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We study the effects of international outsourcing on equilibrium unemployment in a high-wage economy with labour market imperfections. We demonstrate, consistent with empirical results, that the wage elasticity of labour demand is increasing as a function of outsourcing. Furthermore, we show that a production mode with more outsourcing reduces the negotiated wage in a high-wage country with labour market imperfections if the relative bargaining power of the labour union is sufficiently high. Under such circumstances outsourcing reduces equilibrium unemployment. Finally, we characterize the optimal production mode showing that stronger labour market imperfections induce a production mode with more outsourcing.

On a global scale wage differences are enormous across countries ranging from, for example, 1.10 € per hour in China to almost 28 € per hour in Germany (see, e.g. Sinn, 2006 and Sinn, 2007). Wage differences like this constitute a central explanation for the increasingly dominant business practice of international outsourcing across a wide range of industries. For example, Business Week (2003), Amiti and Wei (2005) as well as Rishi and Saxena (2004) refer to the huge difference in labour costs as the key explanation for the strong increase in outsourcing of both manufacturing and services to countries with low labour costs. However, the exploitation of the marginal cost advantages offered by production in low-wage countries typically requires that the firms make sunk investments into the establishment of networks of suppliers in the relevant low-wage countries. In countries with strong labour market imperfections the labour unions, and sometimes citizens more generally, typically express deep concerns when facing the challenge of large-scale outsourcing. These concerns often seem to focus on the consequences of large-scale outsourcing for employment in high-wage countries. This is the topic of this article. More precisely, we design a model to answer the following questions: What is the effect of a commitment to outsourcing on wage formation in an imperfectly competitive labour market where labour unions and firms negotiate over wages? What are the associated effects on equilibrium unemployment in a country with such labour market imperfections? We also explore the relationship between outsourcing and wage formation in the other direction, by asking: How does the presence of labour market imperfections in the high-wage country impact on the outsourcing incentives of firms? Will stronger labour market imperfections increase the optimal scale of outsourcing?

We have studied the consequences of outsourcing for unemployment as well as the incentives associated with the introduction of outsourcing. We have shown that the wage elasticity of labour demand is increasing as a function of the amount of outsourcing, which is a result consistent with existing empirical research (see Slaughter (2001), Senses (2006) and Hasan et al. (2007)). Furthermore, we have demonstrated that a production mode with more outsourcing reduces the negotiated wage in a high-wage country with sufficiently strong labour market imperfections. Consequently, with sufficiently strong labour market imperfections outsourcing reduces equilibrium unemployment. Finally, and importantly, we have characterized the optimal committed production mode by demonstrating that stronger labour market imperfections, measured by the relative bargaining power of labour unions, lead to a production mode with a higher share of outsourcing. The interpretations of our model could most likely be extended to cover foreign direct investment (FDI) in a world with labour, domestic and foreign, as the only production factor in the following respect. In the long run the firm could commit to an FDI programme, which makes it possible to exploit low-cost workers in the foreign country with no labour market imperfections. Within such a framework of such an interpretation the crucial mechanism of our model focuses on how firms can make use of strategic FDI-commitments as a wage-moderating device. Interestingly, the strategic wage-moderating effect of the FDI is realized with no reference to potential product market imperfections.6 Essentially, our model incorporates no features of asymmetric information and for that reason our model cannot easily be used to distinguish capacity expansions which take place based on contracting with external suppliers from those based on firm-internal investments.