Offshoring and its effects on innovation in emerging economies

Ursula Fritsch, Holger Görg 23 September 2013

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Most empirical studies of the impact of outsourcing on firms look at industrialised countries. However, outsourcing is also common in emerging economies, and firms in middle-income countries split up their production processes similarly to firms in developed countries (see figures in Miroudot et al. (2009) on trade in intermediates). Recent research analyses the benefits to firms from outsourcing, focusing mainly on productivity and innovation effects. The latter are particularly important, since innovation is a key determinant of productivity improvements and – ultimately – growth.

In a recent paper (Fritsch and Görg 2013), we find robust evidence that outsourcing is associated at the firm level with:

  • Spending on research and development.
  • The introduction of new products.
  • Upgrading existing products.

We also show that the results depend crucially on the level of protection of intellectual property in the economy. Firms increase their R&D effort in the wake of outsourcing only if they operate in an environment that intensively protects intellectual property.

We distinguish in our analysis between domestic outsourcing and offshoring – the latter is a transaction that crosses borders. In terms of innovation effects, we have two mechanisms in mind:

  • First, outsourcing allows firms to reduce factor costs and restructure their operations towards higher value-added activities such as R&D and innovation (e.g. Glass and Saggi 2001) – a channel highlighted in the context of developed countries.
  • Secondly, if offshoring takes place to technologically advanced countries, it may provide access to higher quality inputs (e.g. Griffith et al. 2006). This allows the firm to learn new technologies and expand its technological frontier.

While the restructuring effect is present for both outsourcing and offshoring, the technology effect is likely to be particularly important for offshoring. The use of imported inputs – in particular from industrialised countries – can provide strong learning effects for emerging-market firms, thus enhancing their technology level and innovation activities (e.g. Goldberg et al. 2010). Studies for a multitude of developing economies have shown that imports enhance the productivity of firms in these countries. Thus, we would also expect to see that firms in emerging economies increase innovation as a result of engaging in offshoring, which is an alternative method of international sourcing.

Empirical strategy

We use firm-level data from the Business Environment and Enterprise Performance Survey – provided by the EBRD-World Bank – for 27 transition countries. The dataset covers companies located in eastern and central Europe, and in central Asian countries. The novelty of our approach is that we separate out the effects of outsourcing, offshoring, and intermediate imports on innovation activities. Our outsourcing and offshoring measures reflect the fact that firms carry out an activity themselves in one period, but no longer do so in the next. The dataset also offers different innovation measures. We use dummies for whether the firm spent on R&D, introduced new products and services, or upgraded existing products and services. We use data from two or three rounds of the survey, and we implement an instrumental variables strategy to ensure that our results are not subject to endogeneity bias.

Outsourcing and offshoring are common phenomena

Outsourcing is a common practice among the firms covered in the sample – 25% of firms state that they outsourced production in the last three years. Of those firms that outsourced, 43% also offshored, with the remaining 57% only outsourcing domestically. Overall, 11% of the firms in our sample offshored.

Outsourcing and offshoring positively influence innovation

Our empirical results show that, compared to firms that produce everything themselves, outsourcers spend more often on R&D, and are more likely to introduce new products and upgrade existing products. They are also more likely to be importers. Furthermore, offshoring firms are even more likely to engage in innovation activities and to import than domestic outsourcing firms. Indeed, the positive effect of offshoring is stronger than the effect of outsourcing in the case of R&D.

This corroborates our initial hypothesis that, compared to domestic outsourcing, offshoring provides an additional channel to transfer superior technology or to increase productivity through lower factor prices. Of course, these channels might not be mutually exclusive. One potential implication of these results is that sourcing foreign technology and increasing R&D activities may be complements. We also find that the economic magnitude of the estimated coefficients is significant. In most specifications, outsourcing and offshoring increase the probability of engaging in innovation by about 10%. Offshoring provides a strong additional effect over and above outsourcing in the case of R&D spending.

We find that only domestic outsourcing positively influences the introduction of new products. One explanation could be that firms source superior inputs from foreign multinationals located in the country, or from firms that are part of large, diversified business groups. Domestic and international outsourcing both positively affect upgrading. This makes sense, as domestic and international suppliers both have the potential to provide better goods and services to the firm – particularly when it involves only small changes to an existing product or service.

Intellectual-property protection is essential

We also show that these effects on innovation activity depend crucially upon the protection of intellectual property in the economy. Specifically, firms only benefit from outsourcing in terms of higher R&D spending if their intellectual property is sufficiently protected. We interpret this as suggesting that a lack of protection of intellectual property prevents firms from restructuring towards innovation activities.

Intellectual property rights protection does not matter for the introduction of new products or for upgrading. Since we control for R&D spending at the firm level, offshoring activity reflects access to better technology from foreign firms. Of course, protection of this external knowledge does not matter for the sourcing firm. Thus, intellectual property protection matters whenever firms engage in innovation effort through their own R&D.

Conclusion

Our study shows that outsourcing and offshoring induce positive effects on innovation for firms in emerging economies. This corroborates the view that outsourcing is beneficial for firms. It also implies that outsourcing might help emerging economies to enhance their productivity and hence increase their competitiveness. Although we cannot explicitly test the complementarity of firms sourcing superior technology and upgrading their own technology, we suspect that this mechanism is at work. If this is indeed the case, then outsourcing would allow firms in these countries to offer more sophisticated products and services.

References

Fritsch, Ursula and Holger Görg (2013), “Outsourcing, Offshoring and Innovation: Evidence from Firm-level Data for Emerging Economies”, Kiel Working Paper No. 1861, Kiel Institute for the World Economy.

Glass, Amy J and Kamal Saggi (2002), “Intellectual Property Rights and Foreign Direct Investment”, Journal of International Economics 56(2): 387–410.

Goldberg, Pinelopi K, Amit K Khandelwal, Nina Pavcnik, and Petia Topalova (2010), “Imported Intermediate Inputs and Domestic Product Growth: Evidence from India”, Quarterly Journal of Economics 125(4): 1727–1767.

Griffith, Rachel, Rupert Harrison, and John Van Reenen (2006), “How Special Is the Special Relationship? Using the Impact of US R&D Spillovers on UK Firms as a Test of Technology Sourcing”, The American Economic Review 96(5): 1859–1875.

Miroudot, Sebastien, Rainer Lanz, and Alexandros Ragoussis (2009), “Trade in Intermediate Goods and Services”, OECD Trade Policy Working Paper No. 93.

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Topics:  International trade Productivity and Innovation

Tags:  R&D, offshoring, innovation, international trade, emerging markets, outsourcing, technology transfer

Researcher, Kiel Institute for the World Economy; PhD candidate, University of Kiel

Professor of International Economics, Kiel Institute for the World Economy and University of Kiel

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