Why Is China Cheaper?

For several decades now, company after company has outsourced manufacturing to China. Even "patriotic" items, like flags, are often stamped "Made in China."

Why do companies send their manufacturing overseas? The main driver, obviously, is labour cost. If the wages of an American manufacturing worker are at least $10-15 per hour, while the Chinese worker costs $1 per hour (minimum wage in expensive Guangzhou Province is ~$1.25/hr), then you can, at first blush, save 90% (!) of your labour costs by manufacturing there! Sure, you have to deal with shipping, lead time, import duties, borders, intellectual property violations, quality control and coordination from thousands of miles away. But with labour often being the majority cost in manufacturing, the sheer cost savings often more than make up for the rest of the challenges.

The question then, isn't why companies outsource to China; the question is why is it so much cheaper to manufacture in China?

Yes, labour is cheaper. But labour is usually cheaper because productivity is lower. If employees in location A are twice as productive as employees in location B, then usually the wages of employees in location A are twice those of employees in location B. Since labourers in China cost 10% or less of those in, say, Illinois, then they should be 1/10 as productive!

I had this exact discussion with my business-school economics professor, John Coleman, on a bus from Tianjian Economic Development Area (TEDA), a planned high-tech city, to Beijing. John said that Chinese labourers actually are more productive than their wages would indicate. A Chinese labourer in a plant making Beanie Babies or iPhones may get paid only 1/10 of the wages of their American counterpart, but are actually only 1/5 (or more) as productive.

If I can pay the worker 1/10 of the American wage, but it only takes him 1/5 or 1/4 the time to get the work done, then I might not have a 90% savings, but 50% savings is pretty good as well!

Of course, this begs the question: if the Chinese worker is 1/5 as productive, why is s/he getting only 1/10 the wage? Shouldn't the worker be getting 1/5 the wage?

This was the exact question that stumped us. The answer, as philosophers love to say, is the difference between the short term and the long term. As of today (see here), the population of China is ~1.3BN, about 50% in cities, mostly on the urbanized East Coast, and the rest in the poor rural provinces. As recently as 10 years ago, only ~33% were urbanized.

This leaves half the population - ~650MM people, or equal to the entire combined population of the US and the EU - for whom $1/hour is a Godsend. This massive population willing to take low-wage jobs, despite quickly becoming more productive than their wages suggest, creates strong downward pressure on wages and keeps them below their productivity level.

Ah, you will ask, but as China rapidly urbanizes, eventually, won't the excess population be used up? Indeed it will! Eventually, Chinese workers will be no more or less expensive, for the work you get, than a worker in the US, Canada, the Philippines or anywhere else. At that point, China will have to compete on its expertise - which may turn out to be electronics manufacturing, toy manufacturing or anything else - and innovation, just like any other developed country.

In short, Chinese manufacturing is nothing more or less than a temporary imbalance between the costs of two items. China is an arbitrage play.

Postscript: I asked John how long he thought this situation would last. His answer: "between 10 and 20 years." John and I had this conversation in February 2005, or just under 9 years ago. If you look at the graph of Chinese population urbanization, the trend is accelerating rapidly, and is highly likely to complete within the next ten years. The trend appeared far slower back in 2005, and looked like the 30-40 years of which the pundits spoke; John knew of what he spoke.