Russ Roberts

Leamer on Outsourcing and Globalization

EconTalk Episode with Ed Leamer
Hosted by Russ Roberts
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Is outsourcing good for America? How does foreign competition affect wages in the United States? Ed Leamer, professor of economics at UCLA, talks about the effects of outsourcing on wages, jobs, and the U.S. standard of living. Drawing on a review of Thomas Friedman's The World is Flat, Leamer talks with host Russ Roberts about technology, trade, productivity and inequality.

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0:36Intro. Review of Friedman's The World is Flat: American workers are worried that we are all in competition with each other, they will lost their jobs. Flatness metaphor: Warning is that your job is contested by foreigners. But contestability is limited by geography. There are special relationships between buyers and sellers in the same neighborhood. In reality, there are some who lose jobs--apparel, consumer electronics, textiles, footware--but as you go up the value chain in manufacturing the extent is limited. Most of those jobs have already left the U.S. The countries that have been successful in competition have benefited from the emergence of China, Brazil, etc. Early jettisoning of these footloose jobs by successful countries. Both countries benefit. Markets, relationships, contestability. A "market" is a metaphor, a reference to a medieval town where buyers and sellers would get together and haggle over price, resulting in market price where supply and demand are equalized. Word "market" is also used by economists to describe all kinds of transactions, like the "labor market". But the labor market creates a relationship, not a market in the sense of buying and selling tomatoes. You can't sell a tomato for a penny more than the market price; but jobs are more complex. You are not in competition with a Chinese laborer. UCLA doesn't get special value from Ed Leamer, but a good substitute might be someone else. Flair and distinctiveness Ed brings to the job, intangible, are what make him have less competition for his job by other economists. Quality competition is non-market, as opposed to price competition. Trust: employer/employee relationship are built up over time. UCLA knows more about Ed than U. of Chicago or GMU. Business firms are keenly aware of special functions served by specific employees
10:02Proximity. If wages are cheap in Mexico or India, will enormous numbers of jobs flow out of the U.S.? Gravity model: proximity matters. Analogy with physical gravity: proportional to the product of the masses divided by the square of the distance between the two objects. In economics, amount of transactions that occur between two points in space is proportional to the product of the masses (measured by GDPs), divided by the distance raised to a lower power (not quite squared). Fits quite well. German trade with its neighbors, U.S. trade with Mexico and Canada. Cheaper to ship short distances; but surprisingly, it matters for jobs, too. Not just transportation costs. Constant since the 1950s even with large reductions in shipping and communications. Most economic transactions occur within a couple hundred miles of where you live. Trust and understanding. The farther you go away, the less trust. Doesn't matter for a commodity, whose value can be determined by inspection. Chinese products were thought of as commodities for a while, but health problems and reliability are making for a pulling back. Same language also helps with trust. Countries with successful outcomes are physically clustered together. New Zealand and Australia had good ability to communicate and similar legal systems that enabled them to trade with England and Europe. Countries that are farther away (in opportunity) tend to have to build a cultural bridge--send kids to school in the U.S., for example. Measure of closeness to global GDP. In Africa, you are far from where most of the GDP originates.
16:21David Ricardo. Comparative advantage. Trade is driven by the differences between us and the opportunity to specialize in what we do most effectively even makes the observable differences more dramatic than the underlying differences. Critiques of Ricardo: 1. If you look at the pattern of trade, it seems to be between similars--wealthy nations trade with each other. 2. Ricardo didn't foresee the modern world, including capital mobility, other modern developments. With regard to 1., international economists have Ricardian- and Heckscher-Ohlin type models that deal with those inequalities in global distribution of resources. Other models, associated with Paul Krugman's name, looking at economies of scale, product differentiation. Trade between U.S. and Europe, Canada, Japan is trade amongst countries with very similar endowments of capital and resources. North/South trade (U.S. and Mexico, Brazil) are more likely to be captured by Heckscher-Ohlin models, trade between countries with unequal supplies of unskilled workers. Ricardian model doesn't apply to everywhere (neither does Heckscher-Ohlin). Economies of scale idea is implicit in Adam Smith. James Buchanan, earlier podcast (Mike Munger, Division of Labor): Two reasons for specialization: we're different, and extent of the market. Leamer: It's not really economies of scale, but rather keeping the human capital operating for long periods of time during the day. Building a pin requires two tasks, building the shaft and building the head. When done by one person, most of the person's capital sits idle, as opposed to at a factory, which minimizes the capital costs. Market creates specialized activities, legal system is now highly specialized, deployed for long hours during the day. Multitasking helps a little, but the brain is physically constrained by being in separate people.
23:21With regard to second critique of Ricardo: our traditional models of comparative advantage and gains from trade may not hold because of new conditions, and outsourcing is to be feared instead of embraced because of new conditions. Senator Charles Schumer on the economic quotient, to Paul Samuelson. Chuck Schumer and Paul Craig Roberts wrote an op ed piece in NY Times, discussing mobility of factors, which has come to be called "outsourcing". Note that traditional meaning of "outsourcing" was different and applied to when a business does a function internally instead of externally. In this podcast, "outsourcing" refers to intellectual service activities delivered over the internet or other electronic transmission (call centers, R&D, reading of x-rays by Indian medical personnel, writing of headlines, etc., as if these people had emigrated to the U.S., factor flow same as factor mobility. From Schumer/Roberts
And one thing is certain: real and effective solutions will emerge only when economists and policymakers end the confusion between the free flow of goods and the free flow of factors of production.
They are arguing that the Ricardian model only applies if there is no factor movement, neither physically nor over the internet. That's just wrong. They need to go back and read Adam Smith and write on the blackboard that there are gains from exchange. The Adam Smith argument is that if there is an exchange, the exchange itself reveals that there is a gain. Factor mobility doesn't eliminate the gain, still a gain from every exchange that occurs. What it does, though, is change the supply and demand relationships and equilibrium relative prices. Relative to those new equilibrium relative prices you may be worse off. Imagine that communications are not good enough to allow software coding to be done in India, and all has to be done in the U.S.--requiring close physical proximity for creativity. U.S. historically got started on it first, so monopoly rent accrues to the U.S. in that circumstance. (Talent distribution is limited is additional assumption, else U.S. software programmers themselves would compete away the economic rents.) Something changes--technology, communication, whatever--makes it feasible to be done elsewhere. Supply increases, no longer monopolized, can be made anywhere in the globe. U.S. terms of trade deteriorates. U.S. producers of software are worse off, U.S. is worse off. Is the U.S. in total worse off? Isn't there also an enormous advantage to the U.S. software buyers to being able to buy it at low cost? Doesn't it also unleash resources for other things? Ricardian: workers all identical. Heckscher-Ohlin: designers and helpers. It is in the second model where the outsourcing may in fact help everyone.
34:05Human capital: if you have a very specialized skill and suddenly there is competition for it, what can you do with the rest of your brain that's productive? Around 2000, people who had been making web pages found themselves with competition because it had become routine--not outsourcing. Had to think of something else to do. Technology and trade are very similar in their impacts. Enjoying the benefits requires flexibility with your skills. Different kinds of functions: mundane functions on which people around the globe can bid based on specs; but creative functions are impossible to spec. Initial burst of demand for intellectual services, but later standardization means it can be shopped around the globe. Competing against the computer is tough. We don't want to endow our children with limited skills to compete against the Chinese, or against the computer--in both cases they would end up very poor. Need wherewithal to do creative functions and flexibility. Dan Pink podcast: how to distinguish yourself creatively. Competitive process creates our standard of living, not something to be afraid of. Enriches life that the creative can ultimately be made mundane.
39:44Forklift vs. microphone example: Which is the computer? A forklift is a symptom of the industrial age, innovative equipment, allows each of us to lift the same amount no matter what our physical endowment, higher wages but equal wages because it equalizes the effects of our endowments. A microphone by contrast differentially benefits the people with natural talent. Every town had its supply of entertainers in the Middle Ages but now a single entertainer can serve the whole world. Hollywood stars. Technology helped those with natural talent and who also work hard. Is a computer a forklift or a microphone? Will the productivity improvements benefit all or some? Labor markets increasingly look like Hollywood labor markets and less and less like Detroit labor markets. Computer has aspects of both. Taleb in The Black Swan uses this example: small town entertainers replaced by those who want to hear Pavarotti. Small town entertainers become music teachers--or other things. You don't need as many people singing, but those who lose their jobs as singers are freed up to do other things--like become economists. Two things: fewer people doing it, and their rewards are enormous. Communications revolution changed the payments and the number of people doing it. Downsides are social and cultural. Detroit vs. Hollywood: If you imagine a world that has both, the productivity improvements frees up people and still allows the displaced to earn a decent living. But if what was 35% of jobs becomes 11%, like in manufacturing, where most of middle class has been, where are all these people going to find other employments? But think about early 1900s this happened when farming shrunk. When we transitioned from an agrarian to an industrial society at that time, millions of farmers did find other kinds of employment. Why won't same thing happen? Compensation rates on factory floor ended up 3 times that of the farm. Great if that can happen. Leamer: the income inequality of movie stars is a symptom of a concern that the economic growth will not be as widespread. Proportion of the employment in manufacturing: hasn't it been falling since the 1940s, not just since 1970? Welfare--well-being: Will the gains be concentrated in the hands of the few? Russ: So long as I am gaining, why should I worry if a few gain even more? What would be alarming would be if a handful gained at the expense of others. Some of the gains have to be shared, else no one will buy Pavarotti's CDs.
50:53California becoming Hispanic. Many recent immigrants, low current education. Ladder of improvement last century was through manufacturing. Migrants who arrived at Ellis Island didn't speak English. Endicott-Johnson, shoe manufacturer: immigrants were told to ask question, "Which way EJ?" California doesn't have that easy manufacturing rung. How will CA absorb all these immigrants with only agriculture to offer? First, just because that's the way it's been doesn't mean it has to always be. Second, high school is not a ticket to the middle class any more. Immigrant children will probably not stop at high school, but will go on to college. In D.C. what immigrants do it painting, yardwork, physical labor that is not a middle class lifestyle right away but they make a much better life than in Guatemala. Their children go on to become educated. Too optimistic or not? Our ability to assimilate these immigrants is fundamentally different from 100 years ago.
54:40The facts: Chart looking at transformation of world income from 1980 to 2000, period during which trade increased dramatically around the world. Why doesn't everybody earn $5000 in 1979 dollars, world per capita income? In America very high, in other parts of the world much lower. In 1980 U.S. per capita income was about $20,000. Fear was that U.S. would experience an enormous fall in per capita income as a consequence of global competition. That didn't happen. Global income changed dramatically, but it wasn't a great equalization. High income countries and low income countries both experienced very substantial income growth, but countries in the middle were left behind, slow growth or even reduction. Chinese and Indians are not competing with U.S. and Japan but with Latin American countries like Brazil and Mexico, offering the globe to do the same services in footware, textiles, etc. U.S. as a whole benefits enormously. Worries of the middle class include fringe benefits, have to think of accuracy of these numbers. Broad government statistics are reported with precision but are really very fuzzy. E.g., whole world statistically runs a trade deficit with itself--obviously impossible because we are not trading with Mars--it's a measurement problem, imports and exports are not measured accurately. Imports are scrutinized but exports are not. Truckers at Canadian border.
1:00:03Study by Alan Blinder: Claims that 30-40 million service jobs are off-shoreable, so people with high levels of skills are at risk and potentially could see their wages fall dramatically (over the next decades). No evidence of that. Elasticities. Blinder goes through the lists of labor descriptions and makes subjective judgments, but there is no evidence that it's anywhere near that severe. Radiologists job prediction called attention to the study. Turns out that very few x-rays have been read abroad. You want to trust the person who reads your x-rays; you want to trust your lawyer to know local law; you want to shake hands as well as knowing the same language, want to probe and ask questions face-to-face. Likeability in-person has a big impact on who we hire for many jobs.

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COMMENTS (11 to date)
Andrew Stewart writes:

Dear EconTalk:

Today's podcast by Ed Lerner suggests that relationships will help define the extent to which organizations will globalize. I found this discussion very intereting.

I am the former Chairman of the Board for the Somerset Medical Center and found the observations about Radiology practices interesting. We at Somerset along with other NJ hospitals did contract with a Radiology Group Practice in India to read our radiology tests during the overnight hours and on weekends. This gave us a great way to cover our downtimes which had become an increasing economic issue for the private practice radiologists here in NJ.

We took steps to mitigate the negative impacts that Ed references regarding radiology. One of the mitigations was to add these physicians to our medical staff and have their credentials reviewed by our Medical Staff Credentials Committee. None- the-less, today we benefit from this top notch review of diagnostic tests in a cost effective manner - (these tests results can be reviewed by our on site Radiologists to support the concerns about having a stranger in India read the tests.

The impact of globalizing medicine for productivity gains is gaining momentum. On of the next steps in this arena will be remote surgeons driving surgical robots in the local hospital over the web to enable patients to increase their surgeon choices and to improve quality.

Moving ideas and information rather than physically will provide a new medical paradigm which will impact both cost and quality.

Andrew Stewart
Basking Ridge, NJ

Brad Hutchings writes:

Andrew makes a very interesting point about India's location on the other side of the world. I have a friend who has a medical transcription business. He actually outsourced his own job to India a couple years ago, moving his young family back so the kids could grow up with extended family around. But he maintains a small office in SoCal. Clients call in and dictate medical reports to an automated system. He has contractors in India and Bali transcribe the reports while it is night here, ready for download the next morning. His business, however, is all about building relationships. He mostly serves small practices and personally visits most before they sign up. They also tend to ramp up usage of his service with time rather than dive in head first.

nr writes:

Great interview as usual. I agree with Russ that the forklift/microphone metaphor is terrific, an example of how a good metaphor can help create wonderful insights. Your interviews and related materials are unique in that they are sophisticated yet accessible to non-economists. If only there were a way to get the message(s) out to much wider audience. To allude to your previous interview, it would be a great contribution to making the irrational voter a little less so...

Plinius writes:

I don't see why you couldn't skype a radiologist in India and ask him/her questions about this and that spot, thereby developing a great relationship with a perfect stranger. It's funny that in other languages the word "stranger" (or derived form) is used instead of "foreigner". The bit about relationships sounds like anti-stranger bias.

Rupert Gow writes:

I tend to think we do have an anti-stranger bias - as a rational way of minimizing risk.

We could go with Indian radiologists, but we don't know much about them. On the other hand, even if we don't know any of the local radiologists, we know that the local clinic depends on a positive reputation with our neighbors. Consequently i think we tend to perceive the local clinic's radiologists as less risky or more trustworthy than the Indian ones.

I think this applies to the example of the the university hiring of professors discussed in the interview. A university may choose not to replace Ed Learner with a cheaper lecturer because of the risk that the new lecturer would be worse. So even if their skills were exactly the same or were close substitutes, due to uncertainty, the university may elect to keep the more expensive lecturer to minimize risk.

However surely if the price were sufficiently low, the cheaper price could compensate for the risk in switching. The cheaper worker could reduce this risk premium by signaling her quality.

Jason Barnhart writes:

I agree with almost all of this and don't mean to take it to the mast. Really solid assesment of the current economic atmosphere; so many great paradigms.

I would humbly caution against undervaluing the increasing adeptness of communication methods and the equalizing factor of improving networks and their ability to better facilitate cultivation of realtionships regardless of distance.

mwk writes:

Once again, a great discussion. The comments on anti-stranger bias and relationships perhaps lend weight to the case made by some, that India will eventually outpace China, partly for demographic reasons, but also partly because of history and India now being the largest Anglophone nation.

I am skeptical of the optimism about globalization of medical services. Historically, the AMA and like self-regulating bodies have taken Public Choice theory to the nth degree and resisted any regulatory and trade policies that would put them on the other side of the Baumol equation, thereby diluting the market. Current election rhetoric suggests we will continue to see supply and demand fail to meet.

Theresa Lohman writes:

At the end of the discussion, Leamer said that our x-rays will not be read with any great frequency in Indaia or where-ever. I beg to differ. When I was working in a labor and delivery area at night, our ultrasounds were sent to Australia to be read. This meant our own radiologist did not need to be on call.
A physician colleague of mine has a brother who is a radiologist. He is licensed in 5 states here. He has moved back to India and will read x-rays sent to him from here from these 5 states and will make more than if he were living here and live a very nice life there.
I think you are not in touch with reality.

Russ Roberts writes:

Theresa (and others)

Ed may have been overly optimistic/pessimistic (choose one, depending on your view of the benefits or costs of outsourcing) about the likelihood of x-rays being read at a distance. The important point is that people will want to make sure that the quality of the reading will matter. If reading x-rays doesn't require much interpretation or if the interpretation is straightforward and doesn't require people to interact much with the reader, then it will get done where it's cheapest.

Of course the ideal would be a world where the x-rays would talk and tell us the problem rather than having to have a highly trained specialist (here or outside America) to read them. An even better world would be one where people didn't get sick and just dropped dead at 150. We slowly move torward both of those worlds. We will lose all those "high-paying" medical jobs yet we will be richer other than those doctors who lose income during the transition.

nr writes:

I just finished Leamer's paper and it's an example of the very best kind of economic writing: using empirical data and slam-bam economic reasoning he upends some of the most widely held conventional wisdom of the day. Nothing more fun. And he does it entertainingly, with a sly sense of humor that pops up delightfully and unexpectedly. A big plus: he cuts down to (very small, by the time Leamer's through) size an annoying know-it-all whose main talent is journalistic glibness. Not to mention an eye for attention grabbing title, unless his editor gets credit for that.

For my money Leamer's paper is much better reading than Freakonomics, which leaned for its success on statistics and (in some cases) controversial subject matter far more than economic reasoning and insight. Leamer, how about a book??? I'm ready to pre-order!

Dan Kurt writes:

1) Buy and read The End of Medicine: How Silicon Valley (and Naked Mice) Will Reboot Your Doctor (Hardcover or Soft Cover)
by Andy Kessler.

2) One of the tacit assumptions in the discussion of the Mexicanization of California is that "all people are essentially the same." They are not. The people coming into the USA from Europe a century or so ago, which you discussed, with little or no skills had a lot better a chance for gradual success because their mean IQ was about 100. The "latinos" coming into the USA bring with them mean IQs circa 80 to 85 at best. Check out the following site: www.lagriffedulion.f2s.com/index.html and read the articles on Smart Fraction Theory. The "smart fraction" represents those people in a society with IQs of 106 and over who make the society work. The larger the "smart fraction" the better the society functions. Mexicans bring with them a dearth of "smart fraction" individuals and portend a dramatic decline in the cognitive abilities of Californians of the future and with that the ability of California to remain an economic powerhouse.

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