Outsourcing, Unemployment and Welfare Policy

Outsourcing of labor intensive activities challenges the welfare state and undermines the protection of low-skilled workers. The stylized facts are that profits are concentrated among the high-skilled, involuntary unemployment is mostly among the low-skilled, and private unemployment insurance is missing. This paper analyzes the effectiveness of redistribution and insurance policies when heterogeneous firms can outsource labor intensive components to low-wage economies. The main results are: (i) Social insurance props up wages, leading to more outsourcing and unskilled unemployment. (ii) Redistribution from the skilled to the working poor acts as a wage subsidy to unskilled workers, thereby reducing gross wages, outsourcing and unemployment. (iii) A trend to outsourcing, induced by lower transport costs of imported components, depresses low-skilled wages, raises unemployment, and boosts profits. The resulting polarization of society and the increased income risk of unskilled workers emphasizes the social gains from redistribution and insurance and thus calls for a more active role of the welfare state in more open economies.