Paul Samuelson’s mistake about offshore outsourcing

One of the more common critical responses to defenses of offshore outsourcing is the claim that defenders of the practice are being deluded by a set of archaic economic ideas that only work in the ivory towers — they need to get out in the real world, man. Beyond ignoring the intrinsic value of economic theory as a device for understanding the world, what’s amusing about this line of argumentation is that protectionists throw it out the window the moment someone comres up with an economic theory that seems to support their argument. Which is fine — except that, far more often than not, the models they embrace rest on assumptions that are often harder to satisfy in the real world than the standard neoclassical trade models. For exhibit A on all this, consider Paul Samuelson’s recent contribution to the outsourcing debate. In The American Prospect, Eamonn Fingleton has a rhetorical field day proclaiming that Samuelson’s bombshell has eviscerated the orthodoxy of free trade. One excerpt:

For James Fallows, a liberal-leaning critic of Washington’s blink-first style in trade diplomacy, Samuelson’s analysis is a call to policy-makers to break free from utopian theories and, instead, take a hard look at the real world. “The great problem in Western discussion of trade theory has been its simpleminded Panglossianism,” he says. “The main thing that has supported globalism, apart from the self-interest of many powerful participants, has been the idea that economic theory was 100 percent on the side of Dr. Pangloss. To have the most esteemed of all modern economists say that things are not this simple is a very important step.”

There’s just one problem with all of this — Samuelson’s paper has nothing to do with offshore outsourcing as it’s commonly understood. Arvind Panagariya — Professor of Economics at Columbia — provides a concise explanation for where Samuelson gets confused on offshore outsourcing (thanks to Asif Dowla for the link). Here’s a long excerpt to explain what Samuelson was arguing:

Samuelson employs the standard Ricardian model, which assumes two countries (called America and China), two goods (called 1 and 2) and one factor of production (called labor). Because the endowment of labor is taken as fixed in the Ricardian model, any change in the total national income are reflected fully in the change in the real wage. If the real wage rises, real incomes of all individuals and therefore the nation rise. Alternatively stated, the wage also represents the per-capita income in the model…. Samuelson conducts three experiments in this model:

(1) He starts at autarky and then allows the countries to trade. Both America and China unambiguously benefit from this opening to trade. America has a comparative advantage in good 1 and specializes completely in that good and China in good 2. Nothing controversial arises here. 2) Starting at this free-trade equilibrium, Samuelson next introduces a productivity increase in China in the good it exports, good 2. With more of good 2 produced, its relative price falls. America can now buy good 2 more cheaply from China, which benefits America. Nothing controversial arises here either, at least from the American viewpoint. (3) Starting once again at the free-trade equilibrium, Samuelson finally introduces a productivity improvement in China in the good it imports and America exports, good 1. If this productivity improvement is just right to equalize the cost ratios between America and China that gave rise to trade in the first place, all trade is wiped out and America is robbed off all benefits of trade it previously enjoyed….

Samuelson?s analytic result… that technical progress in China can wipe out all potential gains for America is not in dispute at all?as I describe below, it has been known to trade economists at least since 1950s when the late Harry Johnson who taught International Trade at the University of Chicago first demonstrated it. What is in dispute is whether it represents outsourcing. Thus consider the example given by Samuelson in the last first of the two paragraphs quoted above (which is incidentally fully in conformity with the definition of offshore outsourcing provided at the beginning of this note): ?High I.Q. secondary school graduates in South Dakota, who had been receiving from my New York Bank wages one-and-a-half times the U.S. minimum wage for handling phone calls about my credit card, have been laid off since 1990; a Bombay outsourcing unit has come to handle my inquiries. (Emphasis added)? In the analytic model, the good experiencing productivity change in China is the one exported by the United States to China (i.e., good 1). But did any high I.Q. secondary school graduates from South Dakota (or elsewhere in America for that matter) handle the phone calls for the customers in China? Not really. The calls were made by the Americans and answered by the Americans?no international trade in them took place. Virtually all activities associated with outsourcing?call center services, x-rays transmitted electronically to be read abroad, transcribing services, accounting services and virtually all back office services?have this property of having been non-traded before the Internet, phone and fax turned them into traded services. Therefore, the equilibrium at which Samuelson considers the productivity change is simply the wrong one to represent outsourcing.