Offshoring to a Developing Nation with a Dual Labor Market

Abstract

This article analyzes developed-to-developing nation offshoring in the presence of a dual labor-market structure in the developing nation. While the developed nation's labor market is assumed to feature flexible wages and full employment, the developing nation is characterized by a dual labor market where a formal and an informal sector coexist. While the formal sector is subject to a minimum-wage regulation, the informal sector is assumed to be able to circumvent that law or the law does not apply to it and pay a lower market-clearing wage. It is also possible that the formal sector circumvents the law by outsourcing to the informal sector or hiring informal or casual workers to perform certain tasks. Consideration of labormarket duality leads to some important departures from the existing literature on trade in tasks, which was pioneered by Grossman and Rossi-Hansberg (2008, GRH hereafter) among others. As described in Bhagwati and Panagariya (2013), India has over 200 labor regulations that apply to firms in the formal sector. These regulations make labor costs higher than what they otherwise would be and adversely affect the flexibility of firms in responding to shocks. We present a model of offshoring of tasks to a developing nation characterized by a minimum-wage formal sector and a flexible-wage informal sector. Some offshored tasks are outsourced by the formal sector to the lower-wage informal sector. Productivity improvements in performing offshored tasks in the developing nation increase offshoring, but not necessarily formal-to-informal sector outsourcing, which can cause the developed nation's wage to fall. Productivity improvements in the developing nation's informal sector expand both offshoring and outsourcing, causing the developed nation's wage to rise. When the minimum wage is reduced in the developing nation, the developed nation's wage falls when most of the efficiency gains accrue to the informal sector. (JEL F1