Firm outsourcing decisions: evidence from U.S. foreign trade zones

DEBORAH L. SWENSON [*] This article examines the operations of firms located in U. S. foreign trade subzones to study the responsiveness of outsourcing to international cost changes. I find that firms reduce their reliance on foreign inputs when dollar depreciation increases the relative price of imported inputs. The effect is pervasive across industries and is economically significant. In addition, firms that rely more heavily on imported intermediate inputs reduce their overall shipments when dollar depreciation elevates their imported input costs. However, the magnitude of the shipments effect is economically small, suggesting that firms respond to exchange rate movements by adjusting their operations on other dimensions. (JEL F23, F1) I. INTRODUCTION During the NAFTA debates, U.S. industry argued that it would be placed at a competitive disadvantage if it failed to gain access to Mexican parts that benefited from tariff reductions. In the absence of such benefits, it was argued that U.S. firms might even move their production off shore. At the same time, U.S. trade unions expressed great concern that jobs and high levels of economic activity would be lost if NAFTA caused a rise in the outsourcing of intermediate inputs. Although these countervailing concerns have attracted much attention, very little is known about the responsiveness of firm outsourcing to relative price changes or about its secondary effects on firm shipments, since outsourcing decisions are made at the firm level and appropriate data is rarely available to researchers. This article seeks to address this void by analyzing a data set that provides information on these purchasing and shipment decisions. Recent aggregate evidence indicates that firms are purchasing an increasing portion of their intermediate inputs from their foreign affiliates or from unrelated parties located abroad. [1] It is argued that advances in transportation and communications have facilitated the trend toward the dispersion of production activities. While the aggregate trends are striking, little research has focused on individual firm decisions. One exception is Brainard and Riker's [1997] examination of multinational firms' employment choices as they respond to international wage changes. Brainard and Riker conclude that the degree of firm substitution among a firm's numerous foreign affiliates is much higher than that between parent firms and their foreign affiliates, which is relatively small. This labor market evidence suggests that foreign affiliate labor is not easily substituted for home labor and that the two may even be complements. [2] In contrast, a higher degree of substitutability is implied by work including Feenstra a nd Hanson [1996] and Irwin [1996] for the United States or Campa and Goldberg [1997] for the United States, United Kingdom, Japan, and Canada, which documents that the usage of imported intermediate inputs has increased in almost all cases since the 1970s. [3] This article studies the issue of input sourcing flexibility and its consequences by examining individual firm decisions. The analysis is based on the activities of a set of firms located in U.S. foreign trade subzones. I focus on this subset of firms, since the U.S. Foreign Trade subzones program provides a unique opportunity to examine firm level decisions regarding inputs and shipments. The reporting requirements of the Foreign Trade Zones program enable us to view aspects of firm sourcing decisions that are usually unobservable. I use two estimation methods to measure the general substitutability of inputs and outsourcing flexibility. First, I develop a Constant Elasticity of Substitution (CES) model of input demand. I then use nonlinear least squares techniques to estimate the underlying demand parameters implied by the structural equations. I then perform a tobit analysis of firm sourcing decisions. The benefit of the second form of analysis is that it allows me to study additional determinants of outsourcing, and it does not require strong assumptions about the functional form of the production function. …