The Lost Decade for the U.S. Manufacturing Jobs: A Story of Cost and Risk

The period of 2002-2009 witnessed large losses of job in the U.S. manufacturing sector to countries in Asia. Previous research attributed these losses to firms seeking cost arbitrage, better labor and resource availability, incentive to agglomerate, and, importantly, the grant of permanent normal trade relations (pNTR) status to China in late 2000. Interestingly, the magnitude of job losses has not been uniform across manufacturing industries. In this paper, we explain this phenomenon from the risk mitigation perspective. To that end, we develop a model of a firm managing demand risk and choosing whether to invest in domestic production capacity that is capital intensive and inflexible versus invest in overseas production capacity that is labor intensive and more flexible. The model predicts a higher investment into overseas production when the reduction in variable costs is high, switching cost is low, demand volatility is high, and the systematic risk is above a certain threshold. In empirical tests, for years 2002 to 2009, the model explains a substantial part in job-loss variability, after controlling for factors such as labor costs, profitability, capital, labor and skill intensity, as well as, the expected losses due to China’s pNTR status. Thus, our model provides an additional rationale for outsourcing decisions. Together with the empirical results, it informs policy makers on prioritizing efforts to promote flexibility, mitigate risk and preserve the U.S. manufacturing jobs.