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Thursday, December 11, 2003

Outsourcing and surplus capital

Edward’s recent post “Warehouses of Brains” and a much earlier post China's

Real Manufacturing Revolution
touched on how outsourcing not only results in lower

operating costs due to lower wages but also lower capital costs as well. Most of the time

discussions of globalization fixate on the effects of reduced product prices or wages. The

effects of reduced capital costs were something I hadn’t considered before.

A micro picture:

A firm liquidates a factory in a developed country, freeing up capital, Kf. It moves the factory

to China. This move imposes transaction costs T. The new factory, is built for a capital

commitment, Kc, where Kf > Kc. (This assumes that each factory can produce the same

quantity of goods.)

If Kf > Kc + T then there is surplus capital.

[Even if Kf < Kc + T, the lower operating/wage advantages may still justify a move.]

The earlier post also touched on another aspect – the transaction cost, T, drops as firms

become more adept at outsourcing. Over time, transaction costs shrink and the surplus

capital increases. The reduction in transaction costs makes outsourcing more attractive. This

positive feedback would tend to accelerate outsourcing over time – at least until wages (

operating costs) in the destination country started to rise. That is an interesting conclusion in

its own right – but what happens to the surplus capital?

For the sake of simplicity assume that this surplus is either returned to investors or invested in

increasing the new factory’s capacity. If the firm is a price-taker and that there aren’t

decreasing economies of scale, then economic incentives for further investment don’t

diminish. In this case, it’s hard to see why the firm wouldn’t invest in additional capacity.

A macro picture:

For the reasons outlined above, industries undergoing rapid outsourcing would be susceptible

to excess investment in capacity. This excess capacity would be an additional deflationary

pressure, atop the global wage and price pressures.

Even if the capital isn’t invested in additional capacity, it could be invested elsewhere. If the

flows were large enough, this could fuel speculative bubbles (e.g. real estate).


To be honest, I don’t have numbers to support this hypothesis (too lazy). It happens to jibe

with many of the recent posts so I thought I would throw it out.

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