Monday, April 30, 2007

Alan S. Blinder has gone soft

Alan Blinder is a brilliant economist but judging from this article in the WSJ opinion journal, I'm wondering what he's been drinking. He has missed out a very large part of the outsourcing issue and because of this, he is wrong.

One of the determinants of price is productivity. If Lineland can produce 3 widgets per worker while Flatland can produce 9 widgets per worker then all things being equal, a worker in Flatland will earn 3x as much (if he earns more than 3x then it is more economical to produce in Lineland). Now because of comparitive advantage if a worker in Lineland can produce either 3 widgets or 1 blob and a worker in Flatland can produce 9 widgets and 15 blobs then even though Flatland has a considerable productivity advantage for both widgets and blobs, Flatland will tend to specialize in blobs and Lineland will specialize in widgets as this will yield the biggest advantage to both nations.
China fits into this classic mould - China produces widgets (manufactured goods) with relative efficiency while the US produces blobs (services) with relative efficiency. The end result is that the US is still a net exporter of services. That there is a huge trade deficit stems from other issues that we can discuss later (clue: a huge source of the US trade defecit is not China...).

It gets murkier when both Flatland and Lineland have specialized in the same area.
India is one of these anomalies. Blessed by a decent higher education system, and the fact that the manufacturing section was tied down by red tape, their services sector took off. This is not a sustainable model. India has hundreds of millions of poor people who don't have a hope of ever getting a high school education let alone a university education - many these people are unemployed because the traditional route up through manufacturing is blocked to them. This will be a source of major social instability in the future.

This anomaly in India is manifested in some pretty obvious ways. Witness the airport in Delhi compared to Shanghai. Shanghai is a modern, efficient airport where it is clear where to go and how to get there while Delhi is a total mess. If you're not careful in Delhi, you could easily get into some serious trouble. Other differences are also apparent - bad roads, terrible train transportation, awful telephone system, unbelievable amount of red tape - the list goes on. The services sector is booming but everything else in India seems to be struggling. Already their infrastructure deficiencies are having an impact on their growth.

Are there productivity differences between an information worker in the US vs. an information worker in India (for example)? While I am not questioning the talented young men and women in India, the answer is clear. An IT worker in India has to contend with: poor communications networks, bad roads (to go to and from work), inefficient retail networks (and logistics), less powerful machines (though the cost of a PC has been going down steadily while becoming more powerful, the cost of the most powerful machines at the time has remained high), less efficient financial markets to produce venture capital and less effective management. Were all of these factors equalized, the cost of an IT resource in India would be the same as that in the West.

It is almost surprising that we are able to outsource to India given the fact that the West has the same relative efficiencies as India. But this is not surprising when we start to break down the numbers. Where India has excelled is in the low margin, high volume sort of work. In sheer quality of research and product development, most of the innovation still happens in the West (with some notable exceptions). This does not mean that the West should be complacent. Protected industries are ripe for outsourcing as the price far exceeds the productivity of the resources. Restrictive immigration laws also works as a form of industry protectionsim by reducing the supply of workers. Old controls need to break down - unions and professional bodies need to accept that the market must determine wages not committees. And in the end, it is better to have workers come and work in your country than having the firm move away in search of workers.

Returning to Mr. Blinder, a professional in the West does not have anything to worry about if they keep their productivity advantage and if their industry has a relative productivity advantage to the rest of the economy of their country.

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