Interest effect of international outsourcing, foreign investment, and welfare

Abstract

This paper investigates the welfare ramifications of international outsourcing in the presence of foreign investment initiated by outsourcing‐induced interest effect. Utilizing the Heckscher‐Ohlin model of general equilibrium, we show that unlike the common view that outsourcing renders negative effects on domestic employment, but positive effect on the welfare, (a) the output and employment effects of outsourcing are ultra‐biased such that it always increases (decreases) those of the outsourcing (nonoutsourcing) sector; (b) the effects of outsourcing on factor‐intensities and factor‐prices depend on the factor intensity ranking such that outsourcing occurring in the capital‐intensive (labor‐intensive) sector lowers (raises) the capital‐labor ratio of both the outsourcing and the nonoutsourcing sectors, lowers (raises) the real wage rate and raises (lowers) the real interest rate, and hence worsens (improves) income distribution; (c) in the presence of foreign investment, outsourcing in the capital‐intensive (labor‐intensive) sector may be welfare‐reducing (is always welfare‐increasing) due to increase (decrease) in the outsourcing‐induced interest payments for the foreign capital stock. Noting that international outsourcing nowadays serves as a key driving force for production fragmentation and supply chain formation, this paper discovers an important, but previously unnoticed feature in international outsourcing, namely, the outsourcing‐induced an interest rate effect on foreign capital movement.