Foreign Outsourcing: Economic Implications and Policy Responses

^Pr^ep^ar^{ed f}^o^r^M^e^m^b^ers^an^d^Com^mⁱ^t^t^ees^of^C^ong^r^e^ss

Foreign outsourcing—the importing of some intermediate product (i.e., a portion of a final
product or some good or service needed to produce a final product) that was once produced
domestically—is not a new phenomenon, nor is it one that is economically distinct from other
types of imports in terms of its basic economic consequences. A steadily rising level of trade in
intermediate products is one of the salient characteristics of U.S. trade and world trade for the last
30 years. It has been estimated that as much as a third of the growth of world trade since 1970 has
been the result of such outsourcing worldwide. While foreign outsourcing may seem different
from traditional notions of trade in that it involves exchange of a productive resource (capital or
labor) rather than an exchange of a final good and service, the ultimate economic outcome is
exactly the same: a net increase in economic efficiency through the elimination of economic
inefficiencies that occur when countries use only the productive resources found within their
borders. This gain is not likely to be achieved, however, without causing costly disruptions for the
particular workers and sectors tied to the now-imported good.
Foreign outsourcing, trade in general, and trade deficits tend to change the composition of total
output and the composition of total employment, but it is unlikely that economy-wide they lead to
any change in the overall level of either. In some areas of the economy output falls and jobs are
destroyed, but in other areas output is increased and jobs are created. There are two
complementary reasons for this. First, the Federal Reserve using monetary policy can set the
overall level of spending in the economy to a level consistent with full employment. With
aggregate spending at the right level, full employment is possible with or without outsourcing,
trade deficits, or trade in general. Second, according to basic economic principles any increase in
the demand for an import will also lead to adjustments in the foreign exchange market that will
induce an equal increase in the demand for the country’s exports of goods or assets. The positive
stimulus to employment of the increased export of goods is direct, that of the increased export of
assets is indirect, but both tend to create jobs in other parts of the economy. Indirect evidence of
this inherent “two-way” nature of trade and that increased outsourcing over the last 30 years has
not likely led to a significant net diversion of employment or output abroad is found in the
relatively stable patterns of employment and output between the domestic parent and foreign
affiliates of U.S. multinational corporations. In addition, there is evidence of sizable foreign
outsourcing to and job creation in the United States.
The destructive aspects of foreign outsourcing are costly and distressing to those whose jobs are
lost to increased imports. Therefore, matters of efficiency and equity are intertwined and one of
the principal challenges for policymakers in the face of foreign outsourcing (and trade in general)
is to find ways to ameliorate the associated harm, without sacrificing the economy-wide gains
that such trade generates. Compensation for loss and adjustment assistance is thought by
economists to offer the best chance for securing higher economic efficiency along with
distributional equity. This report will be updated as events warrant.

Introduc tion ..................................................................................................................................... 1
Lost Jobs?........................................................................................................................................2
Evidence from U.S. Multinational Companies.........................................................................4
Evidence from International Investment Flows........................................................................5
Evidence from Employment Trends in the IT Sector................................................................6
Trade, Outsourcing, and Wages.......................................................................................................7
A Rising Level of Trade and Economic Well-Being.......................................................................9
Effects on the Export Side.........................................................................................................9
Effects on the Import Side.........................................................................................................9
Gains from Trade Over Time...................................................................................................11
The Gains from Trade, Outsourcing, and the “Product Cycle”...............................................12
Are Services Different?.................................................................................................................13
Implications for Economic Policy.................................................................................................15
Is Protection Appropriate?.......................................................................................................16
The Sectoral Burden of the Trade Deficit...............................................................................18
Under-Investment in the Economy’s Creative Powers............................................................19
Ameliorating Outsourcing’s Costs..........................................................................................21
Author Contact Information..........................................................................................................22

Foreign outsourcing—the importing of some intermediate product (i.e., a portion of a final
product or some good or service needed to produce a final product) that was once produced
domestically—is not a new phenomenon, nor is it one that is economically distinct from other
types of imports in terms of its basic economic impact. A steadily rising level of trade in
intermediate products is one of the salient characteristics of U.S. trade and world trade for the last
30 years. Lower transportation costs, improved international communication, and the reduction of
government barriers to trade have helped propel the transformation to an ever more
internationally fragmented production process in many industries. An obvious example of this is
the automobile: no matter what the nameplate, the raw materials are produced in many different
places, and parts are manufactured all over the world for final assembly often, but not always, in
the destination country. It has been estimated that as much as a third of the growth of world trade ¹
since 1970 has been the result of such outsourcing worldwide. In the United States, large shares
of both exports and imports are intermediate products. In the recent years, just the capital goods
category by itself has accounted for about 50% of nonagricultural goods exports and around 30%
of nonpetroleum goods imports. And the greatest change, for the United States has occurred on
the import side. Using capital goods as an example again, in 1970 such exports were about 40% ²
of total exports, while imports had a share of only 11%.
Outsourcing may seem different from traditional notions of trade in that it involves exchange of a
productive resource (capital or labor) rather than an exchange of a final good and service, but it
can be analyzed within the same framework as increased importing of a final product or increased
trade in general. The central economic question to be answered is whether increased foreign
outsourcing increases or decreases overall economic well-being. To answer that question will
certainly require an accounting of the deleterious effects of foreign outsourcing on domestic
workers and industries who once produced the now outsourced product, but it will also require an
accounting of the gains to domestic consumers of the now imported product as well as any
induced benefits to exporting industries. If benefits exceed costs, then measures to constrain
outsourcing will tend to reduce overall economic well-being. But even if it is clearly a “net gain”
foreign outsourcing brings into conflict the goals of increasing economic efficiency and
maintaining an equitable distribution of those gains. This intertwining of economic efficiency and
distributional equity will mean that policymakers may find it difficult to take advantage of the
increase in economic efficiency that foreign outsourcing affords without also establishing policies
to assure equitable treatment of those whose jobs are lost and whose lives are disrupted by this
market churning force.
What economic analysis also highlights is the inherent “two-way” nature of trade, including
foreign outsourcing. Something is given up and something is gained. More imports tend to beget
more exports. If there are economic reasons for U.S. firms to outsource abroad, there are likely
similar reasons for foreign firms to outsource to the United States. Jobs are created and destroyed.
What is produced and what is traded for will not be determined just by relative wages, but rather
the relative efficiency in the production of traded products. Low wages will likely attract certain
types of production. However, because of differences among countries in their capacity for

¹^Davi^d^Hu^mm^el^s,^Juⁿ^Ishⁱⁱ^,^and^Kei^M^u^Yi^,^“T^h^e^Nat^u^{re and}^G^r^o^w^t^h^o^f^V^e^rtⁱ^cal^S^p^eci^alⁱ^zatⁱ^o^{n i}ⁿ^W^o^rl^d^T^r^ad^e,^”
^J^ourⁿ^a^{l o}^f^Iⁿ^te^r^nati^oⁿ^a^{l Ec}^on^omⁱ^c^s^,^vo^l^.⁵⁴⁽^J^un^{e 20}⁰¹⁾^,^p^p^.⁷⁵^-^96.
²^P^r^e^s^ideⁿ^{ts C}^o^uⁿ^c^{il of}^Ec^o^nom^ic^A^d^vⁱ^sors,^Ec^onom^ic^Re^p^o^r^t^{of T}^h^e^Pr^e^s^ideⁿ^t⁽^F^e^b^{. 2}⁰⁰⁴⁾^,^p.⁴⁰^4.

innovation, in their technical prowess, and in their workers’ skills and productivity, there will be
many things that can be produced more efficiently in high-wage economies such as the United
States. Over time an economy’s relative advantages may change but there need be no general
deterioration in what it gains from trade.
Perhaps foreign outsourcing is now more noticed because it is occurring with rising frequency in
the service sector and adversely effecting a strata of the labor force that heretofore was more
insulated than goods producing industries from the pressures of international competition. But the
nature of the process is the same whether it is trade between individuals, regions, or countries; or
trade of final goods or services; or trade of intermediate goods and services: increased economic
well-being results from producing what one does best and trading for the rest. In this economic
framework it follows that, for the nation, trade is ultimately not about competition, rather it is a
process of mutually beneficial exchange.
As noted above and developed more fully below, the overall macroeconomic impact of foreign
outsourcing will be a net effect, involving negative and positive impulses that create and destroy
jobs. Unfortunately, there are no public data series that allows a ready tallying of the net impact ³
of foreign oursourcing on the economy. Therefore, beyond the predictions of economic theory,
analysis of this phenomenon must use indirect evidence. Since foreign outsourcing has already
occurred on a relatively large scale in the goods-producing sector of the U.S. economy, this report
takes the approach that this experience will be the best predictor of the economic effects of
outsourcing’s spread to the service sector. Further, it is assumed that the tools of economic
analysis used to isolate and evaluate these past economic effects are appropriate for judging the
probable economic effects of current and future outsourcing, wherever in the economy they might
occur.

Foreign outsourcing destroys jobs in those parts of the economy that once produced the now
imported product, but economic analysis tells us that due to off-setting employment effects in
other parts of the economy, foreign outsourcing (or imports in general) is unlikely to cause a net
loss of jobs economy-wide. A steady churning of labor markets is a normal characteristic of a
dynamic market economy like the United States. Foreign outsourcing and increased imports can
contribute to that “churning,” and in doing that can be expected to change the composition of
total output and the composition of total employment, but they do not necessarily permanently
reduce the level of either.
There are two complementary reasons for the relative steadiness of total employment and output
in the face of foreign outsourcing and other disruptive market forces. First, the Federal Reserve,
using monetary policy, can set the overall level of spending in the economy to a level consistent

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^Le^viⁿ^e^.

with full employment.⁴ While deviations from full employment can occur, a well run monetary
policy will minimize the incidence and duration of such episodes and help keep the total level of
employment high in most years with or without outsourcing, trade deficits, or trade in general. To
give some perspective on the relation between “job loss” and total employment, as well as the
potential significance of foreign outsourcing in this dynamic process, consider that in any quarter
of 2000, at the peak of the last economic expansion, with total employment at about 111 million,
gross job losses tallied between 8.5 and 9.0 million. Nevertheless, the economy at that time was
operating at the lowest rate of unemployment in 40 years. Over the whole course of that
expansion gross job loss actually rose as the unemployment rate steadily fell. But with adequate
economy-wide spending, it was possible to create job gains that more than offset job losses. In the
somewhat more tepid labor market conditions of the current economic expansion, gross job losses
per quarter between 2002 and 2005 have averaged around 7.4 million—compared with gross job
gains in this period that have averaged about 7.8 million per quarter and, as a result, led to a rise
in total employment during the 2002-2005 period. In either time period gross job losses occurred ⁵
on a scale well beyond what is currently attributed to foreign outsourcing.
Second, against the economic backdrop of adequate aggregate spending, any increase in the
purchase of imports will tend to generate an equal increase in the sale of the country’s exports of
goods or assets. This outcome follows from the fundamental economic requirement that imports
must be paid for and exports are the only means for making that payment. The export sold does
not have to be a currently produced good or service, it can also be the sale of an asset such as a
deposits in a bank account, shares of stock, bonds, or real property, but in the end when tallied
across transactions in goods and assets, a nation’s trade is always in balance in the sense that any
imbalance in goods trade must be offset by a compensating imbalance in asset trade. Both types
of export sales will have a positive effect on domestic output and employment, countering across
the whole economy the negative effect of increased imports. In short, the U.S. deficit in trade is
offset by the surplus in capital flows.
Consider, for example, a situation where a service once provided domestically is now imported
from a country such as India. Since foreign suppliers do not spend dollars, the U.S. importer will
have to buy the foreign currency needed from its foreign exchange market or pay in dollars and
let the foreign supplier buy local currency from its foreign exchange market. Either way, to
generate the foreign exchange the United States must export something. It can sell U.S. goods or
services, or it can sell U.S. assets (i.e., bank deposits, stocks, bonds, real property, etc.). The
positive stimulus of the increased export of goods is direct. When foreigners purchase U.S. goods,
U.S. output and employment rise to offset the loss of service jobs to India. If exports increase less
than the amount needed to offset jobs lost, the United States then must, in effect, borrow the
money needed to pay for the increased imports through the sale of an asset. The stimulus from an
increased export of assets is indirect. Because the sale of an asset is equivalent to an increase in

⁴^Ec^on^om^ie^s^a^l^w^a^y^s^ha^v^e^s^o^m^e^am^{ount of}^une^m^p^loy^m^eⁿ^{t. Ea}^c^h^e^c^onom^y^w^{ill te}^{nd to}^ha^v^e^a^na^tura^l^ra^te^of
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the flow of saving available to the U.S., it exerts a downward push on domestic interest rates,
stimulating interest-sensitive activities such as spending on consumer durables and residential ⁶
construction, and raising output and employment in these sectors. Therefore, whatever negative ⁷
effects increased imports have on output and employment are offset by the positive economic ⁸
effects of increased exports of goods or assets. The composition of output and employment will
change in response to these changed demands, but so long as the Federal Reserve can maintain
aggregate spending at the an appropriate level, total output and employment will not change. (As
already highlighted above, the ultimate steadiness of total employment in the face of increased
imports does not mean that there are not likely to be important short-run disruptions as displaced
workers adjust to the new market conditions; and the manner of that adjustment is likely to be an
area of pivotal importance to workers and policymakers.)
Given the typical high incidence of intermediate products in export and import flows, we will
probably find that outsourcing into and out of the United States both rise as trade increases. But
this is not a necessary condition because while all foreign outsourcing are imports not all imports
are foreign outsourcing. We might import an intermediate product and pay for it by exporting a
final product. The general impact on employment and output are the same in either case, however.
Multinational companies (MNCs) account for a very large share of the U.S. economy. In 2001,
the MNC’s domestic parents produced about 25% of U.S. gross domestic product (GDP) and
employed over 23 million workers or about 20% of the nonbank work force. MNCs are even
more important in U.S. international trade, being involved in nearly 60% of total goods exports
and about 40% of total goods imports. Because of their central economic role, if a rising level of
international trade and foreign outsourcing were diverting a large number of domestic jobs
overseas, it would be evident in the pattern of employment between the MNC’s domestic parents ⁹
and foreign affiliates. No large scale diversion of employment has occurred, however.
For the period that stretches from 1977 through 1993, MNC employment declined in both parents
and foreign affiliates and the rate of decline was faster in the latter. From 1994 to 2001, MNC
employment rose in both the parents and the foreign affiliates. This time employment in the
affiliates grew slightly faster, but not so much faster as to indicate any major shift. Be mindful

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^s^p^e^ndi^ng^be^low^w^h^a^t^{it ot}^he^r^w^is^{e w}^{ould be}^.
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^g^o^ing^to^be^f^ille^{d by}^those^w^hose^{jobs w}^e^re^de^stroy^e^{d. Se}^e^A^ndre^w^{B. Be}^rna^r^{d a}^{nd J.}^Bra^d^f^o^{rd Je}^nseⁿ^{, “}^E^x^por^te^rs,
^J^obs^{, a}ⁿ^{d W}^a^g^e^s^{in U}^.^{S. Ma}^nuf^a^c^turⁱ^ng^,”^Br^ookⁱⁿ^gs^P^ape^r^s^oⁿ^Ec^o^nom^ic^Ac^tiv^ity^:^Mi^cro^eco^no^mi^cs^{, no. 47}⁽¹⁹⁹⁵⁾^{, pp}^.
^67-¹¹^2.
⁹^Ray^m^{ond J}^.^Ma^ta^l^oni^J^r^{., “}^A^N^o^te^on^P^a^t^t^e^r^ns^of^P^r^o^duc^ti^on^aⁿ^d^E^m^plo^y^m^e^{nt by}^U^.^{S Multina}^tⁱ^ona^l^Com^p^aⁿ^ie^s^,^”
^S^u^r^{vey o}^f^C^u^rren^t^B^u^siⁿ^e^ss^{, v}^o^l.^84,^no^{. 3}⁽^M^a^r^.²⁰⁰⁴⁾^{, p}^p^.^52-⁵⁶^.

that a foreign affiliate’s employment share can increase for reasons unrelated to outsourcing and
may not reduce U.S. employment. Reasons for this would include expanding foreign markets not
easily serviced by exports, faster economic growth abroad, or lower productivity in the foreign
affiliate. That the parents in this time period were also increasing their output share suggests that
the differences in the rates of employment growth largely reflected slower productivity growth in ¹⁰
the affiliates.
The natural “two-way” nature of trade suggests that for a complete view of trade’s employment
effects we also consider the behavior of foreign MNCs in the United States. A U.S. company can
destroy jobs by diverting production abroad, but a foreign company can create jobs by diverting
production to the United States. Economic reasoning tells us that if it is more efficient to produce
some products abroad, it is also likely that it is more efficient to produce other products in the
United States. Therefore, we might expect there to be outsourcing into and out of the U.S.
economy. What we observe is that over the 1977-2001 period, employment in the U.S. by foreign
MNCs grew by 4.7 million, exceeding the 2.8 million increase in employment in the foreign ¹¹
affiliates of U.S. MNCs. Again, employment shifts can occur for reasons other than outsourcing,
but if outsourcing is a phenomenon of some significance for foreign and domestic companies,
then these data could indicate that the United States was more likely to be the destination than the
departure point for foreign outsourcing.
The flow of investment spending on plant and equipment between the United States and other
economies could also be an indirect indicator of a pattern of diversion of capacity and jobs to
foreign locations. If, because of lower labor costs or other factors, foreign locations are
increasingly the preferred site for the production of many goods and services, then we might
expect that there would also be a pronounced tendency for American companies to expand
productive capacity abroad so as to take advantage of these situations. For reasons similar to
those outlined above, foreign investment does not have to lead to a diversion of domestic
employment, but if foreign outsourcing by U.S. companies was occurring on a large scale there
might also be a skewing of foreign investment flows in the same direction. The evidence in this
regard points to a pattern of balance, not a net diversion to foreign locations.
While the image of the American company destroying jobs by closing its domestic operations in
favor of some offshore location comes quickly to mind for many people, it is an incomplete
image of what has been occurring in the U.S. economy for many years now. A more accurate
image and one wholly consistent with the typical “two-way” nature of international economic
exchange is one that also includes large inflows of foreign investment into the United States.
These types of investment flows are termed “direct investment” and their level and direction are ¹²
tallied by the U.S. Commerce Department each year. The data reveal that over the course of the

¹⁰^S^{ee Ro}^b^e^rt^L^a^w^r^en^ce,^G^l^obaliz^at^ion^an^{d Tr}ⁱ^l^ate^r^al^La^bor^M^a^r^k^e^t^s^(Ne^w^York^{: T}^h^e^T^r^ila^te^r^a^{l Com}^mⁱ^ssion,¹⁹⁹⁶⁾^;
^a^{nd “}^S^um^m^a^r^y^Esti^m^a^te^s^f^o^{r Mul}^tina^tio^na^{l Com}^p^aⁿ^ie^s,”^{BEA Ne}^w^s^{, A}^p^r^.²⁰^04.
¹¹^S^{ee M}^a^t^a^l^oⁿⁱ^op^.^ci^t^.^For^a^c^l^os^e^r^look^a^t^t^h^e^na^t^u^r^e^aⁿ^d^e^x^te^{nt of}^o^u^ts^our^cⁱ^ng^{, s}^e^e^C^R^S^R^e^por^{t R}^L³²²⁹²^,^Of^f^s^ho^ri^ng
⁽^a^.k^{.a. O}^ffs^h^o^r^e^O^u^ts^o^u^r^c^ing)^aⁿ^d^J^{ob I}ⁿ^s^e^c^u^r^ity^Am^o^{ng U}^.^{S. W}^o^r^k^e^r^s^{, by}^Lⁱ^nda^L^e^vⁱ^ne^.
¹²^For^a^m^o^r^e^e^x^te^ns^iv^e^e^x^am^ina^{tion of}^the^s^e^pa^tte^rⁿ^s^,^s^e^e^C^R^S^R^e^po^r^t^R^L³²⁴^61,^Ou^t^s^ou^rciⁿ^g^an^{d I}ⁿ^s^o^u^r^ci^ng^Job^sⁱⁿ
^t^h^{e U.}^S^.^E^c^on^o^m^{y: E}^vⁱ^d^eⁿ^{ce B}^a^se^d^on^F^o^rei^g^{n In}^vest^m^en^t^Da^t^a^,^by^J^a^m^e^s^K^.^J^a^ck^s^{on; a}^{nd C}^R^{S R}^e^p^o^r^t^R^S²¹⁸⁵^7,
^F^o^rei^g^{n Di}^rect^In^vest^m^en^{t in}^the^Unite^d^State^s^{: A}ⁿ^Ec^on^omic^An^al^y^s^is^,^b^y^Ja^{mes K.}^Jac^k^soⁿ^.

1992-2000 economic expansion, the United States increased its direct investment in the rest of the
world by $885 billion, while foreign investors increased their direct investment into this country
by $926 billion. The similar size of these flows suggests that in this time period to the extent that
such flows correlate with foreign outsourcing into and out of the United States, this country had
been as likely to be the destination of foreign outsourcing as it is the departure point. In the
current economic expansion, during the period of 2002-2004 for which data are currently
available, the pattern has changed somewhat, with the United States increasing its direct
investment in the rest of the world by about $400 billion, whereas foreign investors increased
their direct investment in the United States by about $200 billion. But as the expansion continues,
inbound direct investment will probably increase relative to outbound direct investment, in part
because growth in the United States is expected to outpace that in the rest of the world.
In addition, data for capital expenditures by U.S. multinational companies show that the shares of
such spending between the parent and the foreign affiliates have been relatively steady suggesting
no increase in preference for foreign over domestic locations for expansion of production ¹³
capacity.
A widely cited study by Forrester Resources projects that 3.3 million U.S. sector jobs will have
moved offshore by 2015. Yet, Jacob Kirkegaard of the Institute for International Economics (IIE)
has done a close examination of the employment trends since 1999 in those occupations deemed
at risk of moving offshore in the Forester study. Some of the findings of the IIE study are as
follows:
• The vast majority of the jobs lost from 2000 to 2002 in the “at risk” occupational
categories were in the manufacturing sector and losses were, therefore, more
likely the consequence of recession and productivity advance than foreign
outsourcing.
• The majority of those occupations affected by foreign outsourcing pay less than
the average U.S. wage and are as likely to face elimination through technological
advance as outsourcing.
• The IT occupations that have seen declines are concentrated in low-skill
occupations.
• High paying IT occupations have generally expanded since 1999.
• More than 70,000 computer programers have lost their jobs since 1999, but more
than 115,000 higher paid software engineers have gotten jobs since 1999.
These findings again suggest that to the extent that foreign outsourcing has affected these “at
risk” occupations, it is part of a “two-way” process involving job destruction and job creation and
that the jobs created may be better jobs than those destroyed. Therefore, while some are hurt, it is ¹⁴
not clear that the overall impact is a negative one.

¹³^Dire^c^t^inv^e^stm^e^{nt is pa}^rt^of^theⁿ^e^{t inte}^rna^tⁱ^ona^{l i}ⁿ^v^e^st^p^o^sⁱ^tⁱ^oⁿ^o^f^t^h^{e Un}ⁱ^t^e^{d S}^t^at^{es and}^t^h^e^d^a^t^a^{are avai}^l^a^b^l^{e f}^r^o^m
^U^.^{S. D}^e^pa^r^t^m^e^{nt of}^C^o^m^m^e^r^c^e^,^B^u^r^e^a^u^of^Ec^on^om^ic^Aⁿ^a^l^y^s^is^,^S^u^r^{vey o}^f^Cu^rren^t^B^u^siⁿ^e^ss⁽^J^uly²⁰⁰³⁾^.
¹⁴^J^o^hⁿ^F.^Kⁱ^r^k^e^g^a^a^r^{d, “}^O^uts^our^cⁱⁿ^g^—^Staⁱ^ns^on^the^W^h^ite^C^o^lla^r^”^p^hot^oc^opy^{, I}ⁿ^s^tit^ute^f^o^r^Iⁿ^te^rⁿ^a^t^ioⁿ^a^{l Ec}^on^om^ic^s^,
²⁰⁰^3.

Another common concern with a rising level of trade and the foreign outsourcing that
accompanies it, is the belief that it must put downward pressure on the wages of domestic
workers. Outsourcing is commonly seen as a process driven by the search by companies for low-
wage environments, that ultimately places American workers in effective competition with a vast
pool of lower-wage foreign labor, and exerts downward pressure on worker wages. This
competition, it is argued, will result in the so-called “race to the bottom” between domestic and
foreign workers.
For many, the reality of the deleterious effect of trade on wages was given credence by the
observed slowdown in the growth of real wages and the widening wage inequality between
skilled and less-skilled workers that occurred concurrently with the growth of trade over the last
25 years. Further, there are credible economic reasons that increased trade and foreign
outsourcing could have an adverse effect on the distribution of income. The adverse distributional
effect could manifest itself as a deterioration of the position of labor relative to capital and a
falling average wage, or as a deterioration of the position of one class of labor (less skilled)
relative to another (more skilled) and increased inequality of wages.
The effect of trade on wages in the U.S. economy has been the focus of numerous studies over the
last 10 years, and the conclusions that may be drawn from these efforts are as follows:
• As regards the slow growth of the average real wage from the mid1970s to the
late 1990s, increased trade is not seen as being the cause of that sluggish
performance, rather the identified reason was slow productivity growth. Labor’s
share of the economic pie was not getting smaller; the economic pie just was not ¹⁵
growing as fast. That the level of wages is most often reflective of the level of
worker productivity also explains why higher wage American workers are not
necessarily at a disadvantage to lower wage foreign workers. The critical
comparison is of unit labor costs, not of the level of wages. The high productivity
that is the basis of a high wage means that unit labor costs can be lower in the
high-wage economy than in the low-wage economy because productivity in low-
wage economies is commensurately low as well.
• As regards trade and increased wage inequality, the research indicates that trade
was a contributing factor, but a minor one, accounting for perhaps 10% to 20% of
the observed increase in wage inequality. It would seem then that from the
standpoint of the economy as a whole, trade with low-wage economies has not
triggered a “race to the bottom.”
A likely important reason for the small effect of trade on wages for the U.S. economy was that
trade with low-wage countries was still relatively small, amounting to less than 5% of GDP in

2005. In fact, among U.S. trade partners the average wage level in manufacturing relative to the ¹⁶

U.S. manufacturing wage level grew from 60% in 1975 to 76% of the U.S. level in 2000. This

¹⁵^T^h^is^c^onc^lusⁱ^on^is^a^l^s^o^c^o^nf^ir^m^e^{d by}^the^a^b^s^e^nc^e^of^aⁿ^y^de^te^rⁱ^or^a^tion^{in la}^bor^’^s^s^h^a^r^e^of^na^tio^na^{l in}^c^o^m^e^,^w^h^ic^{h ha}^s
^re^m^aⁱⁿ^ed^at^ab^ou^t⁷⁰^{% t}^h^r^o^u^gho^ut^t^h^e^p^o^s^t^-^W^o^rl^{d W}^a^{r II era.}
¹⁶^U^.^{S. D}^e^pa^r^t^m^e^{nt of}^L^a^bor^{, B}^u^r^e^a^u^of^L^a^bor^Sta^tis^tic^s^,^“^A^P^e^r^s^pe^c^t^iv^e^{on U}^.^S.^aⁿ^d^For^e^igⁿ^C^o^m^p^eⁿ^s^a^{tion C}^o^s^t^sⁱⁿ
^Ma^nuf^a^c^t^ur^ing^,^”^Moⁿ^t^h^l^{y L}^a^bo^r^R^evi^ew^,^vo^l^.¹²⁵^,^no^.⁶⁽^J^un^{e 20}⁰²⁾^,^p^p^.³⁶^-⁴⁹^.

has occurred because many trading partners who were once low-wage economies have, with open
trade and steady economic growth, become high-wage economies. As the once poor have moved
up the income ladder, they have also withdrawn from the production of goods that use low-skill
and low-wage labor intensively and these products are then imported from the newer emerging
economies. China has picked up this task, as other East Asian economies have withdrawn, and, in
turn, as these economies did when Japan shifted away from this type of production. So U.S. trade
with low-wage economies is not rising to a significant degree; rather, it is shifting location.
Economies of scale are also a factor that likely helps hold up industrial wages in the face of low-
wage foreign competition. Scale effects are thought to be a significant force in many industries
and, when present, would tend to increase worker productivity and decrease unit labor costs. It is
also possible that the increase of competition itself spurs companies to higher levels of efficiency
that also lowers unit labor costs and helps preserve a higher wage level.
Another reason for the small impact of trade on wages in the United States is that as the once
low-wage economies transform to high-wage economies, two events occur: one, they tend to
produce less of the goods typically produced by low-wage workers; and two, they tend to increase
there demand for the products produced by low-wage workers. The two effects exert upward
pressure on the wages of these workers, including any producing similar products in the United
States. This outcome is consistent with the evidence that for the United States the relative price of ¹⁷
unskilled, labor-intensive, import competing goods rose in the 1980s and 1990s.
Of course, it cannot be ruled out that if trade with relatively low-wage economies does grow in
importance, the negative effects on U.S. worker wages of such trade would grow in significance.
Yet, there is probably an upper bound to this effect, for it is possible that in the future with only
relatively moderate differences between home and foreign production costs, complete
specialization would occur. That is, the United States would no longer produce much of what is
imported from low-wage foreign economies. Since the United States would then no longer have
industries that use low-wage labor intensively, there would be no downward pressure on domestic
wages caused by such trade. To the extent that this pattern of trade allows for a fuller realization
of economies of scale and lowers product prices, domestic workers’ real wages could be
increased. The change in the location of U.S. imports from low-wage economies noted above
suggests that a sizable amount of such specialization may have already occurred. Reviewing the
period 1994 through 2003, the Council of Economic Advisors concludes that for United States the
increase in share of total U.S. imports accounted for by imports of goods from China has been
largely offset by a decrease in the share of goods imports from other Pacific Rim countries. The
value of imports from both sources has increased considerably. Still, many of the export jobs in
non-China Asia are migrating to China, so the distributional effects of this change fell on workers ¹⁸
in China and the Pacific Rim economies rather than workers in the United States.
Also we know that industries that export pay wages that are, on average, higher wages than
industries that compete with imports. Therefore, as a rising level of trade and outsourcing creates

¹⁷^J^a^g^d^is^{h B}^h^a^g^w^a^{ti a}^{nd Viv}^e^k^D^e^he^jia^{, “}^F^r^e^e^r^T^r^a^d^e^a^{nd W}^a^ge^s^—^I^s^Ma^r^x^Strⁱ^kⁱ^ng^A^g^aⁱ^n,”^{in J}^a^g^d^is^{h B}^h^a^g^w^a^{ti a}^nd
^M^a^rvin^Ko^sters,^ed^s.^,^Tr^a^d^e^a^nd^W^age^s^:^Le^v^e^{ling W}^a^ge^s^D^o^wⁿ^?⁽^W^a^s^hing^{ton: A}^E^I^P^r^e^s^s^,¹⁹⁹⁵⁾^{, p}^p^{. 3}⁶^-^75.
¹⁸^T^hⁱ^s^al^so^su^ggest^{s an}^y^rest^ri^ctⁱ^oⁿ^p^l^aced^on^Chiⁿ^{a’s i}^m^p^o^r^t^s^t^o^t^h^e^Unⁱ^t^e^d^S^t^at^{es w}^o^u^l^d^no^tⁱⁿ^{crease d}^o^m^estⁱ^c^o^u^t^pu^t^,
^r^a^the^r^{it w}^ould^inc^r^e^a^s^e^the^o^u^t^p^u^t^of^the^P^a^cⁱ^fⁱ^c^Rⁱ^m^ec^onom^ie^s^w^hos^e^e^x^por^ts^t^o^t^h^e^Uⁿ^ite^{d Sta}^t^e^s^w^{ould inc}^r^e^a^s^e^a^s
^the^y^be^c^o^m^e^a^r^e^pla^c^e^m^e^{nt f}^o^r^r^e^s^t^rⁱ^c^t^e^d^C^hⁱⁿ^e^s^e^g^oods^.^For^a^dis^c^us^sⁱ^on^of^this^aⁿ^d^othe^r^a^s^pe^c^t^s^of^tr^a^d^e^w^{ith C}^hⁱⁿ^a^,
^see^The^Ec^on^om^ic^Re^por^t^of^the^P^r^e^s^ideⁿ^t⁽^W^a^s^hing^ton:^G^P^O^,²⁰⁰⁴⁾^,^pp.⁶⁵^-⁶^{8, a}ⁿ^{d C}^R^S^R^e^por^{t R}^L³²¹⁶^5,^C^hⁱ^na'^s
^C^u^r^r^e^nc^y^:^Ec^onom^ic^I^s^s^u^e^s^an^d^O^p^tio^ns^for^U^.^S.^Tr^a^d^e^Polⁱ^c^y^{, by}^W^a^yⁿ^e^{M. Mor}^rⁱ^s^o^{n a}ⁿ^{d Ma}^r^c^L^a^bonte^.

jobs in exporting industries, and destroys jobs in import-competing industries there is a tendency
for the average industrial wage to rise. It is also useful to keep in mind that the U.S. economy is
still largely domestic in orientation, with perhaps as much as two-thirds of the labor force
working and having wages determined in activities largely unaffected by trade.

For the economist, the central economic question to be answered in regard to foreign outsourcing,
or increased international trade in general, is not its particular impacts on employment or wages.
Those effects are not to be ignored, but they are symptoms of a larger process. The answer
economic analysis attempts to provide is whether that larger process ultimately makes the United
States richer or poorer. As economic growth abroad expands the number of competitive sources
of production, will substituting foreign for domestic output generate gains from trade and raise
overall economic well-being? Whether such foreign outsourcing is occurring in the service
producing sector or the goods producing sector, there will be the same array of possible positive
and negative effects on the economy. Because importing must be accompanied by exporting, the
possible effects on the economy can be grouped into two general categories: economic effects
related to exporting and economic effects related to importing.
• If increased foreign production is of goods that the United States also exports
then domestic exporters will face more competition and their product prices will
fall. A fall of export prices raises the effective cost of imports and decreases our
gains from trade.
• Rising foreign production also raises income of foreign producers and workers.
Higher income increases the demand for U.S. exports (goods or assets) and
pushes up their price. A rise of export prices lowers the effective cost of U.S.
imports and increases our gains from trade.
• Domestic households get foreign goods at a lower price. Lower prices also raise
the real income of households allowing them to purchase more of all goods.
Lower import prices increase the gains from trade.
• Domestic businesses get foreign-produced inputs at a lower price, reducing
production costs and increasing profitability. If the good the domestic firm
produces is an intermediate good itself, this effect will reverberate to other
domestic companies that use it as an input. The real income of stock-holders
increases and is a gain from trade. Increased capital inflows from increased
export of assets allows companies to undertake higher levels of investment
raising output, employment and wages. This is also a gain from trade.
• Domestic import-competing products will face more competition and their
product price will fall. Output and employment along with wages and profits in
the affected industry will likely fall. This is a cost of increased trade (and what
popular concern about foreign outsourcing most often focuses on).

The net effect of these several impacts of increased trade or outsourcing can, in theory, be
positive or negative. In most circumstances, however, the strong expectation of economists is that
gains outweigh losses and that trade’s disruptive reshuffling of the economy’s productive ¹⁹
resources does ultimately result in an increase in overall economic well-being. That increased
trade, whether for intermediate or final products, will likely raise economic well-being is ²⁰
confirmed by the preponderance of evidence.
The gains from trade are, however, most often a net gain, because some will be hurt by this
process. Trade, like other market forces, generates increased wealth through a process of
“creative-destruction” which entails what is most often a disruptive re-shuffling of workers and
capital. New opportunities for enrichment are created and resources are drawn towards them. But
other activities that are less efficient are destroyed and resources are pulled away from them.
Because there are net gains, it is also in principle possible for the losers to be compensated and
still leave the winners better off than they were prior to the increased trade. In practice, however,
there may be reason to question how equitable the compensation forthcoming is. It is likely that a
general acceptability of increased trade will hinge on this equity issue.
In most instances the crux of debates about trade are not about the value of trade to the overall
economy, but over who will receive the benefits and who will bear the costs of trade. If a U.S.
worker, without his employer’s knowledge, were able to sub-contract (out-source) his work to a
foreign worker for a fraction of his own wage he would likely do so. While still earning his full
wage, the use of his freed time in other endeavors would make him better off. His employer and
the ultimate consumers of the final product bear the cost in the form of lower profits and higher
product prices than would be the case if the most efficient way of production was used directly.
Of course, if his employer learned of the relative efficiency advantage of the foreign worker, she
would most likely contract directly with that foreign worker (outsource) and lay off the domestic
employee. The gains and costs of trade are still the same as in the first circumstance, but now they
have been redistributed to the benefit of the domestic employer and her customers and to the
detriment of the displaced employee. Economics cannot tell us which distributional outcome is
preferred, but it does tell us that outsourcing the task increases overall economic well-being.
Equity concerns notwithstanding, the expectation of enrichment though trade has propelled
successive rounds of trade liberalization in the post-war era, a process the United States has
consistently played a leadership role in sustaining. Trade has expanded rapidly as has economic
well-being of most trading nations, and the increase in well-being is found to increase with a ²¹
country’s degree of openness—the more open to trade, the greater the gain. The gains from
trade are mutual, occurring even if the trading partners have an absolute advantage or
disadvantage in the production of all traded goods and services. As such, a country does not
compete with its trading partners, it engages in mutually beneficial exchange with them.
Increased foreign outsourcing is a symptom of these expanded opportunities for trade and mutual
enrichment. As the United States has benefitted from increased trade and outsourcing associated
with the post-war industrial resurgence of Europe and Japan, so would it likely benefit through

¹⁹^T^h^e^g^a^ins^f^r^o^m^tr^a^d^e^c^aⁿ^em^e^r^g^e^f^r^o^m^c^o^m^p^a^r^a^tiv^e^a^d^v^a^nta^g^e^,^e^c^onom^ie^s^of^s^c^a^l^e^,^a^{nd i}ⁿ^d^u^c^e^m^eⁿ^ts^{to i}ⁿⁿ^o^v^a^tion
^an^d^t^h^{e gen}^e^ratⁱ^oⁿ^o^f^f^a^st^{er eco}ⁿ^o^mⁱ^c^gro^w^t^h^.^S^{ee f}^o^{r ex}^a^m^p^l^e,^M^a^{x W}^.^Co^rd^en^,^“T^h^e^No^rm^atⁱ^v^e^T^h^eo^ry^o^f
^Inte^rna^tio^na^{l T}^r^a^d^e^,^”ⁱⁿ^The^H^a^nd^book^{of I}ⁿ^te^rⁿ^atio^na^{l Ec}^o^nom^ic^s^,^v^o^{l. 1 (A}^m^s^te^rda^m^{: North Holla}ⁿ^d^{, 1}⁹⁸⁴^).
²⁰^Se^e^,^f^o^r^e^x^am^ple^,^Edw^a^r^d^{E. L}^e^am^e^r^a^{nd J}^a^m^e^s^Le^vⁱ^ns^{ohn, “}^I^nte^r^na^tio^na^{l T}^r^a^d^e^T^h^e^o^r^y^{: T}^h^e^Ev^ideⁿ^c^e^,^”ⁱⁿ^Th^e
^H^and^bo^ok^of^Iⁿ^te^rⁿ^ati^oⁿ^a^{l Ec}^oⁿ^o^m^ic^s^,^v^o^{l. 3 (}^A^m^s^te^r^d^am^{: N}^o^r^t^{h H}^o^lla^nd^{, 1}⁹⁹⁵⁾^;^aⁿ^{d J}^e^f^f^e^r^y^Fr^a^nke^{l a}^{nd D}^a^vⁱ^d
^Ro^m^e^r,^D^o^e^s^Tr^ade^C^aus^e^G^r^ow^t^h^?^{, N}^a^ti^ona^{l B}^u^r^e^a^u^of^Ec^onom^ic^R^e^s^e^a^r^c^h^{, W}^o^r^k^ing^P^a^pe^rⁿ^o^.⁵⁴^{76, J}^une¹⁹^99.
²¹^S^{ee f}^o^{r exa}^m^p^l^e,^Ch^arl^e^{s I.}^Joⁿ^e^s,^Iⁿ^tr^o^duc^tⁱ^oⁿ^to^Ec^o^nom^ic^G^r^ow^t^h⁽^N^e^w^Y^o^r^k^{: N}^o^r^t^on,¹⁹⁹⁸⁾^,^pp.¹³⁴^-¹^38.

increased trade associated with the ongoing economic development of China, India and other
emerging economies.
The gains from trade are not a static phenomenon, however. While at any point in time an
increase in trade (outsourcing) increases economic well-being, over time the size of the gain
could rise or fall as the relative economic circumstances of trading partners change. Therefore, it
can be telling of the economy’s international trade performance and its view of how it is faring
from increased trade to consider whether there has been any long-term trend in the nation’s share
of the gains from trade. More specifically, this is a question about whether, over time, the U.S.
economy’s terms of trade has tended to rise or fall as economic growth has occurred in the rest of
the world, and foreign outsourcing has grown in significance.
The terms of trade is a ratio of average export price to average import price and as such is a
measure of the export cost of acquiring imports. An increase in this ratio—an improving terms of
trade—means that any given volume of export sales will now exchange for a larger volume of
imports, indicating an increase in the gains from trade. A rising trend would indicate that a
country’s trade performance has improved relative to other trading countries, reaping an
increasing share of the gains from trade, and real income benefits for the economy. Similarly, a
decrease in the ratio of export prices to import prices—deteriorating terms of trade—raises the
export cost of acquiring imports and reduces the gains from trade. A falling trend would be
indicative of deteriorating trade performance, decreasing share of the gains from trade, and ²²
decrements to real income.
Over time it is likely that economic growth, at home and abroad, will tend to show either a bias
towards the production of goods a country exports or a bias towards production of the goods a
country imports. If export biased, there is a more then a proportionate increase in the worldwide
supply of goods that compete with U.S. exports, inducing a deterioration of the U.S. terms of
trade over time, to the benefit of our trading partners. In contrast, if growth in the rest of the
world is import biased, there is a more than proportionate increase in the worldwide supply of the
goods the U.S. imports, inducing an improvement in the U.S. terms of trade over time, to the
detriment of our trading partners.
Increased foreign outsourcing is clearly a manifestation of economic growth in the rest of the
world and in recent years this has included the expanded participation of lower income
developing economies in the internationally fragmented production processes that now propel a
large and growing share of international trade. As was discussed in the “Introduction” section of

²²^A^de^te^rⁱ^or^a^ting^te^r^m^s^of^tr^a^d^e^doe^s^{not m}^e^aⁿ^tha^t^tr^a^d^e^,^ov^e^r^a^{ll, is}^ha^r^m^f^u^{l a}^{nd tha}^t^w^e^w^ould^be^be^t^t^e^r^of^f^w^ithout
^tra^d^e^.^It^ha^{s m}^e^r^e^l^y^be^c^o^m^e^le^{ss be}^ne^fⁱ^cⁱ^a^l^{. In m}^o^{st c}ⁱ^rc^u^m^staⁿ^c^e^s^t^h^e^r^e^w^{ill be}^{no a}^b^sol^u^te^de^c^lineⁱⁿ^re^a^l^inc^o^m^e^,
^ra^the^r^the^ra^te^of^g^r^ow^{th of}^inc^o^m^e^w^{ill be}^slow^e^r^thaⁿ^{it o}^t^he^rw^ise^w^{ould ha}^v^e^be^eⁿ^{. A}^l^{so, t}^h^e^te^rm^s^of^tra^d^e^w^{ill not}
^f^u^ll^y^r^e^f^l^e^c^t^the^g^a^ins^f^r^o^m^tr^a^d^e^tha^t^c^o^m^e^f^r^om^the^r^e^a^liz^a^{tion of}^e^c^onom^ie^s^of^s^c^a^l^e^.^T^h^is^is^of^s^o^m^e^sⁱ^gⁿ^if^ic^aⁿ^c^e^f^o^r
^tr^a^d^e^be^tw^e^eⁿ^m^a^tur^e^e^c^onom^ie^s^tha^t^ha^v^e^sⁱ^m^ila^r^f^a^c^t^or^pr^op^or^ti^oⁿ^s⁽ⁱ^.e^.,^the^Uⁿ^ite^{d S}^t^a^t^e^s^{, Eur}^ope^{, J}^a^pa^{n, a}ⁿ^d
^C^a^na^da⁾^a^nd^ha^s^m^o^s^t^lik^e^l^y^s^t^e^a^d^ily^rⁱ^s^e^{n in im}^por^ta^nc^e^f^o^r^s^u^c^h^e^c^onom^ie^s^.^T^h^is^c^aⁿ^be^ta^k^e^{n a}^s^{, a}^t^le^a^s^{t, a}^pa^r^tia^l
^of^fse^t^{to a}ⁿ^y^{loss in the}^g^a^{ins f}^r^o^m^tra^d^e^indic^a^t^e^d^by^a^f^a^lling^te^r^m^{s of}^tra^d^e^.^Ne^v^e^rthe^le^ss,^m^o^v^e^m^e^{nt in t}^h^e^te^rm^{s of}
^tr^a^d^e^w^{ould s}^til^{l be}ⁱⁿ^dⁱ^c^a^tiv^e^of^c^h^aⁿ^g^e^s^{in the}^g^a^ins^f^r^om^tr^a^d^e^c^o^mⁱ^ng^f^r^o^m^rⁱ^sⁱ^ng^tr^a^d^e^w^{ith low}^w^a^g^e^ec^onom^ie^s
^tha^t^w^ould^s^till^ha^v^e^v^e^r^y^diffe^reⁿ^t^re^s^ourc^e^eⁿ^d^o^w^m^eⁿ^ts^(i.e^{., re}^la^ti^v^e^l^y^la^rge^s^upplie^s^of^low^-^s^k^{ill la}^{bor a}ⁿ^{d re}^la^tiv^e^l^y
^s^m^a^{ll supplie}^s^of^c^a^p^ita^{l a}^nd^hig^h^sk^{ill la}^bor).^{Nor w}^{ill t}^h^e^te^rm^{s of tra}^d^e^f^u^lly^re^f^l^e^c^t^the^be^ne^f^{it to c}^onsum^e^r^{s tha}^t
^c^o^m^e^f^r^o^m^a^c^c^e^s^s^{to, not}^jus^t^m^o^r^e^g^oods^,^but^a^wⁱ^de^r^v^a^rⁱ^e^t^y^of^g^oods^.

this report, foreign outsourcing is not a new phenomenon, but one that is occurring with a steadily
rising incidence in goods producing industries for the last three decades. At the peak of the last
business cycle in 2000, it is likely that a very large share of total U.S. non-agricultural
merchandise trade, exports plus imports, is of some form of intermediate product and represents ²³
some form of foreign outsourcing.
Has this increase in foreign outsourcing affected the U.S. economy’s terms of trade? Has there
been any tendency for the U.S. share of the gains from trade rise or fall as a result of outsourcing?
Relative to its peak in the mid-1960s, the terms of trade declined at about 1.0% per year through
1980. But while significant, this fall was moderate in scale. This deterioration most likely reflects
the recovery and return to competitive posture of the many high-income economies from the
devastation of World War II. These are largely economies that have resource endowments similar
to that of the United States and who with economic recovery from the war could be expected to
increasingly compete against U.S. exports in world markets. This growth was certainly export
biased and accordingly has pushed down the average price of U.S. exports.
Since the 1980s the U.S. terms of trade has fluctuated, but, overall, has not shown a trend, up or
down: up in the early 1980s, down in the late 1980s and early 1990s, and then up again through
the late 1990s to the present. It is, of course, in this more recent trendless period that the use of
foreign outsourcing was steadily climbing and the period when trade with low-income, low-wage
economies was also on the rise. Yet, the trendless path of the U.S. terms of trade over this period
suggests that these events were not inducing any significant persistent effect on the economy’s
gains from trade. Growth in the rest of the world and the outsourcing that went with it in this
period was, on balance, without a bias towards the goods the United States exports or imports. At
this point there does not seem to be a strong reason to expect the spread of outsourcing to the
service sector to change this outcome.
The idea of the product cycle provides a useful way of understanding how an economy’s gains
from trade over time emerges from a continually changing industrial landscape and how foreign
outsourcing may influence that outcome. It has been long observed by economists that the
production of many tradable products will move from country to country over the life of the ²⁴
product. Innovations have their greatest value and are more likely to occur in high-wage
economies, for the reason that labor in these countries is relatively scarce and costly and
innovations most often offer a means to economize on this expensive resource. In the early life of
a product, production occurs on a small scale using relatively high skill workers. The relatively
high price of the new product will also offer relatively high returns to the specialized capital stock
needed to produce the new product. At this stage the factor endowments of high-income countries
such as the United States will make them the most efficient location for production. As the
product matures, with expanding foreign and domestic sales, a settled technology, the capability

²³^D^u^e^{to a}^la^c^k^of^a^c^o^m^p^r^e^he^ns^iv^{e da}^ta^s^e^rⁱ^e^s^{, the}^sⁱ^z^e^of^tr^a^d^eⁱⁿ^int^e^r^m^e^d^ia^te^g^oods^is^j^udg^e^d^f^r^om^da^ta^on
^merch^aⁿ^dⁱ^{se t}^r^ad^{e b}^y^en^d^-^u^s^{e cat}^ego^r^y^w^hⁱ^c^h^d^o^e^{s i}^d^en^tⁱ^f^y^t^r^ad^{e i}ⁿ^capⁱ^t^a^l^goo^d^s^andⁱⁿ^du^st^ri^al^supp^lⁱ^e^s.^Becau^{se o}^t^h^e^r
^ty^pe^s^o^f^inte^r^m^e^d^ia^te^pr^oduc^ts^{, s}^u^c^h^a^s^a^u^tom^o^tiv^e^pa^r^t^s^a^{nd c}^o^m^pone^nts^,^a^r^eⁿ^o^t^pic^k^e^d^u^pⁱⁿ^the^s^e^t^w^{o c}^a^t^eg^or^ie^s^,^it
^is^m^o^s^t^lik^e^l^y^tha^t^s^u^c^h^aⁿ^e^s^tim^a^t^e^w^{ill unde}^rs^ta^te^the^s^c^a^l^e^of^tra^d^e^{in i}ⁿ^te^rm^e^d^ia^te^produc^ts^.^Se^e^ta^ble^B-1⁰⁴ⁱⁿ
^Ec^onom^ic^Re^por^t^o^f^t^h^e^P^r^esi^d^ent^{, Fe}^br^ua^r^y^2004.
²⁴^R^a^y^m^ond^Ve^rⁿ^oⁿ^{, “}^I^nte^r^na^ti^ona^l^Iⁿ^v^e^s^t^m^e^{nt a}^{nd I}ⁿ^te^rⁿ^a^tⁱ^ona^{l T}^r^a^d^eⁱⁿ^the^P^r^od^uc^{t C}^y^c^l^e^,^”^Q^uar^te^rly^J^ourⁿ^a^l^of
^Ec^onom^ic^s^{, v}^o^l^.^{80 (}¹⁹⁶⁶⁾^{, p}^p^.¹⁹^0-²^07.

for standardized production, and a falling market price, it will become possible and more efficient
to produce the product or significant portions of the product on a mass scale using relatively low
wage labor. At this stage in the product’s life it is likely that production will be pulled toward
economies that have resource endowments relatively rich in low-wage labor, such as China.
Foreign outsourcing, therefore, can be seen as a manifestation of this process of technological
diffusion to other economies. This process is not only relevant to the production of goods. As a
portion or all of the production of a service lends itself to standardization and international
exchange, the incentives to capture efficiency gains by moving the site of production towards
lower wage economies will increase.
In the framework of the “product cycle,” the United States is most likely to be operating at the
innovation stage of this cycle. Therefore, to a significant degree its gains from trade will be
determined by the dynamic balance between the economy’s rate of innovation and the rate of
technological diffusion. While not a necessary outcome, the rate of innovation will likely be
correlated with the growth of new ideas for products and processes in the United States, and the
rate of technical diffusion correlated with the growth of cost reducing incentives afforded by
foreign outsourcing. Unless the economy can generate a pace of innovation to match the pace of
diffusion, its terms of trade will fall, and its share of the gains from trade will decline. (Such a
decline would not be an argument for not engaging in trade as that would reduce the gains from
trade altogether, but it would be an erosion of economic well-being and explain a perception by
some that the economy is getting less out of trade then it once did. As observed above, there has
been no trend decline in the terms of trade over the last twenty years.)
It can be argued that the advance of globalization has accelerated the rate of diffusion, the
seeming rise in foreign outsourcing is a symptom of that acceleration, and the spread of
outsourcing to services is the most recent manifestation of this process. What this suggests is that
preserving or increasing the economy’s gains from trade in the face of globalization will require
an acceleration of the pace of innovation in goods and service producing activities. While market
forces may respond positively to the incentives for innovation offered by expanding trade, a case
can be made that this is an area subject to substantial market failure, and because of that the
optimal amount of innovation will not be forthcoming.
The creation of innovations is largely a process of generating new ideas. To the extent that new
ideas lead to profitable outcomes and those profits can be secured by a private enterprise, the
market economy will generate new ideas and foster technological change. An inherent attribute of
ideas, however, is that they are non-rival, as in, my using the idea does not preclude someone else
from using it. Further, ideas will often have the attribute of limited excludability, meaning the
owner of the idea will find it difficult or impossible to charge a fee for its use. These attributes
will likely cause a divergence of private benefit and social benefit in the idea production process.
(What the creator of the idea can expect to gain will be less than what the overall economy can
expect to gain.) In this situation, less than the socially desirable level of idea generation will
occur. In this circumstance public policy can improve on the free market outcome if it can foster
more idea production.

Trade in services is nothing new to the U.S. economy. In 2005, $380 billion in services were
exported, an increase of over $230 billion since 1990. Service exports now account for about 30%

of the value of all U.S. exports. And the United States has consistently run a trade surplus in ²⁵
services. That surplus stood at $58 billion in 2005, and it can be expected to grow in response to
faster economic growth abroad and a significantly more favorable exchange rate than has
prevailed in recent years. For example, Global Insight projects a U.S. services trade surplus of
over $120 billion by 2008, occurring along with a steady rise in the level (exports and imports) of ²⁶
U.S. trade in services.
In the business, professional, and technical services sub-component of U.S. services trade, an
area where outsourcing could be expected to be most likely, the U.S. had exports of nearly $62
billion against imports of about $23 billion, yielding a surplus in 2004 of about $39 billion, up
from about $16 billion in 2000. This pattern of trade makes clear the “two-way” nature of
services trade and that if the incidence of foreign outsourcing, in both directions, is proportional
to the size of export and import flows, then the U.S. is likely to have more often been the
destination rather than the departure point for the foreign outsourcing of services. This would also
suggest that the United States has a large economic stake in the rising level of services trade.
Employment data for the service sector also suggest significant economic viability. Unlike the
hard hit goods producing sector where recession and a laggard recovery have since 2000 caused
substantial employment losses, employment in service producing industries held up far better. In
that sector employment fell only about 1.0% in the 2001 recession and in contrast to the goods
producing sector, has increased employment since then so that by early 2005 the level exceeded ²⁷
the previous peak.
It is also clear, however, that until recently services had not faced the degree of international
competition that has prevailed in the goods-producing sectors. The need for more person-to-
person interaction and the relatively high cost of international communication made many
services difficult to trade. Now, however, because of the increasing ease, quality, and ever lower
cost of international communication afforded by information technology advances, the
possibilities for the trade of services have greatly expanded, and in response the level of
international competition in services is rising fast.
In this expanding arena for trade, it is likely that the United States, being the world’s largest
producer of services, will have a comparative advantage in many areas of service production, but
not all areas, and not in all aspects of the production of any given service. Therefore, more
foreign competition is likely to change the structure of many services industries. We can expect to
see a substantial increase in the share of what was once done in-house being outsourced (and
becoming a service import), as firms exploit more and more the efficiency advantages afforded by
foreign production of many standardized tasks. Likely many other tasks will be outsourced to the
United States. Again, trade and foreign outsourcing in services will, as it seems to have been in
the wider economy, likely be a “two-way” process.
What the service sector can expect from increased foreign outsourcing has already been
experienced by the manufacturing sector over the last 30 years. That sector has certainly been
greatly transformed, nevertheless manufacturing has maintained a healthy presence in the U.S.

²⁵^Se^r^v^ic^e^s^tr^a^d^e^da^ta^c^aⁿ^be^f^oun^d^{in U}^.^S^.^D^e^pa^r^t^m^e^{nt of}^C^o^m^m^e^r^c^e,^T^h^e^S^u^r^{vey o}^f^C^u^rren^t^B^u^siⁿ^e^ss^,^v^a^rⁱ^ous^is^s^u^e^s^.
²⁶^U^.^{S. Ec}^on^om^ic^O^u^tl^ook^{, G}^l^o^b^a^l^Iⁿ^si^gh^t⁽^L^exiⁿ^gt^oⁿ^:^A^p^rⁱ^l²⁰⁰⁴⁾^,^pp^.⁶⁰^-⁶⁶^.
²⁷^Se^e^B^u^r^e^a^u^of^L^a^bor^Sta^tis^tic^s^,^m^onthly^na^tiona^{l e}^m^ploy^m^e^{nt s}^u^r^v^ey^.

economy. Despite increased foreign outsourcing, through the last business cycle peak in 2000, the
manufacturing sector had
• increased real output 144% since 1970.
• maintained a relatively steady share (17%) of real final demand since the 1980s.
• Despite a declining share of the civilian workforce, maintained a relatively
steady level of employment (17 million) for the period 1980-2000.
• Received large net inflows of foreign investment.
• Increased export sales $400 billion (about 125%) between 1990 and 2000,
despite an unfavorable exchange rate during most of this period.
Since 2000, the manufacturing sector has struggled with falling output and employment.
However, most of the negative effects the U.S. manufacturing sector has endured, particularly
since 2000, are seen by economists to be the consequence of economic forces other than foreign
outsourcing and a rising level of trade. Of greatest significance are changes in consumer
expenditure patterns that place a rising importance on the consumption of services relative to
goods (a change common to most industrial economies), rapidly rising productivity (something
unambiguously good for the overall economy), and the burden of trade deficits on goods ²⁸
producing industries (distinct from the rising level of trade).

The substantive economic conclusion of this report is that foreign outsourcing is international
trade in a somewhat different guise. Like other market forces, it causes disruptions that are costly
to some, but its ultimate effect on the economy is the same as any type of trade—an increase in
overall economic well-being. Because foreign outsourcing has already occurred on a large scale
in the goods producing sectors of the economy over the last 30 years, its impacts are reasonably
evident and seem to confirm this judgement. What often seems to be missing in popular concern
over foreign outsourcing is an appreciation for the mutual or “two-way” nature of the process.
The U.S. economy outsources to foreign economies and foreign economies outsource to the U.S.
economy, jobs are created and destroyed, and overall economic welfare increases through this
exchange.
If foreign outsourcing on balance raises economic well-being, policies aimed at arresting that
activity would have a net economic cost. There are, however, other avenues for policy response
that most economists think could be generally beneficial. One avenue is to work to expand
overseas markets through further removal of foreign trade barriers against American exports. A
second avenue would be to use policy to boost the benefits of trade by correcting deficiencies in
the economy’s ability to create new products and processes that could become attractive exports.
A third avenue is to use economic policy to remove any unwarranted bias against the economy’s
tradable goods sector caused by an elevation of the incentives toward foreign outsourcing that
arise from the economic forces generating the trade deficit. A fourth avenue would be to use

²⁸^Se^e^C^R^S^R^e^por^{t R}^L³²³⁵⁰^,^D^eⁱⁿ^dus^tr^ia^liz^ati^oⁿ^of^the^U^.^{S. Ec}^on^o^m^y^:^The^Role^s^{of Tr}^ade^,^Pr^od^uc^ti^v^ity^{, an}^d
^R^ecessi^oⁿ^{, by}^C^r^aⁱ^g^K^.^Elw^e^{ll a}ⁿ^{d C}^R^S^R^e^p^o^r^t^R^L³²¹⁷^9,^M^a^nu^fa^c^t^ur^ing^Tr^e^nds^:^Lo^ng-^Te^r^m^C^onte^x^{t for}^T^o^d^a^y^’^s
^P^o^lⁱ^{cy Issu}^es^{, by}^Ste^pheⁿ^C^o^one^y^,^B^e^rⁿ^a^r^{d A}^.^G^e^{lb, a}^{nd R}^obe^r^t^Pir^o^g^.

policy to address the hardships and inequities arising from trade and foreign outsourcing by
extending compensation and more effective tools for adjustment to those who are hurt by the
disruptive effects of foreign outsourcing and other market forces.
If international trade, including outsourcing, is economically enriching, using policy to arrest the
phenomenon by imposing barriers to such exchanges will prevent the nation from fully realizing
the economic gains from trade and, therefore, must reduce economic welfare. Economics has long
taught that protection of import-competing industries with tariffs, subsidies, or other devices to
shelter a domestic activity from international competition leads to an over-allocation of the
nation’s scarce resources in the protected sectors and an under-allocation of resources in the
unprotected tradable goods industries. Standard economic theory indicates that reducing the flow
of imports will also reduce the flow of exports because fewer exports are needed to pay for fewer
imports. Clearly, the exporting sector must lose as the protected import-competing (outsource-
competing) activities gain.
But more important, the overall economy that consumed the imported goods would suffer
because the more efficient production process—available through international trade—would not
be used to the optimal degree. This would increase the price and reduce the array of goods
available to the consumer from what they would otherwise be. Therefore, economic analysis
indicates that the ultimate cost of the trade barrier is not a transfer of well-being between sectors,
but a permanent net loss to the whole economy arising from the barrier’s distortion toward the
less efficient use of the economy’s scarce resources. These costs would be magnified if the
trading partners disadvantaged by these actions retaliated against U.S. exports. There is ample
evidence that the economic cost of protection is high. The U.S. International Trade Commission
has estimated the economy-wide cost of existing U.S. trade barriers to be about $12.4 billion. And
this is probably a conservative estimate, because it is difficult to fully account for the costs
associated with lost product variety and productivity. Therefore the full cost of protection is ²⁹
thought by economists to likely be significantly higher than that estimate. A study by Hufbauer
and Eliott found that across 21 industries the economic cost per protected job ranged from
$100,000 to more than $1million and averaged about $170,000. In each case the cost of
protection was far higher than the protected workers average annual earnings and far higher than ³⁰
what any likely worker adjustment program would cost.
A 2004 study of eight industrial nations, including the United States, provides estimates of the ³¹
economic cost of existing trade barriers. It was found that despite considerable lowering of trade
barriers during the period after World War II, sizable barriers still existed (in 1999). It was also
found that removal of the remaining trade barriers among these eight countries would lead to an
increase in global GDP of more than $500 billion (in 1997 dollars), or 2.1% of global GDP. The
gain to the United States alone was estimated to be about $77 billion (in 1997 dollars), or about

1% of GDP. Highlighting the greater gain associated with a multilateral lowering of trade barriers,

²⁹^S^{ee U.}^S^.^Iⁿ^t^e^rn^atⁱ^oⁿ^a^l^T^r^ad^{e Commi}^ssi^oⁿ^,^T^h^e^Effe^c^t^s^of^Si^gni^fic^{ant U}^.^S.^I^m^por^t^Re^s^t^r^aⁱⁿ^ts^{, Public}^a^tion
³²⁰¹⁽^Washⁱⁿ^gt^on^:¹⁹⁹⁹⁾^.
³⁰^S^{ee G}^a^r^y^Cl^y^d^{e Hu}^f^b^au^{er an}^d^Ki^m^b^erl^y^Aⁿⁿ^E^lⁱ^o^t^t^,^M^e^as^urⁱⁿ^{g t}^h^e^C^o^s^t^s^of^Pr^ote^c^tⁱ^{on i}ⁿ^t^h^e^Uⁿ^ite^d^Sta^t^e^s
⁽^W^a^s^hing^{ton: I}ⁿ^s^t^itute^f^o^r^Iⁿ^te^rⁿ^a^tiona^l^Ec^on^om^ic^s^,¹⁹⁹⁷⁾^.
³¹^Sc^{ott Bra}^d^f^o^{rd a}ⁿ^{d Ro}^be^{rt Z.}^L^a^w^r^eⁿ^c^e^,^H^a^s^G^l^ob^aliz^a^tio^{n G}^o^ne^Far^En^ou^gh^?^T^h^{e C}^o^st^o^f^F^r^ag^men^t^ed^Ma^rket^s.
⁽^W^a^s^hing^{ton: I}ⁿ^s^t^itute^f^o^r^Iⁿ^te^rⁿ^a^tiona^l^Ec^on^om^ic^s^,²⁰⁰⁴⁾^.

this study also estimated the gains to each of the eight countries if each removed their trade
barriers unilaterally. In this circumstance, the GDP increase for the United States is pared to $30
billion, or 0.4% of GDP. In general, the welfare gains to the United States are smaller then those
of the other eight countries. This is thought to occur for three reasons: (1) U.S. trade barriers were
already lower than those in the other countries; (2) trade represents a comparatively smaller share
of economic activity in the U.S. economy; and (3) because of the very large size of the U.S.
market there are increases in import prices, causing some deterioration of the terms of trade and
an associated decrement to economic welfare.
The argument may be made that some form of protection is needed to counter the unfair trade
practices of some trading partners. Such practices do occur, and in those instances some form of ³²
retaliatory policy may be appropriate. But it is very unlikely that such unfair trade practices are
the principal force driving the ongoing expansion of world trade and the associated growth of
foreign outsourcing. If most unfair trade practices were gone tomorrow, it is likely that trade
would still be rapidly rising and that most of its associated pressures and problems would still be
with us.
A more credible explanation is that the expansion of world trade is propelled by the prospect of
economic enrichment and enabled by an increasingly open world trading system that allows each
nation to use its resource endowments in more efficient ways. It is differences in those
endowments and how they are used that makes trade mutually beneficial. Yet, it is often those
differences that give rise to perceptions of unfairness. What is an acceptable or unacceptable
practice will not be considered here. But is probably unreasonable to expect our trading partners
to be identical to the United States in their economic and social practices. From an economic
perspective it makes sense that the level of labor and environmental standards would be
correlated with a nation’s level of income. At their current stage of development, many poor
countries, with very low levels of productivity, simply can not afford the economic and social
practices and institutions of a rich economy like the United States. With economic growth, which
trade helps achieve, they may be able to. This is certainly the path that today’s rich nations ³³
followed.
The clear direction of U.S. trade policy in the post-World War II era has been to reduce trade
barriers, not erect them. And it is widely recognized that this process has been beneficial to the
United States and the world economy.
With that gain will likely also come more foreign outsourcing, but we can reasonably expect that
outsourcing to the United States would also rise as exporting opportunities improve along with
importing opportunities. Given that existing foreign barriers are most often higher than existing
U.S. barriers, removing those barriers is likely to have a relatively stronger beneficial effect on
the United States, particularly since many of the remaining barriers are against trade in services,
an area where the United States is likely to be very competitive.

³²^For^a^dis^c^us^sⁱ^oⁿ^of^the^opt^io^ns^a^v^a^ila^ble^,^s^e^e^C^R^S^R^e^por^{t R}^L³²³⁷^1,^Tr^ade^Re^me^die^s^{: A}^Prime^r^{, by}^Vⁱ^vⁱ^aⁿ^C.^J^one^s^.
³³^Som^e^indus^tr^ie^s^,^or^a^t^le^a^s^{t c}^o^m^pone^nts^of^s^o^m^e^indus^tr^ie^s^,^a^r^e^v^ita^{l to}^na^tio^na^{l s}^e^c^u^r^ity^a^{nd pos}^sⁱ^bl^y^m^a^y^ne^e^d^{to be}
^insula^te^{d f}^r^om^the^vⁱ^cⁱ^ssitude^{s of}^inte^rna^tⁱ^ona^{l m}^a^rk^e^t^f^o^rc^e^s^{. T}^h^is^de^te^r^m^ina^{tion is}^be^s^t^m^a^de^{on a}^c^a^s^e^-^b^y^-^c^a^s^e^ba^sⁱ^s
^siⁿ^{ce t}^h^{e cl}^ai^mⁱ^s^m^a^d^e^b^y^m^aⁿ^y^w^h^o^d^oⁿ^o^t^m^eetⁿ^a^tⁱ^oⁿ^a^l^secu^ri^t^y^cri^t^e^ri^a.^S^u^{ch cri}^t^e^ri^{a m}^a^y^al^so^var^y^f^r^o^m^c^a^{se t}^o
^case.

Analysis indicates that trade deficits do not cause a net loss of output or employment for the
overall economy, but they do shift the composition of output and employment and that shift in
composition will have an adverse effect on some domestic industries that produce tradable goods
or services. This bias could tend to raise the incidence of foreign outsourcing.
The U.S. trade deficit has risen more or less steadily since 1992. In 2005, it had grown to a record
size of $805 billion and was equivalent to 6.4% of GDP. Trade deficits are a macroeconomic
phenomenon that reflects a short-fall of domestic saving relative to the domestic investment that
needs to be financed. (This is precisely the same thing as the economy spending beyond current
output.) This imbalance can be reconciled by a net inflow of foreign capital that acts to augment
the flow of saving available and allows the higher level of investment to occur. The capital inflow
pushes up the exchange rate which induces a like sized net inflow of goods and services—a trade
deficit. The rising exchange rate has induced this net inflow of goods by making imports more
attractive to domestic buyers and the economy’s exports less attractive to foreign buyers.
Domestic exporting and import competing industries will find themselves somewhat worse off as
a result. In the current context, job-creating export industries will do less of that, and a rising tide ³⁴
of imports will mean more outsourcing is occurring. This is a distributional effect, however, for
as some sectors lose others gain. The capital inflow that is the necessary counterpart of a trade
deficit serves to increase the flow of saving available to the economy and has favorable effects on
output and employment in activities typically financed by saving flows such as business
investment and residential construction.
Therefore, removing this bias against the tradable goods sectors should be judged against the
benefit to the overall economy of the capital inflow that animates this process. Most recently, the
trade deficits of the 1993—2000 period allowed the U.S. economy to undertake rates of
investment that otherwise could not have occurred. The payoff is faster economic growth. In the
1980s, however, large U.S. trade deficits were used to support public and private consumption
and arose in part from public policies that increased the federal budget deficit. In this case there is
no payoff from faster growth. It also raises the issue of whether the public policies involved were
on balance good or bad. At present, an expanding economy along with large federal budget
deficits may be a recipe for perpetuating large trade deficits more along the lines of the 1980s
experience then that of the 1990s.
If a smaller trade deficit is judged the appropriate goal, economic policy can be used to reach it. If
it is also judged prudent not to achieve this reduction at the expense of domestic investment, then
the economy’s rate of saving will have to be raised. (This is the same thing as saying the
economy’s rate of consumption will have to be reduced.) Economic policy’s ability to affect the
private saving rate is problematic, but macroeconomic policy can certainly change the public
saving rate. Government budget deficits are a subtraction from the nation’s saving and budget
surpluses are an addition to the nation’s saving. Therefore policies that move the budget away
from deficit and toward surplus, other things unchanged, will tend to reduce the trade deficit. This
will occur, of course, as a depreciating exchange rate works to change the composition of
domestic output, stimulates export sales, and dampens import spending, and in the process likely

³⁴^T^h^{e exch}^an^{ge rat}^eⁱⁿ^d^u^ced^bⁱ^{as i}^s^lⁱ^k^el^y^t^o^b^e^p^a^rtⁱ^c^u^l^arl^y^rel^e^v^aⁿ^t^w^h^en^t^h^{e d}^eci^si^on^t^o^p^r^o^d^u^{ce at}^h^o^m^{e o}^r^ab^ro^{ad i}^s
ⁿ^o^t^c^oⁿ^s^t^r^aiⁿ^e^d^b^y^t^h^{e n}^eed^f^o^{r l}^a^{rge scal}^{e c}^a^pⁱ^t^a^lⁱⁿ^vest^men^t^{s t}^h^at^{are l}^e^{ss l}ⁱ^k^el^y^t^o^b^eⁱⁿ^f^l^u^eⁿ^ced^b^y^t^h^{e m}^o^{re n}^ear-
^t^e^rm^e^ffect^{s o}^f^t^h^{e ex}^ch^an^{ge rat}^e^,^an^d^hiⁿ^g^{es l}^a^rgel^y^oⁿ^rel^a^tⁱ^v^{e l}^a^b^o^r^co^st^s.

boosts the output and employment of the U.S. tradable goods sectors.³⁵ This will not stop the rise
in the level of trade, nor eliminate outsourcing, but it can remove some of the bite of that process
on the tradable goods industries.
The presence of a market failure in idea production can be corrected by an appropriate amount of
public support for the idea creation process. Such support could include public funding of
research and development (R&D), both basic scientific research (where the prospect of market
failure is the greatest) and enterprise-specific research; public funding for investment in human ³⁶
capital, particularly education in the sciences and engineering; and public support for
mechanisms to establish and enforce property rights, such as patent and copyright administration.
The intent would be that these actions would boost the economy’s ability to create new products
and better jobs and produce a more appealing counterweight to the destructive effects of
technological diffusion and increased imports and foreign outsourcing. As jobs are destroyed by
foreign outsourcing in one part of the economy, it is hoped that the boost to the idea production
process would improve the attractiveness of U.S. exports on the world market, leading to an
acceleration of the flow of exports and foreign outsourcing into the United States, and boosting
the rate of creation of better jobs in other parts of the economy.
Of course, these are activities that the U.S. government supports now.³⁷ But the open question is
whether such support is well targeted and undertaken at an adequate scale. This is not an easy
question to answer. As regards spending on R&D by private firms, there is a considerable amount
of economic evidence that the social rate of return to R&D for a variety of research projects often
greatly exceeds the private rate of return, suggesting that too little research is being undertaken.
(At optimal scale research projects would be undertaken to the point where the social rate of
return has been pushed down to the level of private return.) By some estimates, the level of
investment undertaken by firms could be as little as 25% of the level what is economically ³⁸
optimal.
Can economic policy entice firms to increase their R&D spending? The patent system is one
manifestation of government’s attempt encourage inventive behavior by providing “property
rights” over new ideas. This is a well developed set of laws in the United States and it is

³⁵^T^h^{e t}^r^ad^{e d}^e^fⁱ^ci^t^w^o^u^l^d^b^e^redu^c^e^dⁱ^f^f^o^rei^gⁿ^l^eⁿ^d^e^{rs cu}^rt^ai^l^e^d^t^h^ei^{r accu}^m^u^l^a^tⁱ^oⁿ^o^f^U.^S^.^asset^s^.^In^t^hⁱ^s^case,
^h^o^w^ever,^t^h^ere^w^o^u^l^d^b^e^noⁱⁿ^{crease i}ⁿ^U.^S^.^saviⁿ^g^.^S^oⁱⁿ^t^hⁱ^s^ci^rcu^m^st^an^{ce t}^h^{e ad}^j^u^st^m^eⁿ^t^m^u^st^o^ccu^{r t}^h^r^o^u^g^h^hⁱ^gh^er
^dom^e^s^tic^inte^re^{st ra}^te^{s a}^{nd low}^e^{r dom}^e^s^tic^inv^e^st^m^e^{nt. T}^h^e^f^a^v^o^ra^b^l^e^e^f^f^e^c^t^of^the^sm^a^lle^{r tra}^d^e^de^fⁱ^c^{it o}ⁿ^tra^d^e
^se^nsitiv^e^se^c^t^{ors w}^{ould be}^c^o^unte^r^ba^la^nc^e^d^by^the^a^d^v^e^rse^e^ffe^c^t^{on d}^o^m^e^stic^inte^re^{st se}^nsitiv^e^se^c^t^o^r^{s. T}^h^e^dolla^r
^de^pr^e^cⁱ^a^tion^s^e^eⁿ^sⁱ^nc^e^e^a^r^ly²⁰⁰^{2 is}^m^o^s^t^lik^e^l^y^be^ing^dr^iv^eⁿ^by^a^s^h^if^{t aw}^ay^f^r^o^m^dolla^r^deⁿ^o^mⁱ^na^te^{d a}^s^s^e^ts^by
^f^o^rei^gⁿⁱⁿ^vest^o^r^s.^Becau^{se t}^h^{e ec}^onom^y^is^now^ope^r^a^ting^w^{ith c}^oⁿ^s^ide^r^a^b^le^s^l^a^c^k^{, the}^a^d^v^e^r^s^e^ef^f^e^c^t^s^of^this^c^a^p^ita^l
^outf^l^ow^ha^v^e^be^eⁿ^ne^g^lig^ible^{. F}^o^r^a^f^u^lle^r^dis^c^us^sⁱ^on^{, s}^e^e^C^R^S^R^e^p^o^r^t^R^L³¹⁰³^2,^T^h^{e U.}^S.^T^r^ad^{e Def}ⁱ^ci^t^:^Ca^u^s^es,
^C^ons^e^que^nc^e^s^{, an}^{d C}^u^r^e^s^{, by}^Craⁱ^g^K^.^Elw^e^ll.
³⁶^Ra^ising^the^sk^{ill le}^v^e^{l of}^w^o^rk^e^r^s^w^{ould a}^l^so^im^prov^e^the^f^l^e^x^ibility^o^f^the^la^{bor f}^o^rc^e^.^Ca^rry^ing^w^{ith the}^m^m^o^re^thaⁿ
^jus^t^j^{ob s}^p^e^cⁱ^fⁱ^c^s^k^ills^w^{ould f}^a^c^ilita^te^a^quic^k^e^r^a^d^jus^t^m^e^{nt of}^w^o^rk^e^r^s^{to e}^c^onom^ic^c^h^aⁿ^g^e^.
³⁷^For^a^dis^c^us^sⁱ^oⁿ^of^c^u^r^r^e^nt^f^e^de^r^a^{l pr}^og^r^a^m^s^{, s}^e^e^C^R^S^I^s^s^u^e^B^r^ief^I^B¹⁰⁰⁸⁸^,^F^e^d^e^ral^R^e^sea^r^ch^an^d^Devel^o^p^m^en^t^:
^Bud^g^e^tin^{g a}ⁿ^d^Priority^-^S^e^ttin^{g Is}^sue^s^{, 10}⁸^th^C^o^ng^ress^{, by}^G^eⁿ^e^vi^e^v^{e Kn}^ezo^.
³⁸^Se^e^Zv^{i G}^r^ilic^he^{s, “}^T^he^Se^a^r^c^h^{for R&}^{D Spi}^llov^e^rs,”^Sc^a^ndi^navⁱ^a^{n J}^our^nal^of^Ec^on^om^ic^s^,⁽¹⁹⁹¹⁾^{, pp. 29}^-⁴^7;^B^r^uc^e
^Sm^{ith a}^{nd Cla}^u^de^Ba^rf^ie^ld,^Te^c^hⁿ^o^lo^gy^{, R&}^D^{, and t}^h^e^Ec^o^nom^y⁽^W^a^s^h^ing^t^{on: B}^r^o^o^kⁱ^ng^s^Iⁿ^s^tit^uti^o^{n, 1}⁹⁹⁶⁾^;^a^nd
^Ch^arl^e^{s I.}^Joⁿ^e^{s and}^Johⁿ^C.^Wⁱ^l^lⁱ^a^ms.^“M^easu^rⁱⁿ^{g t}^h^{e S}^o^ci^al^Ret^u^rn^t^o^R&D,^”^The^Q^u^ar^te^r^l^y^J^ourⁿ^a^{l o}^f^Ec^o^nom^ic^s^,
^v^o^{l. 6}³^,^no.^{4 (}^N^ov^.¹⁹⁹⁸⁾^{, p}^p^.¹¹^19-¹¹^36.

questionable whether initiatives on this front will encourage much more R&D. There is the
prospect that improvement in the establishment and enforcement of property rights
internationally could have a positive effect on domestic R&D activity. The functioning of the
patent system, however, likely involves an economic trade-off. There is an economic gain from
inducing more R&D by companies, but the knowledge that is produced will not be widely
disseminated for the term of the patent. Given the cumulative nature of knowledge production,
this restriction on the flow of knowledge will tend to slow the rate of production of knowledge
generally. Another policy device that attempts to coax more R&D out of business firms is the ³⁹
R&D tax credit. While the evidence indicates that the research tax credit does raise R&D
spending by firms, many economists have significant doubts about how well the tax credit does at
targeting and inducing R&D projects with large social benefits. Why not use direct grants by
government to firms to undertake R&D projects that offer large social benefits relative to private
return? The information requirements for operation of an efficient grant program are likely well
beyond what government could hope to muster. The economic risk is that a program of direct
grants would, by distorting the patten of investment and by encouraging rent-seeking behavior,
generate more inefficiency than efficiency.
The dollar spending levels by industry and government have increased, but as a percent of GDP,
industry’s share has risen and that of government has fallen since the 1980s. It is government
spending on R&D that largely provides support to basic research; this is an area in which the
incidence of market failure in idea production is probably the greatest.
Basic research is currently supported through the budgets of many government agencies,
including the National Science Foundation, National Institutes of Health, NASA, the Department
of Energy’s Office of Science, and the Department of Defense. Much of the actual research is ⁴⁰
done at major universities across the country.
One policy issue for basic research is determining the appropriate level of government funding.
The rate of accumulation of technical knowledge is likely to rise with the level of resources
devoted to it, but the speculative nature of basic research makes it all but impossible to judge
what the economically optimal size of government spending on such research would be. The
absolute level of inflation-adjusted government spending on basic research has increased from
about $1.4 billion in 1953 to about $39 billion in 2004. The intensity of government-funded basic
research, however, has fallen, decreasing from about 0.7% of GDP in 1953 to about 0.2% of GDP
in 2004. International evidence has shown that there is a positive correlation of the intensity of
government-funded basic research and economic growth. Nevertheless, the understanding of
linkage between basic research and economic growth is not well specified, making it difficult to
predict the precise pay-off in economic growth from a given increase in spending on basic
research. This, in turn, makes it difficult to say what the optimal level of such spending should be.
A second policy issue with government-funded basic research is the mix of that funding across
areas of scientific inquiry. The share of government research spending in health-related areas has
risen steadily for the last 30 years and has increased dramatically over the last 10 years. Funding
for life-sciences now accounts for 60% of the government’s basic research expenditures. In

³⁹^Se^e^C^R^S^R^e^por^{t R}^L³¹¹⁸¹^,^Re^s^e^ar^c^h^aⁿ^d^Ex^pe^rⁱ^m^e^ntat^io^{n T}^a^x^C^r^e^d^it:^C^u^r^r^e^nt^St^atus^an^d^Se^le^c^t^e^d^I^s^s^u^e^s^for
^C^ongr^e^s^s^,^b^y^Ga^r^y^Gu^eⁿ^t^h^e^r^.
⁴⁰^For^aⁿ^ov^e^r^vⁱ^e^w^o^f^c^u^r^r^e^{nt f}^e^de^r^a^{l pr}^og^r^a^m^s^s^uppor^ti^ng^R^&^D^,^s^e^e^C^R^S^I^s^s^u^e^B^r^ie^f^I^B¹⁰⁰⁸⁸^,^Fe^de^r^a^{l Re}^s^e^ar^c^h^an^d
^Devel^o^p^m^en^t^:^B^u^d^g^e^tⁱⁿ^g^an^d^P^rⁱ^o^ri^t^y^-S^et^tⁱⁿ^g^Issu^es^,^b^y^Gen^e^vi^e^v^{e Kn}^ezo^.

contrast, inflation-adjusted funding for basic research in the physical sciences has not risen over
the last 30 years and accounts for only 10% of the government’s budget for basic research. Some
argue that this disparity in funding is inconsistent with the often interdisciplinary nature of major
innovations and is a movement away from the balanced basic research portfolio that is most
likely to yield the maximum long-run return. This argument is not that research funds should be
reallocated away from health areas, but rather that there should be a more balanced increase
across all areas of basic research.
Labor market disruptions are not new problems, and most advanced industrial economies have
developed policies to provide some degree of support for those displaced by recession or the ever
present churning of market forces including trade. Because equity goals are as likely to be of as
much concern to citizens and policymakers as are efficiency goals, an economic response of
foreign outsourcing can not be easily separated from consideration how those hurt in this process
will be treated. To the economist, the policy challenge is to craft initiatives that equitably
compensate and assist those who are displaced, while also securing the efficiency gains from
increased trade. At the most general level, the economist would argue for a transfer of some of the
gains from trade from the “winners” to the “losers.” Because increased trade generates benefits in
excess of costs such a transfer can, in principle, compensate those hurt by trade and still leave the
wider economy better off then it would be without trade and outsourcing. Finding and
implementing policies to effect such a transfer remains an area of controversy.
It can be argued that in the United States and other industrial economies, the post-World War II
economic order was built upon an explicit or implicit “social bargain.” Workers would accept the
periodic disruptions associated with the market economy’s cyclical and destructive traits that are
inherent to its rapid creation of wealth and rising economic well-being, if those disruptions were
cushioned by government provision of various types of economic support to see them through
these rough spots. Public support rather than workers themselves buying insurance against the
risk of job loss is thought the preferred method because the “market failure” caused by the
problem of “adverse selection” will prevent the private market from providing an adequate level ⁴¹
of coverage. While the social policies may have changed in form and extent over the years, ⁴²
these worker support policies remain an integral piece of the modern industrial economy.
The level of economic support an unemployed or displaced worker receives can be seen as a form
of social insurance against the “risk” of job loss and its associated costs that a fluctuating and ⁴³
ever churning market economy exposes workers to. The argument can be made that if the
velocity of market “churning” has increased in recent years due to the combined or individual
effects of a rapidly rising level of international trade, accelerating productivity advance, or more

⁴¹^For^f^u^r^t^he^r^dis^c^us^sⁱ^oⁿ^of^the^is^s^u^e^of^publ^ic^v^e^r^s^us^pr^iv^a^t^e^pr^ov^is^io^{n of}^uⁿ^e^m^ploy^m^e^{nt ins}^u^r^a^nc^e^,^s^e^e^C^R^S^R^e^por^t
^R^L³²¹⁹^4,^J^o^{b L}^o^s^s^:^C^a^us^e^s^an^d^Polic^y^I^m^plic^atio^ns^,^by^Ma^r^c^La^bonte^.
⁴²^F^o^{r c}^u^rren^t^l^e^gi^sl^atⁱ^v^{e i}^ssu^{es ab}^ou^t^un^em^p^l^o^y^men^tⁱⁿ^su^ran^ce,^see^CRS^Rep^o^r^t⁹⁵^-74²^,^Une^m^pl^oy^me^{nt Be}^ne^fits:
^L^e^gⁱ^sl^a^tⁱ^{ve Issu}^{es i}ⁿ^t^h^{e 10}⁸^th^C^o^ngr^e^s^s^{, by}^Julie^{M. W}^h^itta^k^e^{r. F}^o^{r m}^o^re^inf^o^r^m^a^{tion o}ⁿ^a^d^j^u^stm^e^{nt a}^ssistaⁿ^c^e^a^nd
^r^e^tr^aⁱ^ning^pr^og^r^a^m^s^{, s}^e^e^C^R^S^R^e^por^{t R}^L³¹²^50,^The^W^o^rk^e^r^Adj^u^s^t^me^{nt a}^nd^Re^trainⁱⁿ^g^Not^ific^ati^oⁿ^Ac^{t (}^W^ARN)^{, by}
^Lⁱ^nda^L^e^vⁱ^ne^{; a}^{nd C}^R^S^R^e^p^o^r^t⁹⁷^-⁵^36,^Jo^b^T^r^aⁱⁿⁱ^ng^Und^e^{r t}^h^{e W}^o^rkf^o^{rce In}^vest^m^en^t^A^c^t⁽^W^IA^{): A}ⁿ^Overvi^ew^{, by}
^Aⁿⁿ^L^o^rd^eman^.
⁴³^T^h^is^c^onc^e^p^t^of^rⁱ^s^k^eⁿ^c^o^m^p^a^s^ses^bot^{h t}^h^e^lik^e^l^y^incⁱ^de^nc^e^{job l}^o^s^s^{, the}^d^u^r^a^tioⁿ^of^une^m^p^loy^m^eⁿ^t,^a^{nd t}^h^e^le^v^e^{l of}
^p^o^ssib^l^{e a}^d^ju^stm^eⁿ^t^co^sts.

quickly shifting consumer demand, then the volatility of the labor market and the risk of
unemployment that each worker faces have also increased.
Some argue that higher level of risk would warrant a higher level of economic support. This does
seem to be the case among Organization for Economic Cooperation and Development (OECD)
countries for exposure to the risk associated with international trade, where there is a fairly strong ⁴⁴
correlation between market openness and levels of government support expenditures. In
addition to the level of support, consideration of the form of that support, particularly the
incentives for quick re-employment, may be important. In this regard, policy areas that might
merit closer examination include wage-insurance, portability of health and retirement benefits,
and incentives for ongoing enhancement of worker skills that could have value to a wider ⁴⁵
spectrum of employers.
^Cr^aig^{K. El}^w^e^ll
^Specialis^{t i}ⁿ^Macroecon^o^mⁱ^c^P^o^licy
^cel^w^e^l^l^@^c^r^s^.l^oc.g^ov^{, 7-}⁷⁷⁵⁷

⁴⁴^Se^e^D^a^{ni R}^o^dr^ik^,^H^a^s^G^l^ob^aliz^at^{ion G}^one^T^o^o^Far^?⁽^W^a^s^hing^to^n:^Iⁿ^s^tit^ute^f^o^r^Iⁿ^te^rⁿ^a^tⁱ^ona^l^Ec^on^o^m^ics^,¹⁹⁹⁸⁾^,^pp^.
^49-^66.
⁴⁵^For^m^o^r^e^dis^c^us^sⁱ^oⁿ^of^polic^y^r^e^spons^e^s^t^o^o^p^eⁿ^tr^a^d^e^s^e^e^G^a^r^y^B^u^r^tle^s^s^,^R^obe^r^t^Z^.^L^a^w^r^eⁿ^c^e^,^R^obe^r^t^{E. L}^ita^{n, a}^nd
^R^obe^r^t^J^.^Sha^p^ir^o,^G^l^o^b^a^p^h^obi^a:^C^onfr^o^ntiⁿ^g^F^e^a^{rs ab}^ou^t^Op^eⁿ^T^r^a^d^e^.^(W^a^s^hing^to^{n D.C.}^{, T}^h^e^Broo^kⁱ^ng^{s Instituti}^on:
¹⁹⁹⁸⁾^.