A Theory of Outsourcing and Wage Decline
We develop a theory of outsourcing in which there is market power in one factor market (labor) and no market power in a second factor market (capital). There are two intermediate goods: one labor-intensive and the other capital-intensive. We show there is always outsourcing in the market allocation when a friction limiting outsourcing is not too big. The key factor underlying the result is that labor demand is more elastic, the greater the labor share. Integrated plants pay higher wages than the specialist producers of labor-intensive intermediates. We derive conditions under which there are multiple equilibria that vary in the degree of outsourcing. Across these equilibria, wages are lower the greater the degree of outsourcing. Wages fall when outsourcing increases in response to a decline in the outsourcing friction.
Holmes acknowledges NSF Grant 0551062 for support of this research. We thank Erzo Luttmer and Charles Thomas and workshop participants at the University of Minnesota for helpful comments on this paper. The views expressed herein are those of the authors and not necessarily those of the Federal Reserve Bank of Minneapolis, the Federal Reserve System, or the National Bureau of Economic Research.