third component can offset the other two and lead to an increase in the demand of skills, and thus also the within-industry skill-intensity. Notice that offshoring does not cause the share of firms using skill-biased technology to rise. The attention towards micro-mechanisms influencing wage and employment inequality is a promising avenue for research, as pointed out by Chausseau and Dumont (2012), and Burstein and Vogel (2010). The most closely related paper is Bustos (2011a) which studies how skill-upgrading raises the wage gap in Argentina as a result of trade liberalization. From that work, I borrow the idea that firms introduce a skill-biased technology because it augments firm level productivity; this way the share of firms using a skill-biased technology is endogenously determined. In Bustos (2011a) this share increases, while in my model it does not change with a reduction of the offshoring costs. firms. With identical relative endowments of skilled versus unskilled labor, also the wage gaps would be identical, and the working of the model would be maintained (Bernard, Redding, and Schott, 2007). 10 In the light of the European case, these lower costs can be interpreted as savings in managerial, legal and financial costs as well as reduction in the riskiness of investing in Central and Eastern Europe country. The process of accession to the EU permitted to Western Europe firms to spread in an investment-friendly Eastern Europe. 11 Notice that firms born in the emerging country never offshore as they would incur in higher variable cost, i.e. labor, whilst paying higher fixed costs. 7

8 2 Model This section presents a model that explains how a reduction in offshoring costs can raise relative demand for skills in both advanced and emerging economies. Two asymmetric countries trade differentiated goods on the same industry at no cost. At the same time, an exogenous wage differential motivates offshoring of production from the high wage country to the low wage country. 2.1 Setup I consider a world with two asymmetric countries, two factors of production (skilled and unskilled labor), and a continuum of heterogeneous firms competing in one industry. Firms from both countries produce differentiated goods under increasing returns to scale à la Krugman (1979) in a monopolistically competitive market. Production entails a fixed cost and a variable cost for which firms have heterogeneous productivities. In addition, as for production technology firms face two choices: firstly, they can upgrade their default low productivity technology by introducing a high productivity skill-biased one which entails higher fixed costs as in Bustos (2011a, 2011b); secondly, they can offshore the variable cost production to the other country by paying a higher fixed cost as in Helpman, Melitz and Yeaple (2004). In both countries the wage rates are exogenously determined, i.e. at the given wages the supplies of skilled and unskilled labor are unlimited. These exogenous wages are higher in one country, hereafter labeled as advanced, and lower in the other one, hereafter labeled as emerging. This is the only source of ex-ante asymmetry. In addition, the model features a common market for goods, i.e. costless international trade. Demand structure Consumers have preferences over a continuum of horizontally-differentiated varieties within the industry. Consumers utility takes the usual CES form [ ] with an elasticity of substitution, and being the measure of existing varieties. The demand for each variety generated by these preferences is where [ ] is the price of the aggregate consumption good defined as, and is the aggregate level of spending in the integrated economy As international trade is costless, firms sell their products in the international market, which includes consumers from both countries 8

9 Entry Each firm is the monopolistic producer of one variety within the industry and uses a technology with increasing returns to scale. In order to enter the industry, firms have to pay a fixed cost which is thereafter sunk. The entry cost uses skilled and unskilled labor under the skill intensity of the default technology, following Cobb-Douglas specification: where, identifies the sunk cost, is the wage of skilled labor and is the wage of unskilled labor in the country of entry. The nationality of firms is defined before entry. Instead, upon entry each firm draws its productivity level from a Pareto cumulative distribution function with. The distribution s shape and parameter are the same in the two countries. Technology and offshoring Once new entrants have learnt about their productivity level, they can decide either to exit either to stay and produce. Firms can operate at the default technology l or upgrade to a skill-biased and more productive one h. In addition, firms can offshore production to the other country, where they can, in theory, operate with technology l or h. Accordingly, each firm faces a choice over four production strategies. The default technology consists of a variable cost and a fixed cost which use skilled and unskilled work as in Bernard et al. (2007). The idiosyncratic productivity level affects the variable cost but not the fixed cost. The resulting total cost function is: ( ) ( ) where identifies the fixed cost, are the produced quantities and and are the wages of skilled and unskilled labor in the country of entry. Accordingly, the constant marginal cost is. 9

10 Firms have the option of decreasing their marginal cost by adopting a skillbiased technology. At the same time upgrading entails higher fixed costs 13. Thus the total cost function of the skill-biased technology is: ( ) ( ) where,, and. The constant marginal cost of the skill-intensive technology is. In addition, firms have the opportunity of offshoring variable cost production in the other country. Doing so entails higher fixed costs. The total cost functions of offshoring technology l and h are respectively: ( ) ( ) where, and and are the wage of skilled labor and the wage of unskilled labor in the other country. Such a cost structure reflects the fact that offshoring firms maintain headquarters activities in the home country 14. Labor market Wages are exogenously determined outside the model. The emerging country has low skilled and unskilled wages ( and ) while the advanced country has high skilled and unskilled wages ( and ): and As for wage gaps, i.e. relative wage of skilled versus unskilled labor, I assume these are the same across countries. 15 Thus, to evaluate the effects of offshoring waves at given wage structure we can look at the relative demand of 13 Skill intensity in variable and fixed cost production is identical, as in Bernard et al. (2007). This assumption does not alter the results. 14 These activities normally include firms departments like direction, R&D, marketing etc. 15 Whereas normally the wage gap is thought to be lower in advanced countries, in this specific model this assumption is founded on three facts. 1) In Europe wage gaps are so diverse within the group of advanced countries as well as within the group of emerging country that it is not possible to establish a valid comparison. 2) If the wage gaps were different, offshoring technology l and offshoring technology h would bring different advantages on wages, while we know from the data that vertical offshoring is mostly motivated by wage differentials across countries and not within countries. 3) The simplification does not alter the results that are drawn on the relative demand of skills in each country. 10

11 skilled versus unskilled labor, which is defined at the country level. An increase in the relative demand of skills implies better employment conditions for skilled with respect to the unskilled. 16 Industry equilibrium To solve for the industry equilibrium it is sufficient to find the equilibrium in the goods market, which rules entry and exit of firms. Indeed, with exogenous wages the labor market is automatically in equilibrium, and in this sense the model delivers a partial equilibrium. Firstly, I show the pricing behavior of firms, which are the same for firms in the advanced and in the emerging country. Secondly, I derive firms behavior and industry equilibrium in the advanced country. Finally, I derive firms behavior and industry equilibrium in the emerging country. Pricing behavior When consumers have CES preferences, profit maximizing firms set a price equal to a constant markup over marginal cost. With costless trade all firms are also exporters. Then, a firm using the default technology sets a price equal to, which depends on its productivity. Instead, if the firm adopts technology h, its price will be, where is the marginal cost advantage of technology h in respect to technology l. Similarly, offshoring firms set prices equal to if using technology l, and if using the technology h, where. Accordingly, in respect to running technology l in the country of entry, offshoring the technology l has a cost advantage of, while offshoring the technology h has a cost advantage of. Since wages are different in the two countries, and wages affect pricing behavior, two ex-ante identical firms born in different countries may operate different strategies and adopt different prices. The strategy adopted by a firm is therefore affected by the country of entry. For this reason I describe firms behavior and equilibrium conditions in the two countries separately. 2.2 Firms behavior and industry equilibrium in the advanced economy The relative profitability of the four strategies determines firms behavior. Profits if using technology in the advanced country are: 16 Wages are not perfectly flexible in the real world. Focusing on relative demand of skills allows ascertaining from this issue, while acknowledging that a rise in relative demand of skills can both cause higher unemployment rates for the unskilled workers and reinforce wage inequality. 11

12 where are revenues. Profits if using technology in the developed country are: where is the constant marginal advantage of the high technology in the advanced country. Profits if offshoring technology are where is the wage differential between advanced and emerging country. Finally, profits if running technology in the emerging country are: For each productivity level, the strategies attaining the highest profits are depicted in Figure 1. The equilibrium represented in the figure mirrors the findings outlined in the introduction: within the industry firms sort in four different groups. The least productive firms cannot cover the fixed costs and exit the market. Low productivity firms ( ) produce under the default technology in the home country; medium productivity firms ( ) choose to upgrade their technology but still produce in the home country. Finally, highly productive firms produce in the host country and use the skill-biased technology. The cutoffs separating the four intervals are defined as follows: Exit cutoff: Technology adoption cutoff: Offshoring cutoff: Figure 1 Firms self selection Advanced country The marginal offshoring firm uses technology, consistently with data. For this order of cutoffs to apply in equilibrium, I need to state the conditions under which: 12

13 -, and - Offshoring technology l is always dominated by some other strategy. Exit The exit cutoff identifies the firm making zero profits. Revenues are just high enough to cover the fixed cost of the default technology. Using this definition we can obtain the following expression for revenues : Technology adoption The technology adoption cutoff is defined by ( ) Adopting technology provides firms a marginal cost advantage with respect to technology l. Thus, with elastic demand, revenues rise: the total benefit is expressed on the left-hand side of the equation above. However, upgrading technology requires higher fixed costs (the term on the right-hand side of the equation). In fact, while the fixed cost is the same for all firms, the benefit of the high technology increases with productivity. As a result, only firms with intrinsic productivity over the cutoff adopt the high technology. Using (4) and rearranging terms we can express the adoption cutoff as 17 : ( ) Offshoring The offshoring cutoff is defined as 17 In order to have firms adopting the technology we need to assume that that. 13

14 The opportunity to offshore variable production cost to the low wage emerging country provides firms a marginal cost advantage. Alike the technology adoption choice, exploiting a cost advantage raises revenues as demand is elastic (total benefit appears on the left-hand side of the equation above). However, offshoring production has higher fixed costs (on the right-hand side of the equation). While these fixed costs are the same for every firm, the benefit rises with productivity. Therefore, among the producers using technology, the most productive ones offshore production to the emerging country. Rearranging terms we obtain: ( ) ( ) Notice that in order to have, we need the following parameter restriction, obtained from the comparison of equation (5) with equation (6). ( ) Once the order of cutoffs depicted is justified, I need to give further conditions to establish that advanced country s firms do not perform technology l abroad in equilibrium. Lemma 1 states these conditions. Lemma 1 Advanced country s firms do not offshore the default technology under the following conditions: - If, then - If, then Proof see the Appendix. Industry equilibrium In an equilibrium featuring free entry in the industry, the expected value of entry must equal the sunk entry cost. The expected value of entry is the expected profitability of producing the good until death, so that the free entry condition is stated as 14

15 where is the probability of survival, are per period expected profits conditional on survival and is the per period probability of exit. Expected profits are the sum of the average profitability of each strategy multiplied by the probability of implementing the strategy: where average profits, is the fraction of firms running technology l and are their average profits, and are their is the fraction of firms running technology h and is the fraction of firms offshoring technology h in and are their average profits. Next, in order to solve for the free entry condition, we need to derive expected profits, which is done in the appendix: ( ) ( ) The model displays positive expected profits only if, assumption that is made hereafter. Plugging the solution expected profits in the free entry condition and solving for we obtain: From the definitions of the technology adoption cutoff and offshoring cutoffs in equations (5) and (6) we obtain: ( ) ( ) ( ) 15

16 2.3 Firms behavior and industry equilibrium in the emerging country Firms in the emerging economy are confronted with the same set of strategies and select the one bringing about the highest profits. Profits if adopting technology in the emerging country are: where are revenues. Profits if using technology are: where is the constant marginal cost advantage of technology h. Firms in the emerging country can decide to offshore production but in equilibrium they never do so. Indeed, offshoring to the advanced country would increase the marginal cost of each technology, while leading to higher fixed costs. Consequently, the strategy choice of firms born in the emerging country is pretty simple: exit, use technology l or use technology h. The best strategy according to productivity level is reported in Figure 2. Figure 2 Firms self selection Emerging country Least productive firms do not make enough revenues to cover the fixed costs and exit the market. Medium productivity firms ( ) use the low technology, while high productivity firms use the high technology. Such cutoffs are defined as Exit cutoff: Technology adoption cutoff: For this order of cutoffs to apply in equilibrium, I only need to state the condition under which. To find the exit and the technology adoption cutoffs we can apply the same procedures used above. Exit The exit cutoff identifies the firm making zero profits. Revenues are just high enough to cover the fixed cost of the default technology. 16

17 Using this definition we can express revenues in a comfortable form: Technology adoption The technology adoption cutoff is defined by ( ) Using technology grants firms a marginal cost advantage with respect to the default technology, while increasing its fixed costs. Exactly like for firms in the advanced country, this leads only firms with intrinsic productivity over the cutoff adopt the high technology. Rearranging terms we get to the following expression of the adoption cutoff: 18 ( ) Industry equilibrium The definition of the equilibrium is parallel to the one given for the developed country s firms: in a free entry industry, the expected profitability of entering the market equals the sunk entry cost. The condition is stated as: where is the probability of survival, are per period expected profits conditional on survival. Expected profits are the sum of the average profitability of each strategy multiplied by the probability of implementing the strategy: where are their average profits, are their average profits. is the fraction of firms using the default technology and is the fraction of firms using technology h and 18 In order to have firms adopting technology we need to assume that. 17

18 To solve for the free entry condition it is necessary to find a solution for the expected profits. Derivations are very similar to the ones detailed for the advanced country case in the appendix. ( ) for Plugging the solution expected profits in the free entry condition and solving we obtain: From the definitions of the technology adoption cutoff (12) we obtain: ( ) 2.4 Offshoring waves: effects on productivity and the labor market With the stated equilibrium cutoffs levels, I can now focus on the impact of a decline in offshoring costs on firms strategies and on the labor market. The first thing to notice is that as emerging country s firms do not engage in offshoring activities, a reduction of its costs do not alter their strategy choice Advanced economy s firms With declining offshoring fixed costs, we have two immediate effects on the advanced economy s firms: first, offshoring firms make higher profits as production levels remain constant while the fixed costs decrease; second, the profitability of the offshoring opportunity rises with respect to the other options, so that more firms choose to exploit the unaltered offshoring benefits paying the lower fixed cost. Together, these two considerations mean that expected profits upon entry are higher. Starting from this result, we can display all consequences of a reduction in offshoring costs, which is done in Proposition The missing feedback relies on the fact that profitability of entry as firm in the emerging country does not change. 18

19 All the effects stemming from a decline in offshoring costs are summarized in Proposition 1. Proposition 1. As result of a reduction in offshoring costs a) the share of high technology firms decreases b) the share of low technology firms remains equal c) the share of offshoring firms increases d) expected profits upon entry rise e) the entry cutoff increases f) the technology adoption cutoff increases g) the offshoring cutoff drops. Proof See appendix. Discussion Figure 3 below displays cutoff s movements caused by a fall in offshoring fixed costs. To analyze how firms behavior changes we can look at how cutoffs move. First, the exit cutoff rises because expected profits upon entry increase ( in the figure). Given a sunk entry cost and rising expected profits from successful entry, the probability to exit must increase, hence the exit cutoff must move up 20. Second, the technology adoption cutoff follows the movement of the exit cutoffs (see equation (7)), and shifts up( in the figure). Third, the offshoring cutoff shrinks: while the exit cutoff tends to increase it (see equation (6)), the fall in the offshoring cost implies that some firms choose to switch from using technology to offshoring technology ( in the figure). Firms switching to an offshoring strategy maintain the skill-biased technology, consistently with existing data. 20 This can be interpreted as an increase in competition for entry. 19

20 Figure 3 Firms reaction to easier offshoring opportunity As the technology adoption cutoff moves exactly as the exit cutoff, the share of firms using the default technology remains constant. As a consequence, the share of firms operating the skill-biased technology, either at home or offshore, also remains constant. 21 In fact, within this group the firms below the threshold start to offshore: while remains constant, the increase in is mirrored by a symmetric fall in Labor markets effects The change in firms behavior in the advanced country causes the relative demand of skills to move in both countries. Indeed, the firms who start to offshore now employ workers in the emerging country to produce the variable cost, while they keep employing workers in the advanced country to produce the fixed cost. Given that the skill intensity of offshorers differs from the average skill intensity in both countries, the relative demand of skills must shift in both countries. Intuitively one would say that it goes down in the advanced country and goes up in the emerging one. I shall show that this is not always the case and we can have relative demand of skills rising in both countries. In order to retrieve these movements, we can start decomposing the demand of skilled and unskilled labor as sums of demands of high and low technology firms, respectively and, where,, and are the demands of unskilled and skilled labor employed by low and high technology producers, which are obtained as sums of firm-level demands. Notice that as for employer status high 21 With respect to Bustos (2011 both) the marginal user of the skill-biased technology is an international firm (exporter). In fact, her results rest on rising share of firms using the skill-biased technology. 20

21 technology firms in one country can be domestic non-offshoring firms (fixed and variable cost production), domestic offshorers (fixed cost production) or foreign offshorers (variable cost production). Instead low technology firms do not offshore so that we only observe national non-offshoring firms. Using Shephard s lemma we can derive the demands of skilled and unskilled labor at the firm-level by differentiating the total cost functions. For low technology firms these are respectively and : ( ) ( ) ( ) ( ) Hence, the relative demand of skills is constant for all low technology firms,. Similarly, high technology firms (but not offshoring) demand functions are for unskilled labor and for skilled labor: ( ) ( ) ( ) ( ) The skill intensity is also fixed for firms of this type,. Offshoring firms demand labor in both countries. Demands of skilled and unskilled labor in the home country are and : ( ) ( ) Demands of skilled and unskilled labor in the host country are and ( ) ( ) 21

22 Therefore, the skill intensity in the home country is while in the host country is. Comparing the relative demands by different types of firms, we re-discover that the skill intensity is attached to a technology as it does not change with production level, but it does change with the wage gap and the intrinsic skill bias ( and ). All high technology firms, irrespectively of the offshoring status and the kind of cost produced, operate under the same skill intensity =. To sum up, in each country the relative demand of skills for the firms using the high technology is, and for low technology firms is 22. Thus, the aggregate relative demand of skills is a weighted average of the skill intensities and, where the weights are given by the share of unskilled employment in the low and high technology firms versus total unskilled employment: The formula above shows that, at given skill intensities 23, when the share of employment in high technology firms rises, the relative demand of skill shifts upwards because the high technology is skill-biased. As in Bustos (2011a), this structure of the relative demand of skill reminds the H-O framework, where skilled and unskilled labor is employed in skill-intensive and unskill-intensive sectors and goods are traded between two countries. In our case the unskill-intensive sector is represented by the low technology firms whereas the skill-intensive sector is represented by the high technology firms, within the same industry. In addition, with costless trade, it is the offshoring activity to move the demand of labor. In next paragraphs I use changes in the ratio at the country level to explain how the relative demand of labor moves. The positive relationship can be established using eq above and skill intensities: [ ] [ ] Deriving with respect to we obtain 22 These are effectively skill intensities since wages are exogenous. 23 Skill intensities are fixed in this model because the wages are exogenous. 22

23 [ ] Advanced country s labor market effects. Workers in the advanced country are employed under the skill-biased technology by high technology firms and by offshoring firms which keep the fixed cost production at home. Thus, to obtain the demand of unemployed workers can sum firm-level demands from all high technology firms that can be grouped according to firm s strategy. Similarly, the demand of unemployed workers be found summing up the firm-level demands from low technology firms. where and are the firm-level demands of unskilled workers according to firm s strategy. Using expressions (15) (17) (19), and the equilibrium quantities we obtain the resulting relative demand of unskilled workers (derivations are detailed in the Appendix): we can ( ) ( ) ( ) When offshoring costs fall, some high technology firms start to offshore variable cost production, which tends to decrease the relative demand of skill; at the same time, the fixed cost production of these firms increase, which tends to increase the relative demand of skill. Proposition 2 states that both the movements can actually take place, depending on the model s parameters. Proposition 2. A reduction in offshoring costs causes the relative demand of skill in the advanced country - to rise if [ - to fall if [ ] ]. 23

24 Proof See Appendix. Emerging country s labor market In the emerging country, workers are employed under the skill-biased technology by domestic high technology firms and by advanced country s offshoring firms. Thus, to obtain the demand of unskilled workers by high technology firms, we can sum the firm-level demands of the two groups. Similarly, the low technology firms demand of unskilled workers of this type. Hence is the sum of all firm-level demands by firms where and are the firm-level demands of unskilled workers according to firm s strategy. Using expressions (15) (21), we obtain the resulting relative demand of unskilled workers (derivations are detailed in the Appendix): ( ) ( ( )) When offshoring costs fall, new advanced country s firms start to offshore variable cost production, which increases the relative demand of skill in the emerging country. This result is stated in Proposition 3. Proposition 3. A reduction in offshoring costs implies higher relative demand of skill in the emerging country. Proof See Appendix. 3 Conclusions Despite its potential benefits, economic integration between different areas can also create winners and losers. A debated topic concerns the presumption that the most skilled and educated workers in each country have more to gain in the process. In the recent past, a special focus has been given to economic integration 24

25 within Europe, especially to the offshoring waves between Western and Central and Eastern Europe occurred in the 2000s. In this paper it is argued that systematic differences between offshoring and non-offshoring firms can be a cause of rising inequality in both the areas. Crucially, the empirical literature has discovered that the offshoring firms operate relatively skill-intensive technologies, but also that they are not induced to upgrade skill. To match these empirical facts of the offshoring waves and illustrate the point, we have seen how, at given wages, sectoral relative employment of skilled versus unskilled workers can shift up in both an advanced country and an emerging country when vertical offshoring takes place between them. At first sight, relative employment should decrease as offshoring firms use skill-intensive production also in respect to advanced country firms. However, it is argued here that the expansion of headquarters, R&D, legal and marketing services taking place within the new offshoring firms can offset this factor and lead to an increase of the demand of skills. This expansion reflects an increase in fixed costs due to offshoring. The mechanism complements the Feenstra-Hanson s view that the relocated input productions are skill-intensive both for the advanced and the emerging country. In this work skill intensity does not vary across tasks performed within the industry but only across firms producing differentiated goods within the industry. Bibliography A. GAUSELMANN, M. KNELL, J. STEPHAN, What drives FDI in Central Eastern Europe? Evidence from the IWH-FDI-Micro database, «Post Communist Economies», 2011, Vol. 23(3), pp S. R. YEAPLE, A simple model of firm heterogeneity, international trade, and wages, «Journal of International Economics», 2005, Vol. 65, pp C. ALTOMONTE, G. BARBA NAVARETTI, F. DI MAURO, G. I. P. OTTAVIANO, Assessing competitiveness: how firm-level data can help, «Bruegel Policy Contribution», 2011, Vol. 16. M. PFLÜGER, U. BLIEN, J. MÖLLER, M. MORITZ, Labor market effects of trade and FDI: recent advances and research gaps, IZA-Discussion paper no. 5385, 2012, Institute for the Study of Labor, Bonn. T. MAYER, G. I. P. OTTAVIANO, The happy few: the internationalisation of European firms, «Intereconomics: Review of European Economic Policy», 2008, Vol. 43(3), pp

26 E. HELPMAN, Trade, FDI, and the organization of firm, «Journal of Economic Literature», 2006, Vol. 44, pp P. ANTRÀS, Firms, contracts, and trade structure, «Quarterly Journal of Economics», 2003, Vol. 118(4), pp P. ANTRÀS, E. HELPMAN, Global sourcing, «Journal of Political Economy», 2004, Vol. 112(3), pp D. GREENAWAY, R. KNELLER, Firm heterogeneity, exporting and foreign direct investment. «Economic Journal», 2007, Vol. 117(517), pp K. HAYAKAWA, T. MACHIKITA, F. KIMURA, Globalization and productivity: a survey of firm-level analysis, «Journal of Economic Surveys», 2012, Vol. 26(2), pp G. BARBA NAVARETTI, D. CASTELLANI, Investments abroad and performance at home: evidence from Italian multinationals, CEPR Discussion Paper 4284, G. BARBA NAVARETTI, D. CASTELLANI, A. DISDIER, 2010 How does investing in cheap labour countries affect performance at home? Firm-level evidence from France and Italy, «Oxford Economic Papers», 2010, Vol. 62(2), pp A. HIJZEN, S. JEAN, T. MAYER, The effects at home of initiating production abroad: evidence from matched French firms, «Review of World Economics» 2011, Vol. 147, pp J. WAGNER, Offshoring and firm performance: self-selection, effects on performance, or both?, Review of World Economics, 2011, Vol. 147, pp J. VAN REENEN, Wage inequality, technology and trade: 21st century evidence, CEP Occasional Paper, No. 28, N. CHUSSEAU, M. DUMONT, Growing income inequalities in advanced countries, ECINEQ Working Paper Series, No , R. CRINÒ, Offshoring, multinationals and labour market: a review of the empirical literature, «Journal of Economic Surveys», 2009, Vol. 23(2), pp R. C. FEENSTRA, G. H. HANSON, The impact of outsourcing and hightechnology capital on wages: estimates for the United States, , «Quarterly Journal of Economics», 1999, Vol. 114(3), pp R. C. FEENSTRA, G. H. HANSON, Foreign investment, outsourcing and relative wages, in R. C. Feenstra, G. M. Grossman, D. A. Irwin, eds., The political economy of trade policy: papers in honor of Jagdish Bhagwati, MIT Press, 1996, pp

27 P. K. GOLDBERG, N. PAVCNIK, Distributional effects of globalization in developing countries, «Journal of Economic Literature», 2007, Vol. 45(1), pp G. M. GROSSMAN, E. ROSSI-HANSBERG, The rbuise of offshoring: it's not wine for cloth anymore, in The new economic geography: effects and policy implications, Federal Reserve Bank of Kansas City (ed.), Jackson Hole, 2006, pp G. M. GROSSMAN, E. ROSSI-HANSBERG, Trading tasks: a simple theory of offshoring, «American Economic Review», 2008, Vol. 98(5), pp P. BUSTOS, The impact of trade liberalization on skill upgrading evidence from Argentina, mimeo, CREI and Universitat Pompeu Fabra, 2011a. P. BUSTOS, Trade liberalization, exports, and technology upgrading: evidence on the impact of MERCOSUR on Argentinian firms, «American Economic Review», 2011b, Vol. 101, pp G. M. GROSSMAN, E. HELPMAN, A. SZEIDL, Optimal integration strategies for the multinational firm, «Journal of International Economics», 2006, Vol. 70, pp A. BURSTEIN, J. CRAVINO, J. VOGEL, Globalization, technology, and the skill premium: a quantitative analysis, NBER Working Paper No , A.B. BERNARD, S.J. REDDING, P.K. SCHOTT, Comparative advantage and heterogeneous firms, «Review of Economic Studies», 2007, Vol. 74(1), pp P. KRUGMAN, Increasing returns, monopolistic competition and international trade, «Journal of International Economics», 1979, Vol. 9(4), pp E. HELPMAN, M. J. MELITZ, S. R. YEAPLE, Export versus FDI with heterogeneous firms, «American Economic Review», 2004, Vol. 94(1), p M. J. MELITZ, The impact of trade on intra-industry reallocations and aggregate industry productivity, «Econometrica», 2003, Vol. 71(6), pp APPENDIX. Proof of Lemma 1. Offshoring the low technology is the best strategy for some firms if for a range of values of it attains the highest profits. Therefore, it is sufficient to show under which parameter restrictions this strategy attains lower profits with respect to the best equilibrium strategy for any value of, as depicted in Figure 1. The comparison with using technology is only meaningful if 27