An Outsourcing Parable

Economists understand that the economy grows and wealth increases when companies "outsource" noncore tasks to lower-cost providers, even when the providers live overseas. This view may seem to defy logic, but in a dynamic economy, it makes perfect sense. Here is a simple parable that illustrates why.

Imagine I own a small workshop that produces widgets. I have just one employee — you.

I pay you \$20 per hour to make widgets for 30 hours each week. Each week, you skillfully crank out 100 widgets. Each widget contains \$2 worth of raw material.

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I also pay you \$10 per hour to enter data into a computer for 10 hours each week. This data-entry requires little skill, and the number of widgets the workshop produces doesn’t affect the amount of time that this computer work takes. Now let’s add up the costs for a week of producing widgets.

 Cost of Making 100 Widgets Per Week Item Cost 30 hours of skilled labor @ \$20/hour \$600 Material for 100 widgets @ \$2/widget \$200 10 hours of unskilled data-entry @ \$10/hour \$100 Total \$900

The total cost to make 100 widgets is \$900, or \$9 per widget.

Now let’s say a company in India is willing to do the data-entry for \$5 per hour. This changes the bottom line.

 New Cost of Making 100 Widgets Per Week Item Cost 30 hours of skilled labor @ \$20/hour \$600 Material for 100 widgets @ \$2/widget \$200 10 hours of unskilled data-entry @ \$5/hour \$50 Total \$850

My cost per widget drops from \$9 each to \$8.50 each. That’s the good news. The bad news is that I don’t need you for data-entry anymore. To make 100 widgets, you would work just 30 hours per week, and your weekly pay would fall by \$100.

Sounds like you lose, right? Not so fast.

Remember, my cost per widget has fallen from \$9 to \$8.50. Let’s say I cut my prices by 50 cents. There is more demand for \$8.50 widgets than \$9.00 ones; this is an unalterable law of economics. How much more demand depends on the particular product and market – it may be a lot, or a little. Buyers and sellers acting in free markets quickly discover the exact values of the terms in this equation.

Let’s say that in this case there is 35 percent more widget demand at the lower price. I now have orders for 135 widgets per week, rather than 100. Some of that demand might even come from the data-entry clerks in India who are now making \$5 per hour, instead of surviving on subsistence agriculture.

Now I need to boost production. Who am I going to call?

You.

Rather than having your hours cut, you are back to 40 hours per week. But, it is all skilled widget production at \$20 per hour, rather than unskilled \$10-per-hour data-entry.

 Your Income, As a Worker, Before and After Outsourcing Before Outsourcing After Outsourcing Work Income Work Income 30 hours of skilled labor @ \$20/hour \$600 40 hours of skilled labor @ \$20/hour \$800 10 hours of data-entry @ \$10/hour \$100 0 hours of data-entry - Total for 40 hours of work \$700 Total for 40 hours of work \$800

Your weekly pay rises from the previous \$700 to \$800. Assuming I keep my per-unit mark-up constant, my total profit also increases by 35 percent. One result of this is that your job just became much more secure.

Who has lost? No one. Economics is not a zero-sum game. In fact, win-win situations are the rule, not the exception.

Here’s the proof: Real incomes and living standards for all segments of our society, rich and poor, have doubled and redoubled many times during the past two centuries. This can happen only in a dynamic, win-win economy.

The example here is obviously simplified. It’s unlikely that a single worker would have his or her low-skill job outsourced and also benefit instantly from new, higher-pay work. In the real world, displaced low-skill workers may need additional training in order to take advantage of the better job opportunities created by an expanding economy. In addition, cost-savings and job displacements are rarely as dramatic as they are in this parable. They usually are smaller and affect only a few people in any given company — they happen "at the margin," as economists put it.

But in the aggregate, the process outlined above is exactly what happens when producers realize cost savings by outsourcing noncore functions. Wealth is created, and everyone’s standard of living gets even better.

People who try to stop this process do not understand that our modern economy is dynamic, not static. To the extent that they are successful in imposing coercive restrictions on the labor market and on trade, real people will have less opportunity and less income.

This is bad for us and for all of our neighbors, at home and overseas.

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Jack McHugh is a legislative analyst at the Mackinac Center for Public Policy, a research and educational institute headquartered in Midland, Mich. Permission to reprint in whole or in part is hereby granted, provided that the author and the Center are properly cited.