why do they just do it? a theory of outsourcing and ... · why do they just do it? a theory of...
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Why do they JUST DO IT?
A theory of outsourcing and working conditions
Alejandro Donado∗
University of Heidelberg
Abstract
Nike and other brand companies have long been the target of widespread crit-
icism for outsourcing their manufacturing production to contract factories with
dismal working conditions. Despite the overwhelming amount of public interest,
there exists no theory for studying this topic. The current paper fills this gap. In
the model, the most productive firms in the North make high profits and outsource
their manufacturing production to contract factories in the South. Factories pay
wages that can compensate for poor working conditions, but these wages might not
cover for workers’basic needs. The paper studies an extension under which factory
workers are not appropriately compensated for inferior working conditions.
JEL: F16, J81, F23, F12, J31, F66, J83.
Keywords: Outsourcing, working conditions, compensating wage differentials, labor
standards, subcontracting, Nike, sweatshop.
∗University of Heidelberg, Department of Economics, Bergheimer Str. 58, 69115 Heidelberg, Germany.
(e-mail: [email protected]). I would like to thank Hartmut Egger, Thomas Eife,
and participants at several workshops and conferences for helpful comments and suggestions.
1 Introduction
In 1997, an audit report revealed poor working conditions at one of Nike’s contract
factories. The factory, located in Vietnam, employed around 10,000 workers and produced
400,000 pair of shoes per month. According to the report, factory workers were exposed
to excessive heat, noise, dust, and toxic fumes. Exposure to some carcinogens even
exceeded by 171 times Vietnamese legal standards. An estimate suggested that more than
77% of the workers were suffering from respiratory diseases. Some of the contributing
causes included inadequate ventilation systems, an understaffed medical room, insuffi cient
protective equipment, and lack of training for workers on occupational health and safety.
In addition, the report found that workers were required to work more hours than the
legal limit and were only paid $10 a week.1
This was neither the first nor the last time that Nike had been accused of outsourc-
ing production to contract factories operating under poor working conditions. But this
report was different. It was not one of the many documents from human rights or labor
groups that had been criticizing Nike’s practices for several years. This was a report
commissioned by Nike itself, and it was prepared by the prominent accounting firm Ernst
& Young. The report was meant to be for Nike’s internal use only, until it leaked to the
media on November 1997, attracting significant press coverage and further damaging the
company’s image (see Greenhouse 1997).
Nike’s business model consists in designing, developing, marketing, and selling the
products, but the actual manufacturing process is outsourced to independent contract
factories located in low-cost countries. In the fiscal year 2012-13, the company employed
1See Ernst & Young (1997). Despite the very serious findings, this report has been criticized for not
being comprehensive enough (see O’Rourke 1997).
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around 48,000 people directly and more than one million people indirectly at 789 contract
factories. Despite the criticisms, the business model has been very successful and has
transformed Nike from a small-scale importer of Japanese shoes to the world’s leader in
athletic footwear, apparel, and equipment. Nike’s gross profits have increased steadily
and surpassed the 12 billion mark in 2014.2
But Nike is by no means the only company that has been accused of benefiting from
exploitative working conditions in developing countries. Other targeted companies in-
clude many brand names such as Reebok, Gap, Mattel, Levi Strauss, Adidas, H&M,
Apple, etc.3 The typical accusations are that workers in the contract factories are forced
to work overtime, under poor working conditions, and for less than the living wage. These
accusations raise several questions. In particular, why do profitable brand companies like
Nike outsource their manufacturing production to contract factories operating under poor
working conditions? Why are working conditions poor in those factories? And why are
factory wages not high enough to cover for workers’basic needs?
The main contribution of this paper is to provide a positive theory of outsourcing and
working conditions that can be used to address these questions. The paper develops an
analytically tractable framework that embeds a compensating-wage-differentials model à
la Rosen (1974, 1987) into the global sourcing model of Antràs and Helpman (2004). The
model consists of two countries, the technologically advanced North and the South. Only
northern firms have the knowledge to design and develop differentiated manufacturing
products. These firms, however, outsource the actual manufacturing stage to contract
factories that can be located either in the North or in the South. Contract factories in
the South can undertake the manufacturing stage at lower costs than contract factories
2See more details in Locke (2003) and Nike (2014a, 2014b).3See, e.g., Moran (2002), Rosen (2002), Esbenshade (2004), Ross (2004), and Sluiter (2009).
2
in the North, but fixed and transportation costs associated with southern outsourcing are
higher. Only the most productive northern firms find it profitable to invest in the higher
fixed costs to benefit from the lower manufacturing costs at southern factories.
Manufacturing production is inherently dangerous. For this reason, good working
conditions are more expensive to provide in factories than in other workplaces in the
economy. In the model, workers’preferences depend not only on wages, but also (in-
directly) on the working conditions prevailing at their workplace. Thus, to be able to
attract workers, factories have to pay workers a wage premium that compensates them
when working conditions are inferior. Factories, however, only need to pay workers their
outside option plus the compensating wage premium. In the model, the factory workers’
outside option is related to the country’s labor productivity, and this productivity is as-
sumed to be higher in the North. Thus, workers’outside option is higher in the North,
and this explains why contract factories in the South can undertake the manufacturing
stage at lower costs.
The benchmark model’s main predictions are:
P1: The most productive northern firms make high profits and outsource their actual
manufacturing stage to contract factories in the South.
P2: The level of working conditions at factories depends on the costs of providing these
working conditions and on the country’s labor productivity.
P3: Workers in contract factories earn more than in alternative workplaces, but wages
are only higher because they compensate workers for inferior working conditions.
P4: Despite being higher, factory wages might not cover for workers’basic needs, but
the reason is that the country’s labor productivity is too low.
3
P5: The only source of comparative advantage is the difference in labor productivities
between the two countries. Thus, a low-productivity country can attract more
outsourcing contracts since it can undertake the manufacturing stage at lower costs.
The benchmark model can be easily extended to study the consequences of other
frequent accusations that have been made to brand companies. One topic that has
attracted considerable attention is factory workers’lack of knowledge about occupational
risks and about their labor rights. This is a problem of asymmetric information on
the workers’side. This extension is important since it shows that workers’asymmetric
information can lead to poorer working conditions and lower factory wages. In particular,
factory workers might not be appropriately compensated for the risks they are taking
on the job. Also, under workers’ asymmetric information, factories can attract more
outsourcing contracts because they can undertake the manufacturing stage at lower costs.
A second important extension is noncompliance. Contract factories, especially in low-
cost countries, are often accused of noncompliance with local legal standards. As an
example of noncompliance, this paper studies the consequences when factories do not
comply with wage and safety standards that seek to alleviate the workers’asymmetric
information problem. The main result is that if compliance inspections are rare and
penalties low, factories can undertake the manufacturing stage at lower costs and are
thus able to attract more outsourcing.
Under asymmetric information and noncompliance, the predictions of the benchmark
model need to be replaced by:
P1’: The most productive northern firms make high profits and outsource their actual
manufacturing stage to contract factories in the South. However, asymmetric
information and noncompliance in the South lead to even higher profits
4
and more outsourcing.
P2’: The level of working conditions at factories depends on the costs of providing these
working conditions, on the country’s labor productivity, and on the amount of
workers’asymmetric information.
P3’: Except for the (unlikely) perfect-misinformation case, workers in contract
factories earn more than in alternative workplaces, but wages are only higher be-
cause they compensate workers for inferior working conditions.
P4’: Despite being higher, factory wages might not cover for workers’basic needs. The
reasons are: low country’s labor productivity and a high level of workers’asym-
metric information.
P5’: There are three potential sources of comparative advantage: (i) differences in labor
productivity; (ii) differences in asymmetric information; (iii) differences
in noncompliance. Thus, a country with a low labor productivity, or in which
workers’asymmetric information is high, or in which factories noncom-
pliance with legal standards is more prevalent can attract more outsourcing
contracts since it can undertake the manufacturing stage at lower costs.
The reminder of the paper is organized as follows. The next section relates this work to
the existing literature. Section 3 introduces the benchmark model and applies this model
to understand Nike’s international labor practices. Section 4 extends the benchmark
model to account for asymmetric information and noncompliance. Section 5 concludes.
A detailed Online Appendix contains all derivations reported in the paper.
5
2 Related literature
Despite the overwhelming amount of attention that working conditions at Nike contract
factories have attracted from activists, college students, labor unions, NGOs, govern-
ments, international organizations, journalists, and the general public (see, e.g., Spar
2002), there exists to this date no integrated theory that can be used to study the topic.
The current paper fills this gap. In doing so, the paper connects two strands of the
literature.
The first strand is fairly recent and studies the global sourcing strategies of firms
that differ in their productivities.4 Following the seminal contribution of Antràs and
Helpman (2004), this literature seeks to explain the organizational mode and location
choice of firms that are able to fragment their production process into smaller segments.
By incorporating contractual frictions between firms and their subsidiaries or suppliers,
the organizational mode and location choice emerge endogenously as an outcome of these
models. Firms with different productivity levels sort into different organizational forms.
In contrast to Antràs and Helpman (2004), the current paper assumes away contractual
frictions. The consequence of this simplification is that the organizational mode becomes
irrelevant and firms only have to focus on the location decision. On the other hand,
the current paper extends this literature by incorporating the role of working conditions.
This extension is crucial for studying the issues surrounding the accusations made to Nike
and other brand companies.
The second strand of the literature that this paper connects is a series of applications
of the compensating-wage-differentials theory.5 This theory goes back to Adam Smith’s
4See, e.g., Antràs and Helpman (2004), Grossman and Helpman (2004), Grossman, Helpman, and
Szeidl (2005), and Antràs and Helpman (2008).5See Rosen (1987) for a summary.
6
Wealth of Nations from 1776 but was first formalized by Rosen (1974). The basic idea
is that jobs have nonpecuniary attributes that can be unpleasant for workers. In order
to attract workers, firms have to pay them a premium (or a “compensating wage differ-
ential”) for accepting those unpleasant attributes. The current paper incorporates this
framework into the model to explain why factory workers in low-cost countries tend to
earn more than in alternative employment. The explanation is that their wages are higher
because workers are compensated for the poorer working conditions at factories.
Finally, this paper also contributes to the literature on labor standards and globaliza-
tion.6 One important concern in this literature is over the universality of labor standards.
In particular, should all countries in the world adhere to a set of minimum universal stan-
dards? One argument in favor is that countries with low labor standards can unfairly
attract more investments and that minimum standards are necessary to avoid unfair
competition. In contrast to this, some scholars have claimed that prematurely impos-
ing labor standards might be counterproductive for developing countries. After all, rich
countries introduced most labor standards after having attained a relatively high devel-
opment level (see, e.g., Hall and Leeson 2007). The framework presented in this paper
proposes a way to rationalize both views. On the one hand, the benchmark model pre-
dicts that the level of working conditions depends naturally on the development level of
a country. On the other hand, the extended version of the model shows that asymmetric
information on the workers’side and factories’noncompliance with minimum standards
can indeed be sources of comparative advantage that might serve the South in attracting
more outsourcing contracts at the expense of the North.7
6This literature is summarized in Brown (2000) and Basu et al. (2003). See also Elliott and Freeman
(2003) and Donado and Wälde (2015).7Although outside the scope of this paper, a few empirical studies have also investigated the impact
7
5 Conclusion
For several years, Nike and other brand companies have been the target of widespread
criticism for outsourcing their manufacturing production to contract factories with dismal
working conditions. The main allegations are that factory workers are paid extremely
low wages, are required to work excessive overtime, and are often exposed to unsafe,
unhealthy, and abusive working conditions. According to critics, these working conditions
stand in stark contrast to the large profits usually reported by brand companies. The
current paper has introduced a theory of outsourcing and working conditions that is able
to rationalize these observations.
In the framework, the most productive northern firms make large profits and out-
source their manufacturing production to independent contract factories located in the
South. Compared to the North, wages and the level of working conditions in southern
factories can be relatively low. Southern workers, despite earning more at factories than
in alternative employment, might not be able to cover for their basic needs. The bench-
mark model predicts that only an improvement in the southern labor productivity can
lift workers out of poverty.
The model, although stylized in some dimensions, is tractable enough to accommo-
date several extensions. The current paper has shown how to incorporate asymmetric
information on the workers side and factories’noncompliance with legal standards. Under
these extensions, factory wages and the level of working conditions are lower than in the
benchmark case. This allows southern factories to undertake the manufacturing stage at
lower costs. As a consequence, more northern firms outsource production in the South,
and the firms that were already engaged in southern outsourcing are able to generate
even higher profits.
40
The benchmark model and the two extensions studied in this paper should be seen as
a first step in our understanding of the interrelationship between outsourcing and working
conditions. The model might be fruitfully extended to capture other dimensions of the
debate on brand companies and their global labor practices. Other important issues
that require further research include the presence of immigrant and underage workers at
contract factories and the impact of codes of conduct on working conditions.
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