The Economics of the Software Industry


At the turn of the century, Silicon Valley looked like the ideal location for an information technology (IT) person seeking employment. The IT economy was booming, firms were hiring, and wages, which were linked with stock options and other incentives, were greatly inflated. Encouraged by speculation and to a much lesser extent by the bottom line of annual reports, investors poured money into the IT industry. Office space, generally a good indicator of the overall economy, in Silicon Valley was leasing for $6.50 per square foot. The word “unemployed” in the IT person’s vocabulary was almost nonexistent. Instead it was replaced with the phrase, “I am starting a company.”

Unfortunately, the speculative bubble burst in late 2000 and has since become known as the dot com crash. Following this burst, unemployment in Santa Clara County peaked at just under 9.0 percent while the national rate was at just 5.7 percent. Currently, office space leases for only $1 per square foot.

Both large and small firms have felt the pressure of the economic down turn. The dot com boom introduced significant competition in the IT industry, and as a result drove prices and operating margins extremely low. Since the crash, firms have been working hard to drive prices even lower to capture whatever market share they can. As a result of these pricing pressures, firms have been seeking ways to reduce operation costs in order to remain profitable.

Furthermore, the Economist has argued that the IT industry has evolved from a phase that stressed innovation to one that stresses execution. For instance, software giant Microsoft has found few projects into which it is willing to invest its $50 billion of excess cash. As a result of Microsoft’s innovation down turn, it has announced its plans to offer its first ever dividend payment to stock holders. What this innovation downturn means to IT professionals is that their innovative skills are less valuable. Instead the job market has begun to favor simple programming capabilities and other even more rudimentary and much more teachable skills.



The Allure of Offshore Labor

The combination of pricing pressures and the industry shift away from innovation has encouraged some companies to look overseas for labor. Offshore labor has proven to be dramatically less expensive. While an average IT worker in the US makes $70,000 per year, an Indian IT worker makes just $8,000 per year. Of course, communication, training and other considerations must be taken into account when a company is contemplating outsourcing labor to offshore facilities.


These and other hidden costs of setting up operations overseas can prove expensive. However, the Economist argues that after training an overseas workforce, adding infrastructure, and communications capabilities companies still achieve savings in excess of 30%.

As a result of the appeal of lower development costs, software companies have been moving operations overseas at a rapid rate. For example Agile Software, a Silicon Valley company that sells programs managing all aspects of a product’s lifecycle, has moved half of its 200 developers to India, Hong Kong and southern China. Larger companies have been moving their workforce abroad as well. Oracle plans on increasing its workforce in India to about 6,000 employees.

Furthermore, India has its own homegrown software companies that have not only been hired to work on US software companies’ projects, but have also been competing with US giants. For example, Indian companies Tata Consultancy Service, Infosys and Wipro have all been competing with Accenture an American outsourcing company.

It is important to note that some companies have had offshore facilities for a long time. Industry giants Microsoft, Hewlett Packard, IBM, and Oracle all had offshore facilities during the 1990s. These companies were attracted to India, Hong Kong, and other developing countries by the promise of inexpensive labor. Interestingly, almost no small software companies used offshoring as a cost minimizing strategy prior to 2000.


The Effects of Offshoring at Home

What does offshore outsourcing mean for US IT employees? In some cases the news in not very positive. Around half a million IT jobs have moved overseas already. However, not all of these jobs were taken from US workers; some have been created solely for offshore facilities. What has truly been driving the debate of offshoring has been the fact that none of these jobs has benefited unemployed US IT laborers even though almost all of the parent companies using offshore labor are based in the US.

When considering the offshore outsourcing dilemma from a macro level, the unemployment problem does not look as negative. A study released by Global Insight, a private consulting firm hired by the Information Technology Association of America, indicates that offshore outsourcing has had a positive impact on job creation within the US. The report found that offshore outsourcing lowered inflation, increased productivity, and was linked with lower interest rates. All these things, according to Global Insight, are positive indicators for the economy as a whole and will encourage job creation. Global Insight claims offshoring has had a “ripple effect in the economy” to the tune of 90,000 new jobs offered in the US in 2003.

Skeptics of offshore outsourcing have had a hard time believing that a “ripple effect” exists. Lee Price, research director at the Economic Policy Institute a think tank in Washington DC told the Wall Street Journal, "I'm dubious that the boost in corporate profitability from outsourcing has contributed much to creating new jobs."

Unfortunately the jobs created, as envisioned by Global Insight, have not been and will not be the same IT jobs that have been shipped offshore. Instead, unemployed IT workers will have to develop new skills, and in some cases move to entirely different industries. Globalization and offshoring, as Bill Clinton noted in his 1992 presidential debate with George Bush and Ross Perot, “will, on the whole, do more good than bad… if [the US] has a genuine commitment to educate and retrain American workers who lose their jobs.” The difficult task facing the US IT industry is determining what to do with unemployed IT professionals.