3 Determinants of offshoring

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Previous studies have identified two main determinants of the growth in offshoring: advances in information and communications technologies (ICTs); and the continuing integration and globalization of production processes (Bartel, Lach and Sicherman 2005; Garner 2004; Trefler 2005).

Information technologies have changed the nature of the production process. For example, cost reductions in telecommunications have permitted call centres to be created far from the production and marketing operation centres of North American companies. But ICTs have also changed the cost of coordination and thus they may have changed the balance between internal versus external production. Finally, new ICT technology itself may have created the need for external specialists to produce new and more sophisticated final products—service specialists that are outside the corporation and who need to be hired on an occasional basis to design products or to create systems.

To examine the relationship between globalization, the use of ICTs and offshoring of material and services inputs in Canada, we estimate the following regression on a sample of industries:

where Δ denotes first differences between periods, osit is the extent of offshoring in industry i in period t, trade measures trade openness, ICTit is ICT intensity, and Di and Dt are a set of dummies for industry and period fixed effects.

We follow most other studies on offshoring and define the offshoring variable os as the ratio of imports in the cost of total material and services inputs (Amiti and Wei 2005; Görg and Hanley 2005, 2003). To examine if the effect of trade integration and ICT on offshoring is different between the service and material inputs, we estimate two separate regressions: one for service offshoring and the other for material offshoring. Service offshoring is defined as the share of imports in total service inputs. Similarly, material offshoring is defined as the share of imports in total material inputs.

We make use of two separate indices that together indicate the degree of trade openness, because we are interested in the effect of changes in trade that occurs within industries—or intra-industry trade—and trade between industries—or inter-industry trade.

The measure of the intra-industry trade intensity used is that suggested by Grubel and Lloyd (1975). For an industry i with exports Xi, imports Mi and gross output Yi, the index is I = [(Xi+ Mi) − |XiMi|]/ Yi. This is the ratio of intra-industry trade to nominal gross output.

The measure of inter-industry trade intensity is the ratio of the difference between total trade (exports and imports) intensity—( Xi+ Mi)/ Yi —and intra-industry trade intensity.

The causes of intra-industry trade are thought to be different from the causes of inter-industry trade. The inter-industry trade variable reflects the force of comparative advantage arising from the difference in factor endowment and technologies. Countries engage in inter-industry trade to exploit benefits from comparative advantages. In contrast, intra-industry trade reflects the force of scale economies and product differentiation within industries. Intra-industry trade or trade in differentiated products takes place to exploit the benefits from economies of scale and specialization within individual product lines in particular industries.

ICT intensity is measured in two ways. First, we use the share of ICT intermediate inputs in total intermediate inputs; second, we use the share of ICT investment in total investment. ICT

intermediate input consists mainly of computer services, semiconductors and other electronic components that are used as intermediate inputs (see Appendix Table A.3). ICT investment consists of investment in computers, telecommunication equipment and software. While most studies interested in ICT focus on ICT investment, Beckstead, Burrows and Gellatly (2007) point out that the intensity of the consumption of intermediate inputs is not perfectly correlated with investments in ICT. The intensity with which these inputs are consumed may determine the extent of substitution possibilities for offshoring production.

To estimate the regression equation, we have divided the 1961-to-2002 period into eight periods of about equal length. These periods include seven of five years and one of seven years. The last period covers the seven years from 1996 to 2003. In all the empirical analysis in this paper, we have chosen this 'long-difference' specification. The data in a short-difference form such as annual difference are more likely to be subject to measurement errors. Further, the short- difference specification does not capture lagged effects unless the lagged independent variables are introduced in the specification.

In all specifications, we include period-fixed effects and industry-fixed effects. The period-fixed effects control for any unobserved time-varying effects common across all industries. Industry- fixed effects control for any unobserved industry characteristics that may affect offshoring, ICT use and trade openness at the same time. For example, there are high-growth industries that invest more in ICT, trade more in goods and services and offshore more inputs to other countries.6

The sample consists of a panel of 88 industries of the business sector from 1961 to 2003. The summary statistics on the main variables are presented in Table A.4 in the appendix.

The results, using Ordinary Least Squares, are presented in Table 9. The share of ICT intermediate inputs is positively related to growth in offshoring in material and service. The correlation is statistically significant at the 5% level. In contrast, the share of ICT investment is not related to growth in offshoring activities in Canadian industries. It is the production process that is related to intermediate factor proportions rather than capital intensity that is more closely related to changes in offshoring at the industry level.

Table 9
Regression results on the determinants of offshoring

Trade openness is an important source of growth in offshoring. A 1-percentage-point increase in the trade–output ratio is associated with a 0.3-percentage-point increase in the ratio of imports in total material and services inputs.

When we divide trade into intra-industry trade and inter-industry trade, we find that both intra- industry and inter-industry trade are positively related to offshoring. But the effect of intra- industry trade on offshoring is about two times as large as the effect of inter-industry trade. This indicates that offshoring largely reflects the force of scale economies and gains from product specialization that come from increasing intra-industry trade.

In Table 10, we examine the determinants of service and material offshoring separately. Increases in intra-industry trade are the main sources of growth in offshoring for both material and services inputs. Growth in inter-industry trade is related to growth in material offshoring, but is not related to service offshoring. The increase in trade openness and globalization tends to have a larger impact on material offshoring than on service offshoring.

Table 10
Regression results on the determinants of material and service offshoring

ICT intermediate input is closely related to service offshoring, and it is more important for growth in service offshoring in the service sector than in the goods sector. The evidence also shows that ICT intermediate input is closely related to material offshoring, and it tends to be more important for the growth in material offshoring in the goods sector than in the services sector.

To sum up, the results suggest that growth in both services and material offshoring reflects the continuing trend in globalization and integration of the production process of world economies. Material offshoring reflects the two forces of globalization: gains from exploiting comparative advantage and gains from the exploitation of scale economies in differentiated product lines. Service offshoring reflects the force of scale economies and product differentiation.

One form of comparative advantages is low production costs and low wage costs in foreign countries. Our results suggest that the low production costs and the low wage costs in foreign countries are important sources of growth in service offshoring. But our results also suggest that the force of scale economies is also an important source in service offshoring by Canadian service industries, which is often neglected in recent discussions about service offshoring.

 

6 We have estimated the regression without industry fixed effects. The results are similar.