Innovation and manufacturing offshoring with fully endogenous productivity growth

This paper developes a two-country model to examine the relationship between net offshoring patterns in innovation and manufacturing and fully endogenous productivity growth. Central to the model, monopolistically competitive firms invest in process innovation that lowers production costs and drives aggregate productivity growth. The occupational choice of skill-differentiated workers into low-skilled employment in production and high-skilled employment in innovation determines national labor allocations, while perfect investment mobility allows firms to shift their production and innovation activities independently between countries. These mechanisms generate a tension between accessing the technical knowledge contained in production processes and sourcing low-cost high-skilled labor as firms select the optimal locations for production and innovation. A key feature of the model is a positive relationship between the unit cost of process innovation and the geographic concentration of industry and innovation as the benefit of greater knowledge spillovers is offset by the cost of rising high-skilled wages.

We characterize location patterns according to trade costs. Specifically, while high trade costs lead to a larger market and the concentration of production and innovation in the asset-wealthy country, when trade costs are low, production and innovation concentrate in proximity to the larger market of the asset-poor country. Given these location patterns, we use the level of trade costs to identify three cases for the directions of net offshoring in innovation and manufacturing. For high trade costs, although the asset-wealthy country has greater shares of industry and innovation, the domestic market is not sufficiently large to attract the production and innovation activities of all firms with domestic owners, and net offshoring thus flows towards the asset-poor country. For intermediate trade costs, however, net offshoring flows from the asset-poor country towards the larger market of the asset-wealthy country. Finally, for low trade costs, the net offshoring flows towards the asset-poor country as it maintains greater concentrations of industry and innovation.

Focusing on the case for which the asset-wealthy country has greater shares of industry and innovation, we investigate the effects of an improvement in knowledge diffusion between countries, and find that net offshoring flows in innovation and manufacturing from the asset-wealthy country to the asset-poor country increase as firms offshore innovation to the asset-poor country to take advantage of lower wages for high-skilled workers. The resulting increased dispersion of industry and innovation activity away from the asset-wealthy country results in a lower unit cost for process innovation and thus accelerates productivity growth.