Offshoring to a Developing Nation with a Dual Labor Market

Abstract

We present a model of offshoring of tasks to a developing nation characterized by a minimum-wage formal sector and a flexible-wage informal sector. Some offshored tasks are outsourced by the formal sector to the lower-wage informal sector. Productivity improvements in performing offshored tasks in the developing nation increase offshoring, but not necessarily formal-to-informal sector outsourcing, which can cause the developed nation's wage to fall. Productivity improvements in the developing nation's informal sector expand both offshoring and outsourcing, causing the developed nation's wage to rise. When the minimum wage is reduced in the developing nation, the developed nation's wage falls when most of the efficiency gains accrue to the informal sector.

Introduction

This article analyzes developed-to-developing nation offshoring in the presence of a dual labor-market structure in the developing nation. While the developed nation's labor market is assumed to feature flexible wages and full employment, the developing nation is characterized by a dual labor market where a formal and an informal sector coexist. While the formal sector is subject to a minimum-wage regulation, the informal sector is assumed to be able to circumvent that law or the law does not apply to it and pay a lower market-clearing wage. It is also possible that the formal sector circumvents the law by outsourcing to the informal sector or hiring informal or casual workers to perform certain tasks. Consideration of labor-­­market duality leads to some important departures from the existing literature on trade in tasks, which was pioneered by Grossman and Rossi-Hansberg (2008, GRH hereafter) among others.

As described in Bhagwati and Panagariya (2013), India has over 200 labor regulations that apply to firms in the formal sector. These regulations make labor costs higher than what they otherwise would be and adversely affect the flexibility of firms in responding to shocks. In practice, firms find ways of getting around these labor regulations by incurring some costs. For example, Ramaswamy (2003) documents that formal sector manufacturing firms in India are able to circumvent labor regulations by hiring temporary (casual) or contract workers to whom those regulations do not apply. Hasan and Jandoc (2013) show that even in large Indian manufacturing firms with employment over 200 workers, casual or contract workers constitute about 30 percent of total employment. Harris-White and Sinha (2007) provide anecdotal evidence supporting outsourcing of certain activities from formal sector to informal sector firms in India. Sundaram (2015) also provides evidence indicative of outsourcing of relatively labor-intensive activities from formal sector to informal sector firms in India. And, finally, Sundaram, Ahsan, and Mitra (2012, p. 79) provide evidence of "linkages between the formal and informal manufacturing sectors through outsourcing." In addition to the evidence for India, there is also evidence for Mexico showing that about 25 percent of employees of formal firms are informal workers; thus, formal firms are able to avoid many labor regulations (Samaniega de la Parra, 2016).

The paper by GRH is one of the first to model trade in tasks in the context of a developed nation offshoring tasks to a lower-wage nation. The paper's structure is similar to neoclassical competitive models of trade. Accordingly, as in the Heckscher-Ohlin type framework, a reduction in the cost of offshoring has a positive wage effect similar to a productivity increase. This leads to the somewhat counterintuitive result that technological improvements in offshoring that lead to more tasks being offshored can actually lead to a higher wage for labor in the developed nation. This is possible because technological improvements lead to cost savings and scale expansion, and these are reflected in a higher domestic wage at full employment. The paper by GRH focuses on the developed nation, and the nation that performs the offshored tasks is modeled simply as a nation with a fixed wage.

Bandyopadhyay et al. (2020) provide a model for the joint determination of wages in the developed (source) nation that offshores tasks and a developing (recipient) nation that completes the tasks. Within the context of this model, they derive several results that show that while a developed nation may gain from technological improvements in offshoring, the developing nation could lose if the labor-saving effect of technological improvements outweighs the scale-expansion effect. One major issue not considered by Bandyopadhyay et al. (2020) is the importance of the informal sector in developing nations. Indeed, while the formal sector can feasibly be monitored by the government, the informal sector is often out of reach of government regulations. This means that labor standards or minimum-wage laws are hard to enforce in the informal sector, which creates an incentive for firms to outsource some of their tasks to the informal sector. Keeping this duality between the formal and informal sectors in mind, we analyze how technological improvements may impact wages and employment in a simultaneous labor market equilibrium in three markets: the developed nation's labor market, the developing nation's formal sector labor market, and finally the developing nation's informal sector labor market. 

We build a model where two nations, which are small in the output market, have a bilateral offshoring relationship in the production of a manufacturing good. As in GRH, competitive firms based in the developed nation produce this good by completing a range of tasks. Some of these tasks are relatively complex and require more labor to be completed in the developing nation, so they are completed in the developed nation, where it is cheaper, while the rest of the tasks are offshored. Among the offshored tasks, intermediate-complexity tasks are completed in the developing nation's minimum-wage formal sector, while the least-complex tasks are completed in its lower-wage informal sector where it is cheaper. This second layer of task allocation is commonly referred to as "domestic outsourcing," which allows formal sector firms to circumvent the minimum wage. 

The focus of our general equilibrium model is simultaneous labor market clearing in the developed and the developing nations, where each nation has two sectors, a manufacturing sector and a numeraire agricultural (food) sector. In the developing nation, there is a dual labor market characterized by a rigid-wage formal manufacturing sector and a common flexible wage in the informal manufacturing sector and the agricultural sector. Flexible wages characterize the developed nation's labor market. The residual labor supplies of the manufacturing sectors are absorbed by the respective agricultural sectors of the two nations. We primarily analyze how the flexible wages in the two nations are affected by changes in offshoring technology and outsourcing technology. We also analyze how these factors and parametric changes affect other endogenous variables of interest, such as the levels of offshoring and outsourcing and the share of the informal sector in the developing nation's economy. 

The comparative static analysis yields some results that depart from the existing literature. For example, while a rise in offshoring productivity raises offshoring, it may reduce the developed nation's wage. This can happen because the developing nation's informal sector wage may rise through offshoring demand effects and also because of the accompanying shift of marginal tasks from the low-wage informal sector to the higher-wage formal sector. As a result, the degree of informality, given by the ratio of informal-to-formal sector manufacturing employment, may fall. Some other results are counterintuitive at first glance. For example, although increased informal sector productivity in the developing nation will raise formal-to-­­informal sector (formal-informal) outsourcing, it may reduce both the informal sector's wage and the degree of informality in the nation's manufacturing sector. Similarly, while a minimum-wage cut reduces informality, it may actually increase the informal wage.