The Theory Behind Outsourcing

In response to an article review on outsourcing.

Great work on your week 3 AR. I want to place this concept in a theoretical light. When Adam Smith wrote the Wealth of Nations in 1776, one of his important insights had to do with the role of specialization in the creation of wealth. If people specialize, they become very efficient at certain types of work. They can do what they do well and then exchange their work for the production of others, who specialize in what they do well. The result is more efficient production and an increase in wealth. Adam Smith provided the following example in the Wealth of Nations.

To take an example, therefore, from a very trifling manufacture, but one in which the division of labour has been very often taken notice of, the trade of a pin−maker: a workman not educated to this business (which the division of labour has rendered a distinct trade, nor acquainted with the use of the machinery employed in it (to the invention of which the same division of labour has probably given occasion), could scarce, perhaps, with his utmost industry, make one pin in a day, and certainly could not make twenty. But in the way in which this business is now carried on, not only the whole work is a peculiar trade, but it is divided into a number of branches, of which the greater part are likewise peculiar trades. One man draws out the wire; another straights it; a third cuts it; a fourth points it; a fifth grinds it at the top for receiving the head; to make the head requires two or three distinct operations ; to put it on is a peculiar business; to whiten the pins is another ; it is even a trade by itself to put them into the paper ; and the important business of making a pin is, in this manner, divided into about eighteen distinct operations, which, in some manufactories, are all performed by distinct hands, though in others the same man will sometimes perform two or three of them. I have seen a small manufactory of this kind, where ten men only were employed, and where some of them consequently performed two or three distinct operations. But though they were very poor, and therefore but indifferently accommodated with the necessary machinery, they could, when they exerted themselves, make among them about twelve pounds of pins in a day. There are in a pound upwards of four thousand pins of a middling size. Those ten persons, therefore, could make among them upwards of forty−eight thousand pins in a day. Each person, therefore, making a tenth part of forty−eight thousand pins, might be considered as making four thousand eight hundred pins in a day. But if they had all wrought separately and independently, and without any of them having been educated to this peculiar business, they certainly could not each of them have made twenty, perhaps not one pin in a day; that is, certainly, not the two hundred and fortieth, perhaps not the four thousand eight hundredth, part of what they are at present capable of performing, in consequence of a proper division and combination of their different operations.

This theory was completed by David Ricardo, who developed the theory of Comparative Advantage. Comparative Advantage says that the person (company, country, etc.) with the least opportunity cost involved in producing the product should produce it and the person with a higher opportunity cost should purchase it. Through this trade, wealth is maximized. Thus, if a company in India has a lower opportunity cost involved in data input than a company in America, both companies are better off if the Indian company does the data input function, while the American company focuses its resources on what it does best. In this way, wealth is maximized.

This theory works at all levels. The reason that we are individually better off learning particular skills, specializing and selling our labor, is because we can then become the lower opportunity cost provider in a certain area and exchange our talents and skills for things produced by others. Without this process described by Smith and Ricardo, none of us would have living standards beyond that of a caveman, if we could survive at all.

The recent change that is often called outsourcing stems from a dramatic reduction in transaction costs facilitated by computers and fiber-optics. While any gain obtained in the past by sending work to India would have been overwhelmed by shipping costs and time delays, today these costs are minimal because of computers, fiber-optics and the Internet. These new tools are creating greater opportunities for more efficiency and greater wealth creation.

		December 18, 2005 *The Theory behind Outsourcing*
	In response to an article review on outsourcing. Great work on your week 3 AR. I want to place this concept in a theoretical light. When Adam Smith wrote the Wealth of Nations in 1776, one of his important insights had to do with the role of specialization in the creation of wealth. If people specialize, they become very efficient at certain types of work. They can do what they do well and then exchange their work for the production of others, who specialize in what they do well. The result is more efficient production and an increase in wealth. Adam Smith provided the following example in the Wealth of Nations. To take an example, therefore, from a very trifling manufacture, but one in which the division of labour has been very often taken notice of, the trade of a pin−maker: a workman not educated to this business (which the division of labour has rendered a distinct trade, nor acquainted with the use of the machinery employed in it (to the invention of which the same division of labour has probably given occasion), could scarce, perhaps, with his utmost industry, make one pin in a day, and certainly could not make twenty. But in the way in which this business is now carried on, not only the whole work is a peculiar trade, but it is divided into a number of branches, of which the greater part are likewise peculiar trades. One man draws out the wire; another straights it; a third cuts it; a fourth points it; a fifth grinds it at the top for receiving the head; to make the head requires two or three distinct operations ; to put it on is a peculiar business; to whiten the pins is another ; it is even a trade by itself to put them into the paper ; and the important business of making a pin is, in this manner, divided into about eighteen distinct operations, which, in some manufactories, are all performed by distinct hands, though in others the same man will sometimes perform two or three of them. I have seen a small manufactory of this kind, where ten men only were employed, and where some of them consequently performed two or three distinct operations. But though they were very poor, and therefore but indifferently accommodated with the necessary machinery, they could, when they exerted themselves, make among them about twelve pounds of pins in a day. There are in a pound upwards of four thousand pins of a middling size. Those ten persons, therefore, could make among them upwards of forty−eight thousand pins in a day. Each person, therefore, making a tenth part of forty−eight thousand pins, might be considered as making four thousand eight hundred pins in a day. But if they had all wrought separately and independently, and without any of them having been educated to this peculiar business, they certainly could not each of them have made twenty, perhaps not one pin in a day; that is, certainly, not the two hundred and fortieth, perhaps not the four thousand eight hundredth, part of what they are at present capable of performing, in consequence of a proper division and combination of their different operations. This theory was completed by David Ricardo, who developed the theory of Comparative Advantage. Comparative Advantage says that the person (company, country, etc.) with the least opportunity cost involved in producing the product should produce it and the person with a higher opportunity cost should purchase it. Through this trade, wealth is maximized. Thus, if a company in India has a lower opportunity cost involved in data input than a company in America, both companies are better off if the Indian company does the data input function, while the American company focuses its resources on what it does best. In this way, wealth is maximized. This theory works at all levels. The reason that we are individually better off learning particular skills, specializing and selling our labor, is because we can then become the lower opportunity cost provider in a certain area and exchange our talents and skills for things produced by others. Without this process described by Smith and Ricardo, none of us would have living standards beyond that of a caveman, if we could survive at all. The recent change that is often called outsourcing stems from a dramatic reduction in transaction costs facilitated by computers and fiber-optics. While any gain obtained in the past by sending work to India would have been overwhelmed by shipping costs and time delays, today these costs are minimal because of computers, fiber-optics and the Internet. These new tools are creating greater opportunities for more efficiency and greater wealth creation.