1 Introduction

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Outsourcing involves moving a portion of production outside of a firm. Offshoring entails sourcing part of inputs outside the country.

While recent interest in outsourcing and offshoring has intensified with rapid economic development in China and India, both these phenomena are at the core ofindustrial economics— focusing on firm behaviour—and international economics—focusing on the reasons behind trade between nations.

Outsourcing decisions affect the boundaries of the firm—what takes place within the firm and what takes place outside the firm. Firms always face the choice between making or buying when it comes to the inputs that they need in order to produce their product. When they choose to make the inputs themselves, they essentially extend the boundary of the firm. When they outsource the input, they are restricting it. In the first case, the firm becomes more integrated; in the second case, disintegration occurs.

Asking what determined the boundaries of firm production, as opposed to the purchasing and assembly of parts, was the focus of Coase's classic 1937 article, where he argued that relative transaction costs lie at the heart of the decision—since firms that internalize production are substituting a set of external contracts at relative certain prices associated with arm's length contracts with an incomplete highly uncertain contract (a labour agreement) when they make the decision to make the input internally. Williamson (1975) extended this analysis to consider the many factors that influence the decision to internalize, as opposed to purchase from outside the firm.

One consideration that is sometimes discussed is the advantage of the division of labour in internal production—Adam Smith's example of the pin factory; but Stigler (1951) pointed out that specialization is not necessarily always associated with internal production even in Industrial England, since it was obtained across many establishments in the Birmingham small-arms gun trade, with each establishment performing one task and one assembler putting the parts together.

Offshoring may be, but is not necessarily, related to outsourcing. It involves decisions both to purchase outside the firm and to do so from abroad. Considerations to do the latter are at the heart of the study of international trade.

Decisions to outsource or to insource production are being made continually as firms experiment with the optimal balance between internal production and external purchases. Within an industry, alternate boundaries of the firm—alternate models of the firm—often exist side by side. For example, auto companies differ in terms of the percentage of parts that are made by in-house subsidiaries as opposed to third parties. Some airlines do most of their maintenance in-house; others purchase it at an arm's-length basis. What may have been the norm at one time can be modified, if the costs and benefits of outsourcing change. Williamson notes functions that are not easily standardized, where external contracts are difficult to supervise and costly should they break down are often done internally. But even then, some external parts in these areas may still be outsourced so as to maintain a discipline on the internal production process. Changes in the degree of outsourcing that are moving in opposite directions are taking place continuously in the economy as technology changes, in order to make external production cheaper or to make internal production more desirable.

Recent interest in outsourcing is related to the notion that new forces are at work to change the production boundaries of firms. Progress in transportation technology that has reduced transportation costs, along with new information and communications technologies (ICT) that allow for improved coordination of geographically dispersed production processes, are seen to be leading to the disintegration of production processes.

At the same time, reductions in trade barriers over the last 50 years have led to increased trade. Some of this has led to increased imports of inputs to the production process. This, in turn, is seen to be contributing to more offshoring—the sourcing of inputs abroad.

One example of situations where the boundaries of the firm have narrowed is those instances where firms increasingly participate in supply chains that involve arm's-length transactions between third parties. Supply chains at first were mainly domestic, involving firms in the same country; subsequently, they have become global in scope as firms take advantage of differences in production costs and technologies across countries.

The disintegration of material inputs has been much more important than the disintegration of service inputs, as most services have been traditionally non-tradable (Feenstra and Hanson 1999). But the disintegration of service inputs and trade in service inputs has become increasingly more important since the mid-1980s, facilitated by the advances in ICT, which have dramatically changing the tradability of a set of information-centred services, launching a revolution in the tradability of services (UNCTAD 2004).

While there is considerable discussion of the outsourcing and offshoring issue in Canada, there have been few empirical studies of its size and impact. Trefler (2005) uses aggregate data and finds that service offshoring is a small fraction of all trade in goods and services, but it has grown at a much higher rate than the growth for trade in goods. He also finds that service offshoring in Canada is dominated by offshoring to the United States and the other Organisation for Economic Co-operation and Development (OECD) countries.

Morissette and Johnson (2006) find that the offshoring of business services has no effect on employment in Canada. Head and Ries (2006) find that service trade, like goods trade, is subject to strong distance effects and the remote supply of services remains limited. They also find that distance costs are declining over time for some categories of service trade. Yan (2006), using a panel regression on the levels of employment shares, finds that foreign outsourcing has increased the demand for non-production workers relative to production workers in the Canadian manufacturing sector.

While there are few empirical studies on offshoring for Canada, there are a large number of studies for the United States and other OECD countries. Olsen (2006) provided a survey of empirical studies on the impacts of offshoring on productivity growth. He concludes that there is no clear pattern as to how offshoring affects productivity. Hartzichronoglou (2006) reviewed empirical studies on the impact of offshoring on labour markets and concluded that offshoring has little effect on employment.

This paper makes a number of contributions to empirical studies on offshoring. First, it provides empirical evidence for Canada for the period since 1961. Second, this paper extends previous studies on service offshoring to include the service-producing industries. Most previous empirical studies on service offshoring have focused on the manufacturing industries, due to the lack of consistent time-series data for the service sector. This is unfortunate, as most service offshoring is undertaken by the service-producing industries. To fill this gap, this paper examines service offshoring in both the manufacturing and services sectors. Third, this paper provides empirical evidence on the effect of offshoring on shifts to high value-added activities. The discussions on service offshoring have focused on service offshoring as a route for firms and industries to move up the value chain (Sako 2006). But there is little empirical evidence on the effects of offshoring on shifts to high value-added activities.

The main data for the empirical analysis is a detailed set of industry data using the KLEMS (Capital, Labour, Energy, Materials and Services) database maintained by the Productivity Accounts at Statistics Canada. This industry database provides consistent time series data on gross output, capital input, labour input, and energy, material and service intermediate inputs for industries based on the 1997 North America Industry Classification System (NAICS) (Baldwin, Gu and Yan 2007).

For the purpose of this paper, we have developed a measure of offshoring by industry that has been merged with the KLEMS database. The measure represents the imported portion of material and services inputs and has been used in previous studies on offshoring (e.g., Feenstra and Hanson 1996, 1999; Amiti and Wei 2005; and Morissette and Johnson 2006).