A Theory of Outsourcing and Wage Decline

This paper develops a theory of outsourcing in which the circumstances under which factors of production can grab rents play the leading role. One factor has monopoly power (call this labor) while a second factor does not (call this capital). There are two kinds of production tasks: labor-intensive and capital-intensive. We show that if frictions limiting outsourcing are not too large, in equilibrium labor-intensive tasks are separated from capitalintensive tasks into distinct firms. When a capital intensive country is opened to free trade, outsourcing increases and labor rents decline. A decrease in outsourcing frictions lowers labor rents. 1Holmes, University of Minnesota, Federal Reserve Bank of Minneapolis, and the National Bureau of Economic Research; Snider, Anderson School of Management, UCLA. Holmes acknowledges NSF Grant 0551062 for support of this research. This paper has benefited substantially from the input of the editor and the referees. We thank Erzo Luttmer and Charles Thomas and workshop participants at the University of Minnesota for helpful comments. The views expressed herein are those of the authors and not necessarily those of the Federal Reserve Bank of Minneapolis or the Federal Reserve System.