What Is Labor Arbitrage?
Labor Arbitrage Explained in Less Than 4 Minutes
Labor arbitrage refers to the financial savings a company may be able to achieve by hiring labor remotely where it is cheaper. Labor arbitrage often involves hiring workers abroad and it's closely linked to the globalization of the economy, but it can happen anytime a company looks to move the labor process to save money.
Keep reading to learn more about labor arbitrage, its benefits, and why it can sometimes be difficult to calculate how much you'll actually save.
Definition and Examples of Labor Arbitrage
Labor arbitrage is often associated with outsourcing or offshoring. The idea is that a certain set of skills could be hired in a different market—another city, region, or country—for less. The difference in labor costs is an incentive to reevaluate the position's geographic location. The labor in question can take any form, whether it's manufacturing, software engineering, or anything else that would require the company to pay labor costs.
The term labor arbitrage comes from a financial concept that refers to identifying the cost differential between two similar or identical products or services in two or more markets and capitalizing on the difference in cost.
For example, financial traders will buy the rights to a million tons of wheat in one state where the price is slightly low and sell it in another state where the price is slightly high. Likewise, if an employer has $10,000 to spend on labor cost, the decision to outsource the labor for $5,000 is far more appealing than keeping up with the rising cost of wages that may require the employer to pay $12,000 for an employee with identical or similar capabilities.
How Does Labor Arbitrage Work?
Labor arbitrage is a broad term, so the details of how it works can vary significantly. Anytime a company reassesses where it hires labor due to financial concerns, it could be an example of labor arbitrage.
Labor cost differentials also may affect an employer's decision to hire an employee with less or even more expertise for the role in that particular region. The cost to employ a New York-based mathematician with 10 years of experience for an entry-level or mid-range position is likely more than the cost to hire a recent college graduate in Oklahoma City. As long as the recent grad in Oklahoma has the basic skills and aptitude necessary to perform the job duties, the company may opt for a less experienced hire.
Accounting for Nuanced Differences Between Labor Pools
When there's an agricultural or manufactured product that's subject to arbitrage, the costs and benefits are more clear. One ball bearing is going to be largely the same as another, regardless of where it was produced or how much it cost to produce. The same goes for bushels of wheat or barrels of oil.
However, the calculation is not as clean when it comes to labor arbitrage. If an investment bank is considering replacing a team of financial analysts in Paris with a team of financial analysts in Berlin, there may be many differences aside from their pay rates. Even if they have similar qualifications, the result of their work would likely be somewhat different. It may be difficult to even determine how exactly the two teams would differ.
The complexity of human beings makes it difficult to directly compare the two teams, and the differences between the two cities' cultures, laws, and customs could further complicate those comparisons.
The lack of certainty in labor arbitrage can be mitigated in several ways. If the outsourced labor in Berlin is less expensive, for example, you may be able to hire a team with more credentials and higher qualifications than the Paris team—helping to ensure that labor arbitrage is a net benefit to the company. Alternatively, you may be able to hire additional team members or managers.
These costs and considerations must be part of the calculation for labor arbitrage benefits. Will outsourcing jobs require expenditures on additional managerial positions? Is the pay still cheaper in the new region, even after accounting for benefits and taxes?
Without answering those questions, labor arbitrage might not be as successful as the company originally thought it would be.
- Labor arbitrage is when a company hires labor from a different geographic area to save on costs.
- Labor arbitrage can take place on any scale—it includes companies who look to another city for labor, as well as those that look to another country.
- Unlike other forms of arbitrage that are more clear-cut, labor arbitrage is nuanced and can come with costs, benefits, and drawbacks that are difficult to quantify or predict.