Performance Pay and Offshoring

• Author: Theofanis Tsoulouhas,Elias Dinopoulos
• DOI: http://doi.org/10.1111/jems.12144
• Published date: 01 April 2016
• Date: 01 April 2016

Performance Pay and Offshoring

ELIAS DINOPOULOS

Department of Economics

University of Florida

Gainesville, FL 32611-7140

dinopoe@ufl.edu

THEOFANIS TSOULOUHAS

The Ernest & Julio Gallo Management Program

SSHA

University of California

Merced, CA 95343

ftsoulouhas@ucmerced.edu

In this paper, we construct a North–South general equilibrium model of offshoring, highlight-

ing the nexus among endogenous effort-based labor productivity and the structure of wages.

Offshoring is modeled as international transfer of management practices and production tech-

niques that allow Northern firms to design and implement performance compensation contracts.

Performance–pay contracts address moral hazard issues stemming from production uncertainty

and unobserved worker effort. We find that worker effort augments productivity and compensa-

tion of those workers assigned to more offshorable tasks. An increase in worker effort in the South,

caused by a decline in offshoring costs, an increase in worker skill, or a decline in production

uncertainty in the South, increases the range of offshored tasks and makes workers in the North

and South better off. An increase in Southern labor force increases the range of offshored tasks,

benefits workers in the North, and hurts workers in the South. International labor migration from

low-wage South to high-wage North shrinks the range of offshored tasks, makes Northern workers

worse off and Southern workers (emigrants and those left behind) better off. Higher worker effort

in the North, caused by higher worker skills or lower degree of production uncertainty, decreases

the range of offshored tasks and benefits workers in the North and South.

1. Introduction

An increasing number of occupations in the U.S. labor market pay workers for their

performance by offering commissions, bonuses, or piece-rate contracts.1A large fraction

of these jobs face the threat of moving to low-wage countries. This threat stems primar-

ily from dramatic improvements in information, communication, and transportation

technologies that have significantly increased the fragmentation of production and task

offshorability. It is now possible for firms to break up the value chain, with numerous

We are grateful to Evangelia Chalioti, Jacques Cr´

emer, Shalah Mostashari, and David Sappington for very

usefulsuggestions. The paper also benefited from comments by the participants of a workshop at the University

of California, Merced, and by the participants of the 2012 Southern Economic Association meetings in New

Orleans, the 2013 Conference on Tournaments,Contests and Relative Performance Evaluation in Fresno, and

the 2013 CRETE Conference in Naxos.

1. Lemieux et al. (2009) report that between 37% and 42% of workers in their sample were assigned to

performance–pay jobs. In addition, the study finds that changes in performance–pay jobs account for most of

the increase in U.S. male wage inequality above the 80th percentile between the late 1970s and early 1990s.

C2015 Wiley Periodicals, Inc.

Journal of Economics & Management Strategy, Volume25, Number 2, Summer 2016, 334–369

Performance Pay and Offshoring 335

activities occurring in various countries. Components of cell phones, airplanes, personal

computers, and cars are being produced in various low-wage countries such as China

or Mexico. Telemarketing, radiology, customer services, accounting, order processing,

and other business services are being provided from low-wage countries such as India.2

Empirical studies document substantial dispersion in management practices across

establishments within industries and across countries. They also report that firms in de-

veloping countries face substantial costs of adopting better management practices, such

as performance monitoring, target setting, and incentive schemes.3Empirical studies

assert that offshoring affects the wages of high- and low-skilled workers and reveal that,

in addition to labor productivity and wage differences between advanced and develop-

ing economies, “tradability” of tasks and occupations determines the extent and pattern

of offshoring.4

In this paper,we construct a North–South general-equilibrium model of offshoring,

highlighting the nexus among effort-based labor productivity, offshoring patterns, and

the structure of wages. We view the production process as a continuum of tasks or

activities, with workers being the sole factor of production. Based on the literature

on performance–pay contracts, we assume that within each activity worker-specific

output depends on observable skill level, unobservable effort, and an unobservable id-

iosyncratic shock. Skill level captures all observable components of exogenous labor

productivity. Worker-specific output is also observable to the manager and is used to re-

ward worker effort via a piece-rate or absolute performance compensation contract. The

contract consists of (i) a base payment, independent of output level, inducing worker par-

ticipation; and (ii) a bonus payment, proportional to output level, encouraging worker

effort.5

We incorporate the production structure in a benchmark general equilibrium

framework consisting of two economies: an advanced high-wage region (the North)

and a developing low-wage region (the South). Both regions produce the same final

homogeneous good under perfect competition. The production structure consists of

two segments producing the same homogeneous good under different technologies: the

modern segment where each firm produces a continuum of offshorable tasks and the

traditional segment where tasks cannot be offshored and production must occur locally.

Driven by uncertainty, we assume that firms in the modern segment know how

to design and implement incentive contracts, inducing workers to exert effort. In con-

trast, firms in the traditional segment lack expertise in modern management practices,

resulting in workers exerting minimum effort. Production in the traditional segment is

carried by small local firms and involves relatively simple production techniques that

do not require quality control, sophisticated performance monitoring techniques, and

advanced human-resource management practices. Wemodel this segment by assuming

2. This phenomenon is generally referred to as “foreign outsourcing” or “offshoring.” We use the latter

term in this paper. See Trefler (2005) and Feenstra and Taylor(2014, Ch. 7) for additional examples.

3. See Bloom and Van Reenen (2010), and Bloom et al. (2013a, 2013b) among others.

4. The term “tradability” refers to the ease with which a task or occupation is offshorable. In this regard,

relevant characteristics are codifiable/noncodifiable instructions and routine/nonroutine occupations. Feen-

stra (2010) documents that offshoring reduced the wage of U.S. low-skilled (production) workers in the 1980s

and raised the wage of U.S. high-skilled (nonproduction) workers in the 1990s. Crino (2010) asserts that, at

any level of skill, offshoring has a negative impact on the level of employment in tradable occupations.

5. In the present context, the absence of a “common” production shock (i.e., a production shock which is

commonamong workers) makes the introduction of relative performance compensation contracts unnecessary.

The main results hold whether a firm uses absolute or relative performance compensation contracts. In

addition, we do not consider optimal compensation contracts to keep the analysis simple and the intuition

clear.

336 Journal of Economics & Management Strategy

that its production process is deterministic and production occurs under a diminishing

returns to labor technology.

The presence of two production segments is designed to capture,albeit in a reduced

form and perhaps in an extreme way, the dispersion of managerial practices across firms

within the same industry (Bloom et al., 2013a). It also serves two analytical purposes: first,

the traditional segment creates a general-equilibrium channel through which offshoring

affects worker reservation utility and worker welfare; and second, it allows us to model

offshoring as the transfer of managerial practices (performance–pay contracts) from

North to South, as discussed below.

In the absence of offshoring, we assume that the South producesthe same final good

using traditional (nonoffshorable) technology. This assumption is made for tractability

purposes and captures the stylistic fact that modern human-resource management prac-

tices including performance monitoring are used much more extensively in advanced

countries than in developing countries.6In the absence of offshoring, no trade occurs

between North and South. In this paper, offshoring is a combination of international

transfer of management practices and production technology, allowing Northern mod-

ern firms to produce a fraction of tasks in low-wage South. Offshoring is associated with

the design and implementation of performance–pay labor contracts. In other words,

production of offshored activities becomes structurally identical to the production of

the same activities in the North: workers in the South receive high-powered incentive

compensation schemes and exert unobservable effort.

Based on the pioneering work of Grossman and Rossi-Hansberg (2008), we as-

sume that Northern firms face heterogeneous offshoring costs that differ across tasks.

Wemodel offshoring costs in the standard “iceberg” fashion: only a task-specific fraction

of offshored output “arrives” to the North.7In addition to standard trade costs, het-

erogeneous offshoring costs capture the notion that some tasks/occupations are more

codifiable than others and thus exhibit lower offshoring costs. In sum, tasks remain in

the North either because they are performed by workers in the modern segment and

entail high offshoring costs (e.g., marketing and R&D), or because they are performed by

firms in the traditional segment (e.g., where effort is observable, or simple compensation

schemes are used).

The assumption of heterogeneous offshoring costs has two important implications.

First, as in Grossman and Rossi-Hansberg (2008), it enables us to obtain an interior

solution for the extent of offshoring. Second, offshoring costs have a directeffect on (i) the

bonus component of workers in the South employed in offshored tasks; (ii) endogenous

effort-based productivity; and (iii) the wage structure in the South. Endogenous effort-

based productivity leads to several additional features that complement the seminal

analysis of Grossman and Rossi-Hansberg. For instance, workers in the South engaged

in more offshorable activities exert higher effort and receive higher compensation. As a

result, offshoring leads to an unequal wage–income distribution within a sector among

(ex ante) identical workers. In other words, the model predicts that offshoring increases

residual wage inequality in the South.

6. Bloom and VanReenen (2010) document the substantial variation of management practices across firms

and countries. Based on survey data, they focus on management practices such as systematic performance

monitoring, setting appropriate targets, and providing incentives for good performance. They assert that

multinational firms engage in international transfers of these practices.

7. Grossman and Rossi-Hansberg (2008) incorporate offshoring costs in activity-specific unit-labor re-

quirements of the production process. In our setting, production uncertainty and endogenous unobserved

effort necessitate the modeling to offshoring costs in the traditional “iceberg” fashion. This difference is

inconsequential.