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A L E X O P O U L O S D I M I T R IG A R C I A J O S E
V I E I R A A N T O N Y
GLOBAL SOURCING (2004)Pol antras
Elhanan Helpman
PLAN
I Introduction II The modelIII Equilibrium IV Organizational formsV Prevalence of Organizational FormsVI Conclusion
I INTRODUCTION
How to produce
To keep the production
Home(standard vertical
integration)
Abroad(FDI)
To outsource an input
Home(domestic
outsourcing)
Abroad(foreign
outsourcing or laquo armrsquos-length
trade raquo)
I INTRODUCTION
Intel Corporation has chosen the FDI strategybull It assembles most of its
microchips in wholly owned subsidiaries in China Costa Rica Malaysia and the Philippines
Nike has chosen the armrsquos-length import strategybull It subcontracts most of its
manufacturing to independent producers in Thailand Indonesia Cambodia and Vietnam
I INTRODUCTION
bull Growth of international specialization has been a dominant feature of the international economy
bull Feenstra (1998) of the $2 export value for the Barbie dolls when they leave HK for the USbull $035 = Chinese laborbull $065 = cost of materialsbull $100 = transportation
bull WTO (1998) in the production of an American car
US37
Korea30
Japan18
Ger-many
8
Taiwan amp Singapore4
UK3
Ireland amp Barbados2
I INTRODUCTION
bull Feenstra and Hanson (1996)bull The share of imported intermediates increased from 53 of
total US intermediate purchases in 1972 to 116 in 1990
bull Bureau of Economic Analysisbull The growth of foreign outsourcing by US firms have
outpaced the growth of their foreign intrafirm sourcing
bull Fan and Lang (2000)bull Decline in vertical integrationbull US manufacturing firms have become more specialized over
time
I INTRODUCTION
bull Issuesbull Outsourcing vs Integrationbull Home vs Foreign productionbull Conclusion need of a theoretical framework in which companies make
endogenous organizational choices
bull Melitz (2003)bull Helpman Melitz and Yeaple (2004)
bull Low-productivity firms serve only the domestic marketbull High-productivity firms also serve foreign markets
bull Among the high-productivity firms that serve foreign markets bull The more productive ones engage in FDIbull The less productive ones exportbull Affiliate sales relative to exports are larger in sectors with more productivity dispersion
bull PB their approach emphasizes variations across firms within industries without addressing the organizational choices of firs that need to acquire intermediate inputs
I INTRODUCTION
bull Grossman and Helpman (2002)bull Address the choice between outsourcing and integration in a one-input general equilibrium
frameworkbull HYP all firms of a given type are equally productivebull Their firms face the friction of incomplete contracts in armrsquos length relationships which they
weigh against the less efficient production of inputs in integrated companiesbull As a result some sectors have only vertically integrated firms whereas others have only
disintegrated firms
bull Antras (2003)bull Approach extended to a trading environment by introducing two new features
bull The friction of incomplete contracts also exists within integrated firmsbull Integration provides well-defined property rightsbull There are two inputs
bull 1 controlled by the final-good producerbull 1 controlled by another supplier inside or outside the firm
bull The sector that is relatively intensive in the input controlled by the final-good producer integrates
bull The sector that is relatively intensive in the other input outsourcesbull In the former sector there is intrafirm trade in inputs in the latter sector there is armrsquos-
length trade
I INTRODUCTION
bull Antras and Helpmanbull Develop a theoretical model that combinesbull The within-sectoral heterogeneity of Melitz (2003)bull With the structure of firms in Antras (2003)
bull The final-good producer controls the supply of headquarter services whereas a supplier of intermediate goods controls the quality and quantity of the intermediates
bull As a result they can study the impact of variations in productivity within sectors and of differences in technological and organizational characteristics across sectors on international trade FDI and the organizational choices of firms
bull In this framework trade investment and organization are interdependent
bull The incentives created by different organizations differences in their fixed costs and wage differentials across countries shape the equilibrium organizational structure
I INTRODUCTION
bull In a world of two countries North and South in which final-good producers are based in the North final-good producers that operate in the same sector but differ in productivity sort intobull integrated companies that produce inputs in the North (do not engage in foreign trade in inputs)bull Integrated companies that produce inputs in the South (engage in FDI and intrafirm trade)bull Disintegrated companies that outsource in the North (do not engage in foreign trade in inputs)bull Disintegrated companies that outsource in the South (import inputs at armrsquos-length trade)
bull in sectors with low headquarter intensity firms do not integrate low-productivity firms outsource in the North whereas high-productivity firms outsource in the South
bull In sectors with high headquarter intensity all four organizational forms may exist in equilibrium and as in sectors with low headquarter intensity high-productivity firms import inputs whereas low-productivity firms acquire them in the North
bull However among the firms that acquire inputs in the same country the low-productivity firms outsource whereas the high-productivity firms insource
bull This implies that the least productive firms outsource in the North whereas the most productive firms insource in the South via FDI
I INTRODUCTION
bull We use the model to study the relative prevalence of different organizational forms
bull We show how prevalence depends onbull the wage gap between the North and the Southbull the trading costs of intermediate inputsbull the degree of productivity dispersion within a sectorbull the distribution of bargaining powerbull the size of the ownership advantage (which may be different in the two countries)bull the intensity of headquarter services
bull Our model predictsbull relatively more final-good producers rely on imported intermediates in sectors with
higher productivity dispersion or lower headquarter intensitybull in sectors with integration and outsourcing which are the sectors with high
headquarter intensity industries with higher productivity dispersion have relatively more final-good producers that integrate
bull As a result such sectors have more intrafirm trade relative to armrsquos-length trade
II THE MODEL
bull Two countries the North and the Southbull A unique factor of production laborbull The world is populated by a unit measure of consumers with
identical preferences
bull x0 consumption of a homogenous good
bull Xj index of aggregate consumption in secor j
bull μ parameter
bull Inverse demand function for each variety i in sector j
II THE MODEL
bull Producers of differentiated products face a perfectly elastic supply of labor in each country
bull Wage rates are fixed and wN gt wS
bull The demand parameters μ and a are the same in every industrybull This helps focus attention on cross-sectoral differences in technology and organizational costs
bull Our aim to explore how differences in technology interact with organizational choices in shaping industrial structure trade flows and FDI
bull Only the North knows how to produce final-good varieties bull To start producing a variety in sector j a firm needs to bear a fixed cost of entry
consisting of fE units of northern labor Upon paying this fixed cost the unique producer of variety i in sector j draws a productivity level θ from a known distribution G(θ)
bull After observing this productivity level the final-good producer decides whether to exit the market or start producing in the latter case an additional fixed cost of organizing production needs to be incurred bull This additional fixed cost is a function of the structure of ownership and the location of
production
II THE MODEL
bull Production of any final-good variety requires a combination of two variety-specific inputsbull hj(i) headquarter services
bull Can be produced only in the North with one unit of labor per unit of outputbull mj(i) manufactured components
bull Can be produced in the North and in the South with one unit of labor per unit of output in each country
bull Output of every variety is a sector-specific Cobb-Douglas function of the inputs
bull θ firm-specific productivty parameterbull ηj sector-specific productivity parameter
bull The larger ηj is the more intensive the sector in headquarter services
bull Two types of agents engaged in productionbull H final-good producers who supply headquarter servicesbull M operators of manufacturing plants who supply intermediate inputs
bull Every H needs to contract with an M for the provision of components bull We allow international fragmentation of the production process so that H can choose
to trans- act with an M in the North or in the South
II THE MODEL
bull It follows from our assumptions that all H locate in the North bull Upon paying the fixed cost of entry wNfE and observing the productivity level θ the unique final-good
producer H of variety i in sector j seeks out a supplier of components M in the North or in the South
bull Simultaneously H chooses whether to insource or outsource intermediate inputs The joint management costs of final and intermediate goods production such as supervision quality control accounting and marketing depend on the organizational form and the location of M
bull All these costs the sum of which we term laquo fixed organizational costs raquo are denominated in terms of
northern labor bull We denote them by wNfk
l
bull k index of the ownership structurebull i index of the country in which M is located and the manufacturing of components takes place
bull The ownership structure takes one of two forms bull vertical integration Vbull outsourcing O
bull The supplier M is located in one of two sites bull in the North Nbull in the South S
bull Therefore k E1113110 V O and l E1113110 N S
bull An organizational form consists of an ownership structure and a location of M
II THE MODEL
bull We assume that the fixed organizational costs are higher when M is located in the South regardless of ownership structure because the fixed costs of search monitoring and communication are significantly higher in the foreign countrybull fk
S gt fVN and fk
S gt fON for k =V O
bull Given the location of M the fixed organizational costs of a V firm are higher than the fixed organizational costs of an O firm bull fV
l gt fOl for l = N S
bull As a result of these assumptions the fixed organizational costs are ranked as follows
bull We adopt this ordering in order to avoid a taxonomy of cases There exists a tension between two considerations that affect the ranking of fV
l and fOl
bull the need to supervise the production of intermediate inputs in addition to other managerial tasks raises man- agerial overload and the fixed organizational costs of a V firm relative to an O firm
bull economies of scope in the management of diverse activities reduce the fixed organizational costs of a V firm relative to an O firm
bull Our ordering amounts to assuming that managerial overload is more important than managerial economies of scope Al- though we believe this assumption to be appropriate in many instances and we therefore maintain it in the main analysis we shall point out how some of the results change when fV
l lt fOl
II THE MODEL
bull The setting is one of incomplete contracts Final-good producers and manufacturing plant operators cannot sign ex ante enforceable contracts specifying the purchase of specialized intermediate inputs for a certain price
bull The parties cannot write enforceable contracts contingent on the amount of labor hired or on the volume of sales revenues obtained when the final good is sold
bull Hart and Moore (1999) and Segal (1999)bull The parties cannot commit not to renegotiate an initial contract and that the precise nature of
the required input is revealed only ex post and is not verifiable by a third party
bull To simplify the analysis we just impose these constraints on the contracting environment
bull Because no enforceable contract can be signed ex ante final-good producers and manufacturing plant operators bargain over the surplus from the relationship after the inputs have been produced We model this ex post bargaining as a generalized Nash bargaining game in which the final-good producer obtains a fraction β1113110E (0 1) of the ex post gains from the relationship
II THE MODEL
bull Following the property rights approach to the theory of the firm we assume that ex post bargaining takes place both under outsourcing and under integration The distribution of surplus is sensitive however to the mode of organization
bull More specifically the outside option of H is assumed to be different when it owns the manufacturing plant than when it does not In the latter case a failure to reach an agreement on the distribution of the surplus leaves both parties with no income because the inputs are tailored specifically to the other party in the transaction
bull However by vertically integrating the production of components H is effectively buying the right to fire M and seize the inputs mj(i) If there were no costs associated with firing the operator of the manufacturing plant the final-good producer would always have an incentive to seize the inputs mj(i) ex post and M wouldhave an incentive to choose mj(i) = 0 ex ante (which of course would imply xj(i) = 0)
bull In this case integration would never be chosen We therefore assume that firing M results in a loss of a fraction 1 1113110- δ of final-good production because H cannot use the intermediate inputs without M as effectively as it can with the cooperation of M
bull We also assume that δN ge δS This captures the notion that a contractual breach is likely to be more costly to H when M is in the South More figuratively we think of this assumption as reflecting less corruption and better legal protection in the North As is clear from the weak inequality however our results still hold when δN = δS
bull The location of M and the mode of ownership are chosen ex ante by H to maximize its profits There is an infinitely elastic supply of M agents in each one of the countries Each final-good producer H offers a contract that seeks to attract a plant operator M The contract includes an up-front fee for participation in the relationship that has to be paid by M This fee can be positive or negative that is the operator can make a payment to the final-good producer or vice versa The purpose of the fee is to secure the participation of M in the relationship at minimum cost to H When the supply of M is infinitely elastic Mrsquos profits from the relationship net of the participation fee are equal in equilibrium to its ex ante outside option For simplicity we set Mrsquos ex ante outside option equal to zero in both countries It is however easy to extend the analysis to cases in which these outside options are positive and different in the North and in the South
III EQUILIBRIUM
bull The organizational structure equilibrium will be determined bybull Incentives created by different organizationsbull Differences in their fixed costsbull Wage differentials across countries
bull Being in an incomplete contract framework it means that the contract will be renegotiated at some point in time Therefore a bargaining game specification is needed
bull If the parties agree in the bargaining the potential revenue from the sale of the final good is given by
(4)
bull The resulting payoffs implies that the final-good producer (henceforth H) appropriate higher fraction of the revenue under integration than under outsourcing with this fraction being higher when integration takes place in the North The payoffs ordering are the following
(5)
III EQUILIBRIUM
bull As we are in an incomplete contract framework both H and M will choose their quantities noncooperatively Each one will produce the quantity that maximises their individual profits Total operating profits are given by
(6)
where
(7)
bull As H has to attract an M agent whose outside option (ie if they fail to agree) is zero and the contract includes a participation fee (t) which can be positive or negative the final-good production (H) will be the one who decides the organizational form because he will have the incentive to increase t as much as he can (as long as the payoff of M is not negative) As a result
III EQUILIBRIUM
bull Thus upon observing its productivity level H will decide the ownership structure and the location of manufacturing that maximizes (6) The productivity threshold will determine whether H exits the industry or not This productivity threshold depends on the sectorrsquos aggregate consumption index X and implies that
(9)
bull In fact to solve this optimization program the final-good producer will have to choose the triplet that maximizes (6)
bull Equation (6) puts in evidence that profits are decreasing both with and Hence from a cost saving point of view H faces a trade-off as fixed costs are higher in the South and variable costs are lower there ( )
bull Next the final good producer cannot freely choose its fraction of revenue bull Although a higher gives H a larger fraction of revenue it also induces M to produce fewer
components Therefore H trades the choice of a larger fraction of the revenue for a smaller revenue level In fact this fraction of revenue will be determined as follows
(10)
III EQUILIBRIUM
bull Each partyrsquos severity of underinvestment is inversely related to the fraction of the surplus that it appropriates Therefore ex ante efficiency requires giving a larger share of revenue to the party undertaking the relatively more important investment
IV ORGANIZATIONAL FORMS
bull Firms face two types of tensions when choosing the organizational formbull Regarding the location decision variable costs are lower in the South but fixed costs are lower in
the Northbull For the ownership decision the firm has to take into account the fact that insourcing entails higher
fixed costs and gives H a larger fraction of the revenue However if the effect of Mrsquos incentives are strong enough Hrsquos profits may be lower under integration (because if H appropriates a large fraction of revenue M will have no incentive to produce the components)
bull In component-intensive sectors firms donrsquot integrate high-productivity firms outsource in the South low-productivity firms outsource in the North and least productive firms exit the industry
bull In headquarter-intensive sectors we can find the four different organizational forms The most productive firms integrate in the South and somewhat less productive firms outsource in the South Firms with even lower productivity acquire components in the North and among them the more productive integrate and the less productive outsource Finally the least productive firms exit
IV ORGANIZATIONAL FORMS
bull A low headquarter intensity is depicted when As indicated by the arrows profits decrease with increases in bull In this situation H prefers outsourcing to
insourcing regardless the manufacturing location because outsourcing has lower fixed costs and it gives H a lower fraction of revenue
bull Depending on whether the cross-county difference in the wage rate is small or large relative to the cross-country difference in the fixed organizational costs the resulting equilibrium can havebull outsourcing in both countriesbull outsourcing in the South only
Low headquarter intensity sector
IV ORGANIZATIONAL FORMS
bull When wage differential is small relative to to the fixed cost differential firms with a productivity higher than the productivity threshold will outsource in the North and firms with even higher productivity will outsource in the South
bull When wage differential is large relative to the fixed costs all firms with a productivity higher than the threshold will outsource in the South
bull With this threshold level being the intersection between the red line and the horizontal axis
(6)
Low headquarter intensity sector
IV ORGANIZATIONAL FORMS
High headquarter intensity sector bull A high headquarter intensity is depicted when As indicated by the arrows profits increase with increases in
bull The figure 4 shows us that is steeper than for
bull When wage differential is small relative to the fixed cost differential and when the sector is relatively more intensive in headquarter services the marginal return of headquarter services is high making underinvestment significantly costly for H Therefore in such a situation itrsquos always profitable for H to insource regardless the manufacturing location because
bull Integration gives H a larger share of revenue However variable costs are lower in the South For that reason can be steeper or flatter than This is to say that can be larger or smaller than
bull Depending on whether the cross-county difference in the wage rate is small or large relative to the difference between and the resulting equilibrium can have bull The four organizational formsbull Outsourcing in the North insourcing in the North and insourcing in the
Southbull Outsourcing in the North and insourcing in the North
(6)
IV ORGANIZATIONAL FORMS
High headquarter intensity sector
(6)
First case
bull It follows that
(14)
bull Given the orderings in (3) and (14) figure 4 shows us that all four organizational forms exist in equilibrium
IV ORGANIZATIONAL FORMS
High headquarter intensity sector
(6)
Second case
bull In this event (14) doesnrsquot hold anymore because and there are only two equilibrium possibilities
bull Either bull Integration in the North
dominates Consequently only 3 organizational forms can exist in equilibrium at best
bull Outsourcing in the North
bull Insourcing in the Northbull Insourcing in the South
IV ORGANIZATIONAL FORMS
High headquarter intensity sector Second case
bull In this event (14) doesnrsquot hold anymore because and there are only two equilibrium possibilities
bull Orbull Integration in the North
dominates outsourcing and insourcing in the South Consequently only two organizational forms can exist in equilibrium at most
bull Outsourcing in the North
bull Insourcing in the Northbull Hence there is no
international trade in inputs
(6)
V PREVALENCE OF ORGANIZATIONAL FORMS
Measure of prevalence the fraction of firms and market share
COMPONENT-INTENSIVE SECTOR
bull No firm integrates low η
The fraction of firms that outsource in the South
1 Lower wage in the south Raises the profit of outsourcing in the SouthRaises The minimal productivity to be active in the sector rises
SO
COMPONENT-INTENSIVE SECTOR
The fraction of firms that outsource in the South
2 Increase in the dispersion of productivity Raises
3 Higher headquarter intensity is less prevalent
4 Smaller fraction of the surplus from outsourcing in the south (β)Raises the profitability of outsourcing in the South is more prevalent
HEADQUARTER-INTENSIVE SECTOR
Organizational forms
HEADQUARTER-INTENSIVE SECTOR
1 Lower wage in the South
2 Increase of productivity dispersionDecline Increase and ambiguous effect in the others
3 Higher headquarter intensity (η) Domestic outsourcing is favored relative to foreign outsourcingIntegration is favored relative to outsourcingThe effects of η on the fraction of firms that insource in the south is ambiguous
HEADQUARTER-INTENSIVE SECTOR
4 Increase in the revenue shares4 Increase in (rises slope of the profit line)
SV
The fraction of outsourcing firms in the South declines and the fraction of insourcing firms in the South rises
HEADQUARTER-INTENSIVE SECTOR
4 Increase in the revenue shares5 Increase in (rises slope of the profit line)
NV The fraction of firms that
outsource in the north declines and these that insource in the north rises The fraction of firms that outsource in the south declines and these that insource in the south does not change
HEADQUARTER-INTENSIVE SECTOR
5 Increase in the primitive bargaining power parameter (β)
bull Shifts the bargaining power in favor of Hbull Outsourcing becomes more attractivebull ise bull The fraction of firms that import components
rises
VI CONCLUDING COMMENTS
1 The high-productivity firms -gt South2 In the same country high-productivity firms
insource 3 In sectors with very low intensity of headquarter
services no firm integrates 1 Low-productivity firms outsource at home 2 High-productivity firms outsource abroad
VI CONCLUDING COMMENTS
4 The prevalence of organizational forms depends on industry characteristics and on the degree of productivity dispersion across firms
1 Sectors with more productivity dispersion (lower z) more imported inputs
1 Within the headquarter-intensive sectors integration is more prevalent
2 Higher headquarter intensity less imported inputs 1 Within the headquarter-intensive sectors integration is more
prevalent
5 Lower wages in the south raises the fraction of firms that import intermediate inputs
1 It raises the fraction of firms that outsource in each country 2 Armrsquos length trade rises relative to intrafirm trade
PLAN
I Introduction II The modelIII Equilibrium IV Organizational formsV Prevalence of Organizational FormsVI Conclusion
I INTRODUCTION
How to produce
To keep the production
Home(standard vertical
integration)
Abroad(FDI)
To outsource an input
Home(domestic
outsourcing)
Abroad(foreign
outsourcing or laquo armrsquos-length
trade raquo)
I INTRODUCTION
Intel Corporation has chosen the FDI strategybull It assembles most of its
microchips in wholly owned subsidiaries in China Costa Rica Malaysia and the Philippines
Nike has chosen the armrsquos-length import strategybull It subcontracts most of its
manufacturing to independent producers in Thailand Indonesia Cambodia and Vietnam
I INTRODUCTION
bull Growth of international specialization has been a dominant feature of the international economy
bull Feenstra (1998) of the $2 export value for the Barbie dolls when they leave HK for the USbull $035 = Chinese laborbull $065 = cost of materialsbull $100 = transportation
bull WTO (1998) in the production of an American car
US37
Korea30
Japan18
Ger-many
8
Taiwan amp Singapore4
UK3
Ireland amp Barbados2
I INTRODUCTION
bull Feenstra and Hanson (1996)bull The share of imported intermediates increased from 53 of
total US intermediate purchases in 1972 to 116 in 1990
bull Bureau of Economic Analysisbull The growth of foreign outsourcing by US firms have
outpaced the growth of their foreign intrafirm sourcing
bull Fan and Lang (2000)bull Decline in vertical integrationbull US manufacturing firms have become more specialized over
time
I INTRODUCTION
bull Issuesbull Outsourcing vs Integrationbull Home vs Foreign productionbull Conclusion need of a theoretical framework in which companies make
endogenous organizational choices
bull Melitz (2003)bull Helpman Melitz and Yeaple (2004)
bull Low-productivity firms serve only the domestic marketbull High-productivity firms also serve foreign markets
bull Among the high-productivity firms that serve foreign markets bull The more productive ones engage in FDIbull The less productive ones exportbull Affiliate sales relative to exports are larger in sectors with more productivity dispersion
bull PB their approach emphasizes variations across firms within industries without addressing the organizational choices of firs that need to acquire intermediate inputs
I INTRODUCTION
bull Grossman and Helpman (2002)bull Address the choice between outsourcing and integration in a one-input general equilibrium
frameworkbull HYP all firms of a given type are equally productivebull Their firms face the friction of incomplete contracts in armrsquos length relationships which they
weigh against the less efficient production of inputs in integrated companiesbull As a result some sectors have only vertically integrated firms whereas others have only
disintegrated firms
bull Antras (2003)bull Approach extended to a trading environment by introducing two new features
bull The friction of incomplete contracts also exists within integrated firmsbull Integration provides well-defined property rightsbull There are two inputs
bull 1 controlled by the final-good producerbull 1 controlled by another supplier inside or outside the firm
bull The sector that is relatively intensive in the input controlled by the final-good producer integrates
bull The sector that is relatively intensive in the other input outsourcesbull In the former sector there is intrafirm trade in inputs in the latter sector there is armrsquos-
length trade
I INTRODUCTION
bull Antras and Helpmanbull Develop a theoretical model that combinesbull The within-sectoral heterogeneity of Melitz (2003)bull With the structure of firms in Antras (2003)
bull The final-good producer controls the supply of headquarter services whereas a supplier of intermediate goods controls the quality and quantity of the intermediates
bull As a result they can study the impact of variations in productivity within sectors and of differences in technological and organizational characteristics across sectors on international trade FDI and the organizational choices of firms
bull In this framework trade investment and organization are interdependent
bull The incentives created by different organizations differences in their fixed costs and wage differentials across countries shape the equilibrium organizational structure
I INTRODUCTION
bull In a world of two countries North and South in which final-good producers are based in the North final-good producers that operate in the same sector but differ in productivity sort intobull integrated companies that produce inputs in the North (do not engage in foreign trade in inputs)bull Integrated companies that produce inputs in the South (engage in FDI and intrafirm trade)bull Disintegrated companies that outsource in the North (do not engage in foreign trade in inputs)bull Disintegrated companies that outsource in the South (import inputs at armrsquos-length trade)
bull in sectors with low headquarter intensity firms do not integrate low-productivity firms outsource in the North whereas high-productivity firms outsource in the South
bull In sectors with high headquarter intensity all four organizational forms may exist in equilibrium and as in sectors with low headquarter intensity high-productivity firms import inputs whereas low-productivity firms acquire them in the North
bull However among the firms that acquire inputs in the same country the low-productivity firms outsource whereas the high-productivity firms insource
bull This implies that the least productive firms outsource in the North whereas the most productive firms insource in the South via FDI
I INTRODUCTION
bull We use the model to study the relative prevalence of different organizational forms
bull We show how prevalence depends onbull the wage gap between the North and the Southbull the trading costs of intermediate inputsbull the degree of productivity dispersion within a sectorbull the distribution of bargaining powerbull the size of the ownership advantage (which may be different in the two countries)bull the intensity of headquarter services
bull Our model predictsbull relatively more final-good producers rely on imported intermediates in sectors with
higher productivity dispersion or lower headquarter intensitybull in sectors with integration and outsourcing which are the sectors with high
headquarter intensity industries with higher productivity dispersion have relatively more final-good producers that integrate
bull As a result such sectors have more intrafirm trade relative to armrsquos-length trade
II THE MODEL
bull Two countries the North and the Southbull A unique factor of production laborbull The world is populated by a unit measure of consumers with
identical preferences
bull x0 consumption of a homogenous good
bull Xj index of aggregate consumption in secor j
bull μ parameter
bull Inverse demand function for each variety i in sector j
II THE MODEL
bull Producers of differentiated products face a perfectly elastic supply of labor in each country
bull Wage rates are fixed and wN gt wS
bull The demand parameters μ and a are the same in every industrybull This helps focus attention on cross-sectoral differences in technology and organizational costs
bull Our aim to explore how differences in technology interact with organizational choices in shaping industrial structure trade flows and FDI
bull Only the North knows how to produce final-good varieties bull To start producing a variety in sector j a firm needs to bear a fixed cost of entry
consisting of fE units of northern labor Upon paying this fixed cost the unique producer of variety i in sector j draws a productivity level θ from a known distribution G(θ)
bull After observing this productivity level the final-good producer decides whether to exit the market or start producing in the latter case an additional fixed cost of organizing production needs to be incurred bull This additional fixed cost is a function of the structure of ownership and the location of
production
II THE MODEL
bull Production of any final-good variety requires a combination of two variety-specific inputsbull hj(i) headquarter services
bull Can be produced only in the North with one unit of labor per unit of outputbull mj(i) manufactured components
bull Can be produced in the North and in the South with one unit of labor per unit of output in each country
bull Output of every variety is a sector-specific Cobb-Douglas function of the inputs
bull θ firm-specific productivty parameterbull ηj sector-specific productivity parameter
bull The larger ηj is the more intensive the sector in headquarter services
bull Two types of agents engaged in productionbull H final-good producers who supply headquarter servicesbull M operators of manufacturing plants who supply intermediate inputs
bull Every H needs to contract with an M for the provision of components bull We allow international fragmentation of the production process so that H can choose
to trans- act with an M in the North or in the South
II THE MODEL
bull It follows from our assumptions that all H locate in the North bull Upon paying the fixed cost of entry wNfE and observing the productivity level θ the unique final-good
producer H of variety i in sector j seeks out a supplier of components M in the North or in the South
bull Simultaneously H chooses whether to insource or outsource intermediate inputs The joint management costs of final and intermediate goods production such as supervision quality control accounting and marketing depend on the organizational form and the location of M
bull All these costs the sum of which we term laquo fixed organizational costs raquo are denominated in terms of
northern labor bull We denote them by wNfk
l
bull k index of the ownership structurebull i index of the country in which M is located and the manufacturing of components takes place
bull The ownership structure takes one of two forms bull vertical integration Vbull outsourcing O
bull The supplier M is located in one of two sites bull in the North Nbull in the South S
bull Therefore k E1113110 V O and l E1113110 N S
bull An organizational form consists of an ownership structure and a location of M
II THE MODEL
bull We assume that the fixed organizational costs are higher when M is located in the South regardless of ownership structure because the fixed costs of search monitoring and communication are significantly higher in the foreign countrybull fk
S gt fVN and fk
S gt fON for k =V O
bull Given the location of M the fixed organizational costs of a V firm are higher than the fixed organizational costs of an O firm bull fV
l gt fOl for l = N S
bull As a result of these assumptions the fixed organizational costs are ranked as follows
bull We adopt this ordering in order to avoid a taxonomy of cases There exists a tension between two considerations that affect the ranking of fV
l and fOl
bull the need to supervise the production of intermediate inputs in addition to other managerial tasks raises man- agerial overload and the fixed organizational costs of a V firm relative to an O firm
bull economies of scope in the management of diverse activities reduce the fixed organizational costs of a V firm relative to an O firm
bull Our ordering amounts to assuming that managerial overload is more important than managerial economies of scope Al- though we believe this assumption to be appropriate in many instances and we therefore maintain it in the main analysis we shall point out how some of the results change when fV
l lt fOl
II THE MODEL
bull The setting is one of incomplete contracts Final-good producers and manufacturing plant operators cannot sign ex ante enforceable contracts specifying the purchase of specialized intermediate inputs for a certain price
bull The parties cannot write enforceable contracts contingent on the amount of labor hired or on the volume of sales revenues obtained when the final good is sold
bull Hart and Moore (1999) and Segal (1999)bull The parties cannot commit not to renegotiate an initial contract and that the precise nature of
the required input is revealed only ex post and is not verifiable by a third party
bull To simplify the analysis we just impose these constraints on the contracting environment
bull Because no enforceable contract can be signed ex ante final-good producers and manufacturing plant operators bargain over the surplus from the relationship after the inputs have been produced We model this ex post bargaining as a generalized Nash bargaining game in which the final-good producer obtains a fraction β1113110E (0 1) of the ex post gains from the relationship
II THE MODEL
bull Following the property rights approach to the theory of the firm we assume that ex post bargaining takes place both under outsourcing and under integration The distribution of surplus is sensitive however to the mode of organization
bull More specifically the outside option of H is assumed to be different when it owns the manufacturing plant than when it does not In the latter case a failure to reach an agreement on the distribution of the surplus leaves both parties with no income because the inputs are tailored specifically to the other party in the transaction
bull However by vertically integrating the production of components H is effectively buying the right to fire M and seize the inputs mj(i) If there were no costs associated with firing the operator of the manufacturing plant the final-good producer would always have an incentive to seize the inputs mj(i) ex post and M wouldhave an incentive to choose mj(i) = 0 ex ante (which of course would imply xj(i) = 0)
bull In this case integration would never be chosen We therefore assume that firing M results in a loss of a fraction 1 1113110- δ of final-good production because H cannot use the intermediate inputs without M as effectively as it can with the cooperation of M
bull We also assume that δN ge δS This captures the notion that a contractual breach is likely to be more costly to H when M is in the South More figuratively we think of this assumption as reflecting less corruption and better legal protection in the North As is clear from the weak inequality however our results still hold when δN = δS
bull The location of M and the mode of ownership are chosen ex ante by H to maximize its profits There is an infinitely elastic supply of M agents in each one of the countries Each final-good producer H offers a contract that seeks to attract a plant operator M The contract includes an up-front fee for participation in the relationship that has to be paid by M This fee can be positive or negative that is the operator can make a payment to the final-good producer or vice versa The purpose of the fee is to secure the participation of M in the relationship at minimum cost to H When the supply of M is infinitely elastic Mrsquos profits from the relationship net of the participation fee are equal in equilibrium to its ex ante outside option For simplicity we set Mrsquos ex ante outside option equal to zero in both countries It is however easy to extend the analysis to cases in which these outside options are positive and different in the North and in the South
III EQUILIBRIUM
bull The organizational structure equilibrium will be determined bybull Incentives created by different organizationsbull Differences in their fixed costsbull Wage differentials across countries
bull Being in an incomplete contract framework it means that the contract will be renegotiated at some point in time Therefore a bargaining game specification is needed
bull If the parties agree in the bargaining the potential revenue from the sale of the final good is given by
(4)
bull The resulting payoffs implies that the final-good producer (henceforth H) appropriate higher fraction of the revenue under integration than under outsourcing with this fraction being higher when integration takes place in the North The payoffs ordering are the following
(5)
III EQUILIBRIUM
bull As we are in an incomplete contract framework both H and M will choose their quantities noncooperatively Each one will produce the quantity that maximises their individual profits Total operating profits are given by
(6)
where
(7)
bull As H has to attract an M agent whose outside option (ie if they fail to agree) is zero and the contract includes a participation fee (t) which can be positive or negative the final-good production (H) will be the one who decides the organizational form because he will have the incentive to increase t as much as he can (as long as the payoff of M is not negative) As a result
III EQUILIBRIUM
bull Thus upon observing its productivity level H will decide the ownership structure and the location of manufacturing that maximizes (6) The productivity threshold will determine whether H exits the industry or not This productivity threshold depends on the sectorrsquos aggregate consumption index X and implies that
(9)
bull In fact to solve this optimization program the final-good producer will have to choose the triplet that maximizes (6)
bull Equation (6) puts in evidence that profits are decreasing both with and Hence from a cost saving point of view H faces a trade-off as fixed costs are higher in the South and variable costs are lower there ( )
bull Next the final good producer cannot freely choose its fraction of revenue bull Although a higher gives H a larger fraction of revenue it also induces M to produce fewer
components Therefore H trades the choice of a larger fraction of the revenue for a smaller revenue level In fact this fraction of revenue will be determined as follows
(10)
III EQUILIBRIUM
bull Each partyrsquos severity of underinvestment is inversely related to the fraction of the surplus that it appropriates Therefore ex ante efficiency requires giving a larger share of revenue to the party undertaking the relatively more important investment
IV ORGANIZATIONAL FORMS
bull Firms face two types of tensions when choosing the organizational formbull Regarding the location decision variable costs are lower in the South but fixed costs are lower in
the Northbull For the ownership decision the firm has to take into account the fact that insourcing entails higher
fixed costs and gives H a larger fraction of the revenue However if the effect of Mrsquos incentives are strong enough Hrsquos profits may be lower under integration (because if H appropriates a large fraction of revenue M will have no incentive to produce the components)
bull In component-intensive sectors firms donrsquot integrate high-productivity firms outsource in the South low-productivity firms outsource in the North and least productive firms exit the industry
bull In headquarter-intensive sectors we can find the four different organizational forms The most productive firms integrate in the South and somewhat less productive firms outsource in the South Firms with even lower productivity acquire components in the North and among them the more productive integrate and the less productive outsource Finally the least productive firms exit
IV ORGANIZATIONAL FORMS
bull A low headquarter intensity is depicted when As indicated by the arrows profits decrease with increases in bull In this situation H prefers outsourcing to
insourcing regardless the manufacturing location because outsourcing has lower fixed costs and it gives H a lower fraction of revenue
bull Depending on whether the cross-county difference in the wage rate is small or large relative to the cross-country difference in the fixed organizational costs the resulting equilibrium can havebull outsourcing in both countriesbull outsourcing in the South only
Low headquarter intensity sector
IV ORGANIZATIONAL FORMS
bull When wage differential is small relative to to the fixed cost differential firms with a productivity higher than the productivity threshold will outsource in the North and firms with even higher productivity will outsource in the South
bull When wage differential is large relative to the fixed costs all firms with a productivity higher than the threshold will outsource in the South
bull With this threshold level being the intersection between the red line and the horizontal axis
(6)
Low headquarter intensity sector
IV ORGANIZATIONAL FORMS
High headquarter intensity sector bull A high headquarter intensity is depicted when As indicated by the arrows profits increase with increases in
bull The figure 4 shows us that is steeper than for
bull When wage differential is small relative to the fixed cost differential and when the sector is relatively more intensive in headquarter services the marginal return of headquarter services is high making underinvestment significantly costly for H Therefore in such a situation itrsquos always profitable for H to insource regardless the manufacturing location because
bull Integration gives H a larger share of revenue However variable costs are lower in the South For that reason can be steeper or flatter than This is to say that can be larger or smaller than
bull Depending on whether the cross-county difference in the wage rate is small or large relative to the difference between and the resulting equilibrium can have bull The four organizational formsbull Outsourcing in the North insourcing in the North and insourcing in the
Southbull Outsourcing in the North and insourcing in the North
(6)
IV ORGANIZATIONAL FORMS
High headquarter intensity sector
(6)
First case
bull It follows that
(14)
bull Given the orderings in (3) and (14) figure 4 shows us that all four organizational forms exist in equilibrium
IV ORGANIZATIONAL FORMS
High headquarter intensity sector
(6)
Second case
bull In this event (14) doesnrsquot hold anymore because and there are only two equilibrium possibilities
bull Either bull Integration in the North
dominates Consequently only 3 organizational forms can exist in equilibrium at best
bull Outsourcing in the North
bull Insourcing in the Northbull Insourcing in the South
IV ORGANIZATIONAL FORMS
High headquarter intensity sector Second case
bull In this event (14) doesnrsquot hold anymore because and there are only two equilibrium possibilities
bull Orbull Integration in the North
dominates outsourcing and insourcing in the South Consequently only two organizational forms can exist in equilibrium at most
bull Outsourcing in the North
bull Insourcing in the Northbull Hence there is no
international trade in inputs
(6)
V PREVALENCE OF ORGANIZATIONAL FORMS
Measure of prevalence the fraction of firms and market share
COMPONENT-INTENSIVE SECTOR
bull No firm integrates low η
The fraction of firms that outsource in the South
1 Lower wage in the south Raises the profit of outsourcing in the SouthRaises The minimal productivity to be active in the sector rises
SO
COMPONENT-INTENSIVE SECTOR
The fraction of firms that outsource in the South
2 Increase in the dispersion of productivity Raises
3 Higher headquarter intensity is less prevalent
4 Smaller fraction of the surplus from outsourcing in the south (β)Raises the profitability of outsourcing in the South is more prevalent
HEADQUARTER-INTENSIVE SECTOR
Organizational forms
HEADQUARTER-INTENSIVE SECTOR
1 Lower wage in the South
2 Increase of productivity dispersionDecline Increase and ambiguous effect in the others
3 Higher headquarter intensity (η) Domestic outsourcing is favored relative to foreign outsourcingIntegration is favored relative to outsourcingThe effects of η on the fraction of firms that insource in the south is ambiguous
HEADQUARTER-INTENSIVE SECTOR
4 Increase in the revenue shares4 Increase in (rises slope of the profit line)
SV
The fraction of outsourcing firms in the South declines and the fraction of insourcing firms in the South rises
HEADQUARTER-INTENSIVE SECTOR
4 Increase in the revenue shares5 Increase in (rises slope of the profit line)
NV The fraction of firms that
outsource in the north declines and these that insource in the north rises The fraction of firms that outsource in the south declines and these that insource in the south does not change
HEADQUARTER-INTENSIVE SECTOR
5 Increase in the primitive bargaining power parameter (β)
bull Shifts the bargaining power in favor of Hbull Outsourcing becomes more attractivebull ise bull The fraction of firms that import components
rises
VI CONCLUDING COMMENTS
1 The high-productivity firms -gt South2 In the same country high-productivity firms
insource 3 In sectors with very low intensity of headquarter
services no firm integrates 1 Low-productivity firms outsource at home 2 High-productivity firms outsource abroad
VI CONCLUDING COMMENTS
4 The prevalence of organizational forms depends on industry characteristics and on the degree of productivity dispersion across firms
1 Sectors with more productivity dispersion (lower z) more imported inputs
1 Within the headquarter-intensive sectors integration is more prevalent
2 Higher headquarter intensity less imported inputs 1 Within the headquarter-intensive sectors integration is more
prevalent
5 Lower wages in the south raises the fraction of firms that import intermediate inputs
1 It raises the fraction of firms that outsource in each country 2 Armrsquos length trade rises relative to intrafirm trade
I INTRODUCTION
How to produce
To keep the production
Home(standard vertical
integration)
Abroad(FDI)
To outsource an input
Home(domestic
outsourcing)
Abroad(foreign
outsourcing or laquo armrsquos-length
trade raquo)
I INTRODUCTION
Intel Corporation has chosen the FDI strategybull It assembles most of its
microchips in wholly owned subsidiaries in China Costa Rica Malaysia and the Philippines
Nike has chosen the armrsquos-length import strategybull It subcontracts most of its
manufacturing to independent producers in Thailand Indonesia Cambodia and Vietnam
I INTRODUCTION
bull Growth of international specialization has been a dominant feature of the international economy
bull Feenstra (1998) of the $2 export value for the Barbie dolls when they leave HK for the USbull $035 = Chinese laborbull $065 = cost of materialsbull $100 = transportation
bull WTO (1998) in the production of an American car
US37
Korea30
Japan18
Ger-many
8
Taiwan amp Singapore4
UK3
Ireland amp Barbados2
I INTRODUCTION
bull Feenstra and Hanson (1996)bull The share of imported intermediates increased from 53 of
total US intermediate purchases in 1972 to 116 in 1990
bull Bureau of Economic Analysisbull The growth of foreign outsourcing by US firms have
outpaced the growth of their foreign intrafirm sourcing
bull Fan and Lang (2000)bull Decline in vertical integrationbull US manufacturing firms have become more specialized over
time
I INTRODUCTION
bull Issuesbull Outsourcing vs Integrationbull Home vs Foreign productionbull Conclusion need of a theoretical framework in which companies make
endogenous organizational choices
bull Melitz (2003)bull Helpman Melitz and Yeaple (2004)
bull Low-productivity firms serve only the domestic marketbull High-productivity firms also serve foreign markets
bull Among the high-productivity firms that serve foreign markets bull The more productive ones engage in FDIbull The less productive ones exportbull Affiliate sales relative to exports are larger in sectors with more productivity dispersion
bull PB their approach emphasizes variations across firms within industries without addressing the organizational choices of firs that need to acquire intermediate inputs
I INTRODUCTION
bull Grossman and Helpman (2002)bull Address the choice between outsourcing and integration in a one-input general equilibrium
frameworkbull HYP all firms of a given type are equally productivebull Their firms face the friction of incomplete contracts in armrsquos length relationships which they
weigh against the less efficient production of inputs in integrated companiesbull As a result some sectors have only vertically integrated firms whereas others have only
disintegrated firms
bull Antras (2003)bull Approach extended to a trading environment by introducing two new features
bull The friction of incomplete contracts also exists within integrated firmsbull Integration provides well-defined property rightsbull There are two inputs
bull 1 controlled by the final-good producerbull 1 controlled by another supplier inside or outside the firm
bull The sector that is relatively intensive in the input controlled by the final-good producer integrates
bull The sector that is relatively intensive in the other input outsourcesbull In the former sector there is intrafirm trade in inputs in the latter sector there is armrsquos-
length trade
I INTRODUCTION
bull Antras and Helpmanbull Develop a theoretical model that combinesbull The within-sectoral heterogeneity of Melitz (2003)bull With the structure of firms in Antras (2003)
bull The final-good producer controls the supply of headquarter services whereas a supplier of intermediate goods controls the quality and quantity of the intermediates
bull As a result they can study the impact of variations in productivity within sectors and of differences in technological and organizational characteristics across sectors on international trade FDI and the organizational choices of firms
bull In this framework trade investment and organization are interdependent
bull The incentives created by different organizations differences in their fixed costs and wage differentials across countries shape the equilibrium organizational structure
I INTRODUCTION
bull In a world of two countries North and South in which final-good producers are based in the North final-good producers that operate in the same sector but differ in productivity sort intobull integrated companies that produce inputs in the North (do not engage in foreign trade in inputs)bull Integrated companies that produce inputs in the South (engage in FDI and intrafirm trade)bull Disintegrated companies that outsource in the North (do not engage in foreign trade in inputs)bull Disintegrated companies that outsource in the South (import inputs at armrsquos-length trade)
bull in sectors with low headquarter intensity firms do not integrate low-productivity firms outsource in the North whereas high-productivity firms outsource in the South
bull In sectors with high headquarter intensity all four organizational forms may exist in equilibrium and as in sectors with low headquarter intensity high-productivity firms import inputs whereas low-productivity firms acquire them in the North
bull However among the firms that acquire inputs in the same country the low-productivity firms outsource whereas the high-productivity firms insource
bull This implies that the least productive firms outsource in the North whereas the most productive firms insource in the South via FDI
I INTRODUCTION
bull We use the model to study the relative prevalence of different organizational forms
bull We show how prevalence depends onbull the wage gap between the North and the Southbull the trading costs of intermediate inputsbull the degree of productivity dispersion within a sectorbull the distribution of bargaining powerbull the size of the ownership advantage (which may be different in the two countries)bull the intensity of headquarter services
bull Our model predictsbull relatively more final-good producers rely on imported intermediates in sectors with
higher productivity dispersion or lower headquarter intensitybull in sectors with integration and outsourcing which are the sectors with high
headquarter intensity industries with higher productivity dispersion have relatively more final-good producers that integrate
bull As a result such sectors have more intrafirm trade relative to armrsquos-length trade
II THE MODEL
bull Two countries the North and the Southbull A unique factor of production laborbull The world is populated by a unit measure of consumers with
identical preferences
bull x0 consumption of a homogenous good
bull Xj index of aggregate consumption in secor j
bull μ parameter
bull Inverse demand function for each variety i in sector j
II THE MODEL
bull Producers of differentiated products face a perfectly elastic supply of labor in each country
bull Wage rates are fixed and wN gt wS
bull The demand parameters μ and a are the same in every industrybull This helps focus attention on cross-sectoral differences in technology and organizational costs
bull Our aim to explore how differences in technology interact with organizational choices in shaping industrial structure trade flows and FDI
bull Only the North knows how to produce final-good varieties bull To start producing a variety in sector j a firm needs to bear a fixed cost of entry
consisting of fE units of northern labor Upon paying this fixed cost the unique producer of variety i in sector j draws a productivity level θ from a known distribution G(θ)
bull After observing this productivity level the final-good producer decides whether to exit the market or start producing in the latter case an additional fixed cost of organizing production needs to be incurred bull This additional fixed cost is a function of the structure of ownership and the location of
production
II THE MODEL
bull Production of any final-good variety requires a combination of two variety-specific inputsbull hj(i) headquarter services
bull Can be produced only in the North with one unit of labor per unit of outputbull mj(i) manufactured components
bull Can be produced in the North and in the South with one unit of labor per unit of output in each country
bull Output of every variety is a sector-specific Cobb-Douglas function of the inputs
bull θ firm-specific productivty parameterbull ηj sector-specific productivity parameter
bull The larger ηj is the more intensive the sector in headquarter services
bull Two types of agents engaged in productionbull H final-good producers who supply headquarter servicesbull M operators of manufacturing plants who supply intermediate inputs
bull Every H needs to contract with an M for the provision of components bull We allow international fragmentation of the production process so that H can choose
to trans- act with an M in the North or in the South
II THE MODEL
bull It follows from our assumptions that all H locate in the North bull Upon paying the fixed cost of entry wNfE and observing the productivity level θ the unique final-good
producer H of variety i in sector j seeks out a supplier of components M in the North or in the South
bull Simultaneously H chooses whether to insource or outsource intermediate inputs The joint management costs of final and intermediate goods production such as supervision quality control accounting and marketing depend on the organizational form and the location of M
bull All these costs the sum of which we term laquo fixed organizational costs raquo are denominated in terms of
northern labor bull We denote them by wNfk
l
bull k index of the ownership structurebull i index of the country in which M is located and the manufacturing of components takes place
bull The ownership structure takes one of two forms bull vertical integration Vbull outsourcing O
bull The supplier M is located in one of two sites bull in the North Nbull in the South S
bull Therefore k E1113110 V O and l E1113110 N S
bull An organizational form consists of an ownership structure and a location of M
II THE MODEL
bull We assume that the fixed organizational costs are higher when M is located in the South regardless of ownership structure because the fixed costs of search monitoring and communication are significantly higher in the foreign countrybull fk
S gt fVN and fk
S gt fON for k =V O
bull Given the location of M the fixed organizational costs of a V firm are higher than the fixed organizational costs of an O firm bull fV
l gt fOl for l = N S
bull As a result of these assumptions the fixed organizational costs are ranked as follows
bull We adopt this ordering in order to avoid a taxonomy of cases There exists a tension between two considerations that affect the ranking of fV
l and fOl
bull the need to supervise the production of intermediate inputs in addition to other managerial tasks raises man- agerial overload and the fixed organizational costs of a V firm relative to an O firm
bull economies of scope in the management of diverse activities reduce the fixed organizational costs of a V firm relative to an O firm
bull Our ordering amounts to assuming that managerial overload is more important than managerial economies of scope Al- though we believe this assumption to be appropriate in many instances and we therefore maintain it in the main analysis we shall point out how some of the results change when fV
l lt fOl
II THE MODEL
bull The setting is one of incomplete contracts Final-good producers and manufacturing plant operators cannot sign ex ante enforceable contracts specifying the purchase of specialized intermediate inputs for a certain price
bull The parties cannot write enforceable contracts contingent on the amount of labor hired or on the volume of sales revenues obtained when the final good is sold
bull Hart and Moore (1999) and Segal (1999)bull The parties cannot commit not to renegotiate an initial contract and that the precise nature of
the required input is revealed only ex post and is not verifiable by a third party
bull To simplify the analysis we just impose these constraints on the contracting environment
bull Because no enforceable contract can be signed ex ante final-good producers and manufacturing plant operators bargain over the surplus from the relationship after the inputs have been produced We model this ex post bargaining as a generalized Nash bargaining game in which the final-good producer obtains a fraction β1113110E (0 1) of the ex post gains from the relationship
II THE MODEL
bull Following the property rights approach to the theory of the firm we assume that ex post bargaining takes place both under outsourcing and under integration The distribution of surplus is sensitive however to the mode of organization
bull More specifically the outside option of H is assumed to be different when it owns the manufacturing plant than when it does not In the latter case a failure to reach an agreement on the distribution of the surplus leaves both parties with no income because the inputs are tailored specifically to the other party in the transaction
bull However by vertically integrating the production of components H is effectively buying the right to fire M and seize the inputs mj(i) If there were no costs associated with firing the operator of the manufacturing plant the final-good producer would always have an incentive to seize the inputs mj(i) ex post and M wouldhave an incentive to choose mj(i) = 0 ex ante (which of course would imply xj(i) = 0)
bull In this case integration would never be chosen We therefore assume that firing M results in a loss of a fraction 1 1113110- δ of final-good production because H cannot use the intermediate inputs without M as effectively as it can with the cooperation of M
bull We also assume that δN ge δS This captures the notion that a contractual breach is likely to be more costly to H when M is in the South More figuratively we think of this assumption as reflecting less corruption and better legal protection in the North As is clear from the weak inequality however our results still hold when δN = δS
bull The location of M and the mode of ownership are chosen ex ante by H to maximize its profits There is an infinitely elastic supply of M agents in each one of the countries Each final-good producer H offers a contract that seeks to attract a plant operator M The contract includes an up-front fee for participation in the relationship that has to be paid by M This fee can be positive or negative that is the operator can make a payment to the final-good producer or vice versa The purpose of the fee is to secure the participation of M in the relationship at minimum cost to H When the supply of M is infinitely elastic Mrsquos profits from the relationship net of the participation fee are equal in equilibrium to its ex ante outside option For simplicity we set Mrsquos ex ante outside option equal to zero in both countries It is however easy to extend the analysis to cases in which these outside options are positive and different in the North and in the South
III EQUILIBRIUM
bull The organizational structure equilibrium will be determined bybull Incentives created by different organizationsbull Differences in their fixed costsbull Wage differentials across countries
bull Being in an incomplete contract framework it means that the contract will be renegotiated at some point in time Therefore a bargaining game specification is needed
bull If the parties agree in the bargaining the potential revenue from the sale of the final good is given by
(4)
bull The resulting payoffs implies that the final-good producer (henceforth H) appropriate higher fraction of the revenue under integration than under outsourcing with this fraction being higher when integration takes place in the North The payoffs ordering are the following
(5)
III EQUILIBRIUM
bull As we are in an incomplete contract framework both H and M will choose their quantities noncooperatively Each one will produce the quantity that maximises their individual profits Total operating profits are given by
(6)
where
(7)
bull As H has to attract an M agent whose outside option (ie if they fail to agree) is zero and the contract includes a participation fee (t) which can be positive or negative the final-good production (H) will be the one who decides the organizational form because he will have the incentive to increase t as much as he can (as long as the payoff of M is not negative) As a result
III EQUILIBRIUM
bull Thus upon observing its productivity level H will decide the ownership structure and the location of manufacturing that maximizes (6) The productivity threshold will determine whether H exits the industry or not This productivity threshold depends on the sectorrsquos aggregate consumption index X and implies that
(9)
bull In fact to solve this optimization program the final-good producer will have to choose the triplet that maximizes (6)
bull Equation (6) puts in evidence that profits are decreasing both with and Hence from a cost saving point of view H faces a trade-off as fixed costs are higher in the South and variable costs are lower there ( )
bull Next the final good producer cannot freely choose its fraction of revenue bull Although a higher gives H a larger fraction of revenue it also induces M to produce fewer
components Therefore H trades the choice of a larger fraction of the revenue for a smaller revenue level In fact this fraction of revenue will be determined as follows
(10)
III EQUILIBRIUM
bull Each partyrsquos severity of underinvestment is inversely related to the fraction of the surplus that it appropriates Therefore ex ante efficiency requires giving a larger share of revenue to the party undertaking the relatively more important investment
IV ORGANIZATIONAL FORMS
bull Firms face two types of tensions when choosing the organizational formbull Regarding the location decision variable costs are lower in the South but fixed costs are lower in
the Northbull For the ownership decision the firm has to take into account the fact that insourcing entails higher
fixed costs and gives H a larger fraction of the revenue However if the effect of Mrsquos incentives are strong enough Hrsquos profits may be lower under integration (because if H appropriates a large fraction of revenue M will have no incentive to produce the components)
bull In component-intensive sectors firms donrsquot integrate high-productivity firms outsource in the South low-productivity firms outsource in the North and least productive firms exit the industry
bull In headquarter-intensive sectors we can find the four different organizational forms The most productive firms integrate in the South and somewhat less productive firms outsource in the South Firms with even lower productivity acquire components in the North and among them the more productive integrate and the less productive outsource Finally the least productive firms exit
IV ORGANIZATIONAL FORMS
bull A low headquarter intensity is depicted when As indicated by the arrows profits decrease with increases in bull In this situation H prefers outsourcing to
insourcing regardless the manufacturing location because outsourcing has lower fixed costs and it gives H a lower fraction of revenue
bull Depending on whether the cross-county difference in the wage rate is small or large relative to the cross-country difference in the fixed organizational costs the resulting equilibrium can havebull outsourcing in both countriesbull outsourcing in the South only
Low headquarter intensity sector
IV ORGANIZATIONAL FORMS
bull When wage differential is small relative to to the fixed cost differential firms with a productivity higher than the productivity threshold will outsource in the North and firms with even higher productivity will outsource in the South
bull When wage differential is large relative to the fixed costs all firms with a productivity higher than the threshold will outsource in the South
bull With this threshold level being the intersection between the red line and the horizontal axis
(6)
Low headquarter intensity sector
IV ORGANIZATIONAL FORMS
High headquarter intensity sector bull A high headquarter intensity is depicted when As indicated by the arrows profits increase with increases in
bull The figure 4 shows us that is steeper than for
bull When wage differential is small relative to the fixed cost differential and when the sector is relatively more intensive in headquarter services the marginal return of headquarter services is high making underinvestment significantly costly for H Therefore in such a situation itrsquos always profitable for H to insource regardless the manufacturing location because
bull Integration gives H a larger share of revenue However variable costs are lower in the South For that reason can be steeper or flatter than This is to say that can be larger or smaller than
bull Depending on whether the cross-county difference in the wage rate is small or large relative to the difference between and the resulting equilibrium can have bull The four organizational formsbull Outsourcing in the North insourcing in the North and insourcing in the
Southbull Outsourcing in the North and insourcing in the North
(6)
IV ORGANIZATIONAL FORMS
High headquarter intensity sector
(6)
First case
bull It follows that
(14)
bull Given the orderings in (3) and (14) figure 4 shows us that all four organizational forms exist in equilibrium
IV ORGANIZATIONAL FORMS
High headquarter intensity sector
(6)
Second case
bull In this event (14) doesnrsquot hold anymore because and there are only two equilibrium possibilities
bull Either bull Integration in the North
dominates Consequently only 3 organizational forms can exist in equilibrium at best
bull Outsourcing in the North
bull Insourcing in the Northbull Insourcing in the South
IV ORGANIZATIONAL FORMS
High headquarter intensity sector Second case
bull In this event (14) doesnrsquot hold anymore because and there are only two equilibrium possibilities
bull Orbull Integration in the North
dominates outsourcing and insourcing in the South Consequently only two organizational forms can exist in equilibrium at most
bull Outsourcing in the North
bull Insourcing in the Northbull Hence there is no
international trade in inputs
(6)
V PREVALENCE OF ORGANIZATIONAL FORMS
Measure of prevalence the fraction of firms and market share
COMPONENT-INTENSIVE SECTOR
bull No firm integrates low η
The fraction of firms that outsource in the South
1 Lower wage in the south Raises the profit of outsourcing in the SouthRaises The minimal productivity to be active in the sector rises
SO
COMPONENT-INTENSIVE SECTOR
The fraction of firms that outsource in the South
2 Increase in the dispersion of productivity Raises
3 Higher headquarter intensity is less prevalent
4 Smaller fraction of the surplus from outsourcing in the south (β)Raises the profitability of outsourcing in the South is more prevalent
HEADQUARTER-INTENSIVE SECTOR
Organizational forms
HEADQUARTER-INTENSIVE SECTOR
1 Lower wage in the South
2 Increase of productivity dispersionDecline Increase and ambiguous effect in the others
3 Higher headquarter intensity (η) Domestic outsourcing is favored relative to foreign outsourcingIntegration is favored relative to outsourcingThe effects of η on the fraction of firms that insource in the south is ambiguous
HEADQUARTER-INTENSIVE SECTOR
4 Increase in the revenue shares4 Increase in (rises slope of the profit line)
SV
The fraction of outsourcing firms in the South declines and the fraction of insourcing firms in the South rises
HEADQUARTER-INTENSIVE SECTOR
4 Increase in the revenue shares5 Increase in (rises slope of the profit line)
NV The fraction of firms that
outsource in the north declines and these that insource in the north rises The fraction of firms that outsource in the south declines and these that insource in the south does not change
HEADQUARTER-INTENSIVE SECTOR
5 Increase in the primitive bargaining power parameter (β)
bull Shifts the bargaining power in favor of Hbull Outsourcing becomes more attractivebull ise bull The fraction of firms that import components
rises
VI CONCLUDING COMMENTS
1 The high-productivity firms -gt South2 In the same country high-productivity firms
insource 3 In sectors with very low intensity of headquarter
services no firm integrates 1 Low-productivity firms outsource at home 2 High-productivity firms outsource abroad
VI CONCLUDING COMMENTS
4 The prevalence of organizational forms depends on industry characteristics and on the degree of productivity dispersion across firms
1 Sectors with more productivity dispersion (lower z) more imported inputs
1 Within the headquarter-intensive sectors integration is more prevalent
2 Higher headquarter intensity less imported inputs 1 Within the headquarter-intensive sectors integration is more
prevalent
5 Lower wages in the south raises the fraction of firms that import intermediate inputs
1 It raises the fraction of firms that outsource in each country 2 Armrsquos length trade rises relative to intrafirm trade
I INTRODUCTION
Intel Corporation has chosen the FDI strategybull It assembles most of its
microchips in wholly owned subsidiaries in China Costa Rica Malaysia and the Philippines
Nike has chosen the armrsquos-length import strategybull It subcontracts most of its
manufacturing to independent producers in Thailand Indonesia Cambodia and Vietnam
I INTRODUCTION
bull Growth of international specialization has been a dominant feature of the international economy
bull Feenstra (1998) of the $2 export value for the Barbie dolls when they leave HK for the USbull $035 = Chinese laborbull $065 = cost of materialsbull $100 = transportation
bull WTO (1998) in the production of an American car
US37
Korea30
Japan18
Ger-many
8
Taiwan amp Singapore4
UK3
Ireland amp Barbados2
I INTRODUCTION
bull Feenstra and Hanson (1996)bull The share of imported intermediates increased from 53 of
total US intermediate purchases in 1972 to 116 in 1990
bull Bureau of Economic Analysisbull The growth of foreign outsourcing by US firms have
outpaced the growth of their foreign intrafirm sourcing
bull Fan and Lang (2000)bull Decline in vertical integrationbull US manufacturing firms have become more specialized over
time
I INTRODUCTION
bull Issuesbull Outsourcing vs Integrationbull Home vs Foreign productionbull Conclusion need of a theoretical framework in which companies make
endogenous organizational choices
bull Melitz (2003)bull Helpman Melitz and Yeaple (2004)
bull Low-productivity firms serve only the domestic marketbull High-productivity firms also serve foreign markets
bull Among the high-productivity firms that serve foreign markets bull The more productive ones engage in FDIbull The less productive ones exportbull Affiliate sales relative to exports are larger in sectors with more productivity dispersion
bull PB their approach emphasizes variations across firms within industries without addressing the organizational choices of firs that need to acquire intermediate inputs
I INTRODUCTION
bull Grossman and Helpman (2002)bull Address the choice between outsourcing and integration in a one-input general equilibrium
frameworkbull HYP all firms of a given type are equally productivebull Their firms face the friction of incomplete contracts in armrsquos length relationships which they
weigh against the less efficient production of inputs in integrated companiesbull As a result some sectors have only vertically integrated firms whereas others have only
disintegrated firms
bull Antras (2003)bull Approach extended to a trading environment by introducing two new features
bull The friction of incomplete contracts also exists within integrated firmsbull Integration provides well-defined property rightsbull There are two inputs
bull 1 controlled by the final-good producerbull 1 controlled by another supplier inside or outside the firm
bull The sector that is relatively intensive in the input controlled by the final-good producer integrates
bull The sector that is relatively intensive in the other input outsourcesbull In the former sector there is intrafirm trade in inputs in the latter sector there is armrsquos-
length trade
I INTRODUCTION
bull Antras and Helpmanbull Develop a theoretical model that combinesbull The within-sectoral heterogeneity of Melitz (2003)bull With the structure of firms in Antras (2003)
bull The final-good producer controls the supply of headquarter services whereas a supplier of intermediate goods controls the quality and quantity of the intermediates
bull As a result they can study the impact of variations in productivity within sectors and of differences in technological and organizational characteristics across sectors on international trade FDI and the organizational choices of firms
bull In this framework trade investment and organization are interdependent
bull The incentives created by different organizations differences in their fixed costs and wage differentials across countries shape the equilibrium organizational structure
I INTRODUCTION
bull In a world of two countries North and South in which final-good producers are based in the North final-good producers that operate in the same sector but differ in productivity sort intobull integrated companies that produce inputs in the North (do not engage in foreign trade in inputs)bull Integrated companies that produce inputs in the South (engage in FDI and intrafirm trade)bull Disintegrated companies that outsource in the North (do not engage in foreign trade in inputs)bull Disintegrated companies that outsource in the South (import inputs at armrsquos-length trade)
bull in sectors with low headquarter intensity firms do not integrate low-productivity firms outsource in the North whereas high-productivity firms outsource in the South
bull In sectors with high headquarter intensity all four organizational forms may exist in equilibrium and as in sectors with low headquarter intensity high-productivity firms import inputs whereas low-productivity firms acquire them in the North
bull However among the firms that acquire inputs in the same country the low-productivity firms outsource whereas the high-productivity firms insource
bull This implies that the least productive firms outsource in the North whereas the most productive firms insource in the South via FDI
I INTRODUCTION
bull We use the model to study the relative prevalence of different organizational forms
bull We show how prevalence depends onbull the wage gap between the North and the Southbull the trading costs of intermediate inputsbull the degree of productivity dispersion within a sectorbull the distribution of bargaining powerbull the size of the ownership advantage (which may be different in the two countries)bull the intensity of headquarter services
bull Our model predictsbull relatively more final-good producers rely on imported intermediates in sectors with
higher productivity dispersion or lower headquarter intensitybull in sectors with integration and outsourcing which are the sectors with high
headquarter intensity industries with higher productivity dispersion have relatively more final-good producers that integrate
bull As a result such sectors have more intrafirm trade relative to armrsquos-length trade
II THE MODEL
bull Two countries the North and the Southbull A unique factor of production laborbull The world is populated by a unit measure of consumers with
identical preferences
bull x0 consumption of a homogenous good
bull Xj index of aggregate consumption in secor j
bull μ parameter
bull Inverse demand function for each variety i in sector j
II THE MODEL
bull Producers of differentiated products face a perfectly elastic supply of labor in each country
bull Wage rates are fixed and wN gt wS
bull The demand parameters μ and a are the same in every industrybull This helps focus attention on cross-sectoral differences in technology and organizational costs
bull Our aim to explore how differences in technology interact with organizational choices in shaping industrial structure trade flows and FDI
bull Only the North knows how to produce final-good varieties bull To start producing a variety in sector j a firm needs to bear a fixed cost of entry
consisting of fE units of northern labor Upon paying this fixed cost the unique producer of variety i in sector j draws a productivity level θ from a known distribution G(θ)
bull After observing this productivity level the final-good producer decides whether to exit the market or start producing in the latter case an additional fixed cost of organizing production needs to be incurred bull This additional fixed cost is a function of the structure of ownership and the location of
production
II THE MODEL
bull Production of any final-good variety requires a combination of two variety-specific inputsbull hj(i) headquarter services
bull Can be produced only in the North with one unit of labor per unit of outputbull mj(i) manufactured components
bull Can be produced in the North and in the South with one unit of labor per unit of output in each country
bull Output of every variety is a sector-specific Cobb-Douglas function of the inputs
bull θ firm-specific productivty parameterbull ηj sector-specific productivity parameter
bull The larger ηj is the more intensive the sector in headquarter services
bull Two types of agents engaged in productionbull H final-good producers who supply headquarter servicesbull M operators of manufacturing plants who supply intermediate inputs
bull Every H needs to contract with an M for the provision of components bull We allow international fragmentation of the production process so that H can choose
to trans- act with an M in the North or in the South
II THE MODEL
bull It follows from our assumptions that all H locate in the North bull Upon paying the fixed cost of entry wNfE and observing the productivity level θ the unique final-good
producer H of variety i in sector j seeks out a supplier of components M in the North or in the South
bull Simultaneously H chooses whether to insource or outsource intermediate inputs The joint management costs of final and intermediate goods production such as supervision quality control accounting and marketing depend on the organizational form and the location of M
bull All these costs the sum of which we term laquo fixed organizational costs raquo are denominated in terms of
northern labor bull We denote them by wNfk
l
bull k index of the ownership structurebull i index of the country in which M is located and the manufacturing of components takes place
bull The ownership structure takes one of two forms bull vertical integration Vbull outsourcing O
bull The supplier M is located in one of two sites bull in the North Nbull in the South S
bull Therefore k E1113110 V O and l E1113110 N S
bull An organizational form consists of an ownership structure and a location of M
II THE MODEL
bull We assume that the fixed organizational costs are higher when M is located in the South regardless of ownership structure because the fixed costs of search monitoring and communication are significantly higher in the foreign countrybull fk
S gt fVN and fk
S gt fON for k =V O
bull Given the location of M the fixed organizational costs of a V firm are higher than the fixed organizational costs of an O firm bull fV
l gt fOl for l = N S
bull As a result of these assumptions the fixed organizational costs are ranked as follows
bull We adopt this ordering in order to avoid a taxonomy of cases There exists a tension between two considerations that affect the ranking of fV
l and fOl
bull the need to supervise the production of intermediate inputs in addition to other managerial tasks raises man- agerial overload and the fixed organizational costs of a V firm relative to an O firm
bull economies of scope in the management of diverse activities reduce the fixed organizational costs of a V firm relative to an O firm
bull Our ordering amounts to assuming that managerial overload is more important than managerial economies of scope Al- though we believe this assumption to be appropriate in many instances and we therefore maintain it in the main analysis we shall point out how some of the results change when fV
l lt fOl
II THE MODEL
bull The setting is one of incomplete contracts Final-good producers and manufacturing plant operators cannot sign ex ante enforceable contracts specifying the purchase of specialized intermediate inputs for a certain price
bull The parties cannot write enforceable contracts contingent on the amount of labor hired or on the volume of sales revenues obtained when the final good is sold
bull Hart and Moore (1999) and Segal (1999)bull The parties cannot commit not to renegotiate an initial contract and that the precise nature of
the required input is revealed only ex post and is not verifiable by a third party
bull To simplify the analysis we just impose these constraints on the contracting environment
bull Because no enforceable contract can be signed ex ante final-good producers and manufacturing plant operators bargain over the surplus from the relationship after the inputs have been produced We model this ex post bargaining as a generalized Nash bargaining game in which the final-good producer obtains a fraction β1113110E (0 1) of the ex post gains from the relationship
II THE MODEL
bull Following the property rights approach to the theory of the firm we assume that ex post bargaining takes place both under outsourcing and under integration The distribution of surplus is sensitive however to the mode of organization
bull More specifically the outside option of H is assumed to be different when it owns the manufacturing plant than when it does not In the latter case a failure to reach an agreement on the distribution of the surplus leaves both parties with no income because the inputs are tailored specifically to the other party in the transaction
bull However by vertically integrating the production of components H is effectively buying the right to fire M and seize the inputs mj(i) If there were no costs associated with firing the operator of the manufacturing plant the final-good producer would always have an incentive to seize the inputs mj(i) ex post and M wouldhave an incentive to choose mj(i) = 0 ex ante (which of course would imply xj(i) = 0)
bull In this case integration would never be chosen We therefore assume that firing M results in a loss of a fraction 1 1113110- δ of final-good production because H cannot use the intermediate inputs without M as effectively as it can with the cooperation of M
bull We also assume that δN ge δS This captures the notion that a contractual breach is likely to be more costly to H when M is in the South More figuratively we think of this assumption as reflecting less corruption and better legal protection in the North As is clear from the weak inequality however our results still hold when δN = δS
bull The location of M and the mode of ownership are chosen ex ante by H to maximize its profits There is an infinitely elastic supply of M agents in each one of the countries Each final-good producer H offers a contract that seeks to attract a plant operator M The contract includes an up-front fee for participation in the relationship that has to be paid by M This fee can be positive or negative that is the operator can make a payment to the final-good producer or vice versa The purpose of the fee is to secure the participation of M in the relationship at minimum cost to H When the supply of M is infinitely elastic Mrsquos profits from the relationship net of the participation fee are equal in equilibrium to its ex ante outside option For simplicity we set Mrsquos ex ante outside option equal to zero in both countries It is however easy to extend the analysis to cases in which these outside options are positive and different in the North and in the South
III EQUILIBRIUM
bull The organizational structure equilibrium will be determined bybull Incentives created by different organizationsbull Differences in their fixed costsbull Wage differentials across countries
bull Being in an incomplete contract framework it means that the contract will be renegotiated at some point in time Therefore a bargaining game specification is needed
bull If the parties agree in the bargaining the potential revenue from the sale of the final good is given by
(4)
bull The resulting payoffs implies that the final-good producer (henceforth H) appropriate higher fraction of the revenue under integration than under outsourcing with this fraction being higher when integration takes place in the North The payoffs ordering are the following
(5)
III EQUILIBRIUM
bull As we are in an incomplete contract framework both H and M will choose their quantities noncooperatively Each one will produce the quantity that maximises their individual profits Total operating profits are given by
(6)
where
(7)
bull As H has to attract an M agent whose outside option (ie if they fail to agree) is zero and the contract includes a participation fee (t) which can be positive or negative the final-good production (H) will be the one who decides the organizational form because he will have the incentive to increase t as much as he can (as long as the payoff of M is not negative) As a result
III EQUILIBRIUM
bull Thus upon observing its productivity level H will decide the ownership structure and the location of manufacturing that maximizes (6) The productivity threshold will determine whether H exits the industry or not This productivity threshold depends on the sectorrsquos aggregate consumption index X and implies that
(9)
bull In fact to solve this optimization program the final-good producer will have to choose the triplet that maximizes (6)
bull Equation (6) puts in evidence that profits are decreasing both with and Hence from a cost saving point of view H faces a trade-off as fixed costs are higher in the South and variable costs are lower there ( )
bull Next the final good producer cannot freely choose its fraction of revenue bull Although a higher gives H a larger fraction of revenue it also induces M to produce fewer
components Therefore H trades the choice of a larger fraction of the revenue for a smaller revenue level In fact this fraction of revenue will be determined as follows
(10)
III EQUILIBRIUM
bull Each partyrsquos severity of underinvestment is inversely related to the fraction of the surplus that it appropriates Therefore ex ante efficiency requires giving a larger share of revenue to the party undertaking the relatively more important investment
IV ORGANIZATIONAL FORMS
bull Firms face two types of tensions when choosing the organizational formbull Regarding the location decision variable costs are lower in the South but fixed costs are lower in
the Northbull For the ownership decision the firm has to take into account the fact that insourcing entails higher
fixed costs and gives H a larger fraction of the revenue However if the effect of Mrsquos incentives are strong enough Hrsquos profits may be lower under integration (because if H appropriates a large fraction of revenue M will have no incentive to produce the components)
bull In component-intensive sectors firms donrsquot integrate high-productivity firms outsource in the South low-productivity firms outsource in the North and least productive firms exit the industry
bull In headquarter-intensive sectors we can find the four different organizational forms The most productive firms integrate in the South and somewhat less productive firms outsource in the South Firms with even lower productivity acquire components in the North and among them the more productive integrate and the less productive outsource Finally the least productive firms exit
IV ORGANIZATIONAL FORMS
bull A low headquarter intensity is depicted when As indicated by the arrows profits decrease with increases in bull In this situation H prefers outsourcing to
insourcing regardless the manufacturing location because outsourcing has lower fixed costs and it gives H a lower fraction of revenue
bull Depending on whether the cross-county difference in the wage rate is small or large relative to the cross-country difference in the fixed organizational costs the resulting equilibrium can havebull outsourcing in both countriesbull outsourcing in the South only
Low headquarter intensity sector
IV ORGANIZATIONAL FORMS
bull When wage differential is small relative to to the fixed cost differential firms with a productivity higher than the productivity threshold will outsource in the North and firms with even higher productivity will outsource in the South
bull When wage differential is large relative to the fixed costs all firms with a productivity higher than the threshold will outsource in the South
bull With this threshold level being the intersection between the red line and the horizontal axis
(6)
Low headquarter intensity sector
IV ORGANIZATIONAL FORMS
High headquarter intensity sector bull A high headquarter intensity is depicted when As indicated by the arrows profits increase with increases in
bull The figure 4 shows us that is steeper than for
bull When wage differential is small relative to the fixed cost differential and when the sector is relatively more intensive in headquarter services the marginal return of headquarter services is high making underinvestment significantly costly for H Therefore in such a situation itrsquos always profitable for H to insource regardless the manufacturing location because
bull Integration gives H a larger share of revenue However variable costs are lower in the South For that reason can be steeper or flatter than This is to say that can be larger or smaller than
bull Depending on whether the cross-county difference in the wage rate is small or large relative to the difference between and the resulting equilibrium can have bull The four organizational formsbull Outsourcing in the North insourcing in the North and insourcing in the
Southbull Outsourcing in the North and insourcing in the North
(6)
IV ORGANIZATIONAL FORMS
High headquarter intensity sector
(6)
First case
bull It follows that
(14)
bull Given the orderings in (3) and (14) figure 4 shows us that all four organizational forms exist in equilibrium
IV ORGANIZATIONAL FORMS
High headquarter intensity sector
(6)
Second case
bull In this event (14) doesnrsquot hold anymore because and there are only two equilibrium possibilities
bull Either bull Integration in the North
dominates Consequently only 3 organizational forms can exist in equilibrium at best
bull Outsourcing in the North
bull Insourcing in the Northbull Insourcing in the South
IV ORGANIZATIONAL FORMS
High headquarter intensity sector Second case
bull In this event (14) doesnrsquot hold anymore because and there are only two equilibrium possibilities
bull Orbull Integration in the North
dominates outsourcing and insourcing in the South Consequently only two organizational forms can exist in equilibrium at most
bull Outsourcing in the North
bull Insourcing in the Northbull Hence there is no
international trade in inputs
(6)
V PREVALENCE OF ORGANIZATIONAL FORMS
Measure of prevalence the fraction of firms and market share
COMPONENT-INTENSIVE SECTOR
bull No firm integrates low η
The fraction of firms that outsource in the South
1 Lower wage in the south Raises the profit of outsourcing in the SouthRaises The minimal productivity to be active in the sector rises
SO
COMPONENT-INTENSIVE SECTOR
The fraction of firms that outsource in the South
2 Increase in the dispersion of productivity Raises
3 Higher headquarter intensity is less prevalent
4 Smaller fraction of the surplus from outsourcing in the south (β)Raises the profitability of outsourcing in the South is more prevalent
HEADQUARTER-INTENSIVE SECTOR
Organizational forms
HEADQUARTER-INTENSIVE SECTOR
1 Lower wage in the South
2 Increase of productivity dispersionDecline Increase and ambiguous effect in the others
3 Higher headquarter intensity (η) Domestic outsourcing is favored relative to foreign outsourcingIntegration is favored relative to outsourcingThe effects of η on the fraction of firms that insource in the south is ambiguous
HEADQUARTER-INTENSIVE SECTOR
4 Increase in the revenue shares4 Increase in (rises slope of the profit line)
SV
The fraction of outsourcing firms in the South declines and the fraction of insourcing firms in the South rises
HEADQUARTER-INTENSIVE SECTOR
4 Increase in the revenue shares5 Increase in (rises slope of the profit line)
NV The fraction of firms that
outsource in the north declines and these that insource in the north rises The fraction of firms that outsource in the south declines and these that insource in the south does not change
HEADQUARTER-INTENSIVE SECTOR
5 Increase in the primitive bargaining power parameter (β)
bull Shifts the bargaining power in favor of Hbull Outsourcing becomes more attractivebull ise bull The fraction of firms that import components
rises
VI CONCLUDING COMMENTS
1 The high-productivity firms -gt South2 In the same country high-productivity firms
insource 3 In sectors with very low intensity of headquarter
services no firm integrates 1 Low-productivity firms outsource at home 2 High-productivity firms outsource abroad
VI CONCLUDING COMMENTS
4 The prevalence of organizational forms depends on industry characteristics and on the degree of productivity dispersion across firms
1 Sectors with more productivity dispersion (lower z) more imported inputs
1 Within the headquarter-intensive sectors integration is more prevalent
2 Higher headquarter intensity less imported inputs 1 Within the headquarter-intensive sectors integration is more
prevalent
5 Lower wages in the south raises the fraction of firms that import intermediate inputs
1 It raises the fraction of firms that outsource in each country 2 Armrsquos length trade rises relative to intrafirm trade
I INTRODUCTION
bull Growth of international specialization has been a dominant feature of the international economy
bull Feenstra (1998) of the $2 export value for the Barbie dolls when they leave HK for the USbull $035 = Chinese laborbull $065 = cost of materialsbull $100 = transportation
bull WTO (1998) in the production of an American car
US37
Korea30
Japan18
Ger-many
8
Taiwan amp Singapore4
UK3
Ireland amp Barbados2
I INTRODUCTION
bull Feenstra and Hanson (1996)bull The share of imported intermediates increased from 53 of
total US intermediate purchases in 1972 to 116 in 1990
bull Bureau of Economic Analysisbull The growth of foreign outsourcing by US firms have
outpaced the growth of their foreign intrafirm sourcing
bull Fan and Lang (2000)bull Decline in vertical integrationbull US manufacturing firms have become more specialized over
time
I INTRODUCTION
bull Issuesbull Outsourcing vs Integrationbull Home vs Foreign productionbull Conclusion need of a theoretical framework in which companies make
endogenous organizational choices
bull Melitz (2003)bull Helpman Melitz and Yeaple (2004)
bull Low-productivity firms serve only the domestic marketbull High-productivity firms also serve foreign markets
bull Among the high-productivity firms that serve foreign markets bull The more productive ones engage in FDIbull The less productive ones exportbull Affiliate sales relative to exports are larger in sectors with more productivity dispersion
bull PB their approach emphasizes variations across firms within industries without addressing the organizational choices of firs that need to acquire intermediate inputs
I INTRODUCTION
bull Grossman and Helpman (2002)bull Address the choice between outsourcing and integration in a one-input general equilibrium
frameworkbull HYP all firms of a given type are equally productivebull Their firms face the friction of incomplete contracts in armrsquos length relationships which they
weigh against the less efficient production of inputs in integrated companiesbull As a result some sectors have only vertically integrated firms whereas others have only
disintegrated firms
bull Antras (2003)bull Approach extended to a trading environment by introducing two new features
bull The friction of incomplete contracts also exists within integrated firmsbull Integration provides well-defined property rightsbull There are two inputs
bull 1 controlled by the final-good producerbull 1 controlled by another supplier inside or outside the firm
bull The sector that is relatively intensive in the input controlled by the final-good producer integrates
bull The sector that is relatively intensive in the other input outsourcesbull In the former sector there is intrafirm trade in inputs in the latter sector there is armrsquos-
length trade
I INTRODUCTION
bull Antras and Helpmanbull Develop a theoretical model that combinesbull The within-sectoral heterogeneity of Melitz (2003)bull With the structure of firms in Antras (2003)
bull The final-good producer controls the supply of headquarter services whereas a supplier of intermediate goods controls the quality and quantity of the intermediates
bull As a result they can study the impact of variations in productivity within sectors and of differences in technological and organizational characteristics across sectors on international trade FDI and the organizational choices of firms
bull In this framework trade investment and organization are interdependent
bull The incentives created by different organizations differences in their fixed costs and wage differentials across countries shape the equilibrium organizational structure
I INTRODUCTION
bull In a world of two countries North and South in which final-good producers are based in the North final-good producers that operate in the same sector but differ in productivity sort intobull integrated companies that produce inputs in the North (do not engage in foreign trade in inputs)bull Integrated companies that produce inputs in the South (engage in FDI and intrafirm trade)bull Disintegrated companies that outsource in the North (do not engage in foreign trade in inputs)bull Disintegrated companies that outsource in the South (import inputs at armrsquos-length trade)
bull in sectors with low headquarter intensity firms do not integrate low-productivity firms outsource in the North whereas high-productivity firms outsource in the South
bull In sectors with high headquarter intensity all four organizational forms may exist in equilibrium and as in sectors with low headquarter intensity high-productivity firms import inputs whereas low-productivity firms acquire them in the North
bull However among the firms that acquire inputs in the same country the low-productivity firms outsource whereas the high-productivity firms insource
bull This implies that the least productive firms outsource in the North whereas the most productive firms insource in the South via FDI
I INTRODUCTION
bull We use the model to study the relative prevalence of different organizational forms
bull We show how prevalence depends onbull the wage gap between the North and the Southbull the trading costs of intermediate inputsbull the degree of productivity dispersion within a sectorbull the distribution of bargaining powerbull the size of the ownership advantage (which may be different in the two countries)bull the intensity of headquarter services
bull Our model predictsbull relatively more final-good producers rely on imported intermediates in sectors with
higher productivity dispersion or lower headquarter intensitybull in sectors with integration and outsourcing which are the sectors with high
headquarter intensity industries with higher productivity dispersion have relatively more final-good producers that integrate
bull As a result such sectors have more intrafirm trade relative to armrsquos-length trade
II THE MODEL
bull Two countries the North and the Southbull A unique factor of production laborbull The world is populated by a unit measure of consumers with
identical preferences
bull x0 consumption of a homogenous good
bull Xj index of aggregate consumption in secor j
bull μ parameter
bull Inverse demand function for each variety i in sector j
II THE MODEL
bull Producers of differentiated products face a perfectly elastic supply of labor in each country
bull Wage rates are fixed and wN gt wS
bull The demand parameters μ and a are the same in every industrybull This helps focus attention on cross-sectoral differences in technology and organizational costs
bull Our aim to explore how differences in technology interact with organizational choices in shaping industrial structure trade flows and FDI
bull Only the North knows how to produce final-good varieties bull To start producing a variety in sector j a firm needs to bear a fixed cost of entry
consisting of fE units of northern labor Upon paying this fixed cost the unique producer of variety i in sector j draws a productivity level θ from a known distribution G(θ)
bull After observing this productivity level the final-good producer decides whether to exit the market or start producing in the latter case an additional fixed cost of organizing production needs to be incurred bull This additional fixed cost is a function of the structure of ownership and the location of
production
II THE MODEL
bull Production of any final-good variety requires a combination of two variety-specific inputsbull hj(i) headquarter services
bull Can be produced only in the North with one unit of labor per unit of outputbull mj(i) manufactured components
bull Can be produced in the North and in the South with one unit of labor per unit of output in each country
bull Output of every variety is a sector-specific Cobb-Douglas function of the inputs
bull θ firm-specific productivty parameterbull ηj sector-specific productivity parameter
bull The larger ηj is the more intensive the sector in headquarter services
bull Two types of agents engaged in productionbull H final-good producers who supply headquarter servicesbull M operators of manufacturing plants who supply intermediate inputs
bull Every H needs to contract with an M for the provision of components bull We allow international fragmentation of the production process so that H can choose
to trans- act with an M in the North or in the South
II THE MODEL
bull It follows from our assumptions that all H locate in the North bull Upon paying the fixed cost of entry wNfE and observing the productivity level θ the unique final-good
producer H of variety i in sector j seeks out a supplier of components M in the North or in the South
bull Simultaneously H chooses whether to insource or outsource intermediate inputs The joint management costs of final and intermediate goods production such as supervision quality control accounting and marketing depend on the organizational form and the location of M
bull All these costs the sum of which we term laquo fixed organizational costs raquo are denominated in terms of
northern labor bull We denote them by wNfk
l
bull k index of the ownership structurebull i index of the country in which M is located and the manufacturing of components takes place
bull The ownership structure takes one of two forms bull vertical integration Vbull outsourcing O
bull The supplier M is located in one of two sites bull in the North Nbull in the South S
bull Therefore k E1113110 V O and l E1113110 N S
bull An organizational form consists of an ownership structure and a location of M
II THE MODEL
bull We assume that the fixed organizational costs are higher when M is located in the South regardless of ownership structure because the fixed costs of search monitoring and communication are significantly higher in the foreign countrybull fk
S gt fVN and fk
S gt fON for k =V O
bull Given the location of M the fixed organizational costs of a V firm are higher than the fixed organizational costs of an O firm bull fV
l gt fOl for l = N S
bull As a result of these assumptions the fixed organizational costs are ranked as follows
bull We adopt this ordering in order to avoid a taxonomy of cases There exists a tension between two considerations that affect the ranking of fV
l and fOl
bull the need to supervise the production of intermediate inputs in addition to other managerial tasks raises man- agerial overload and the fixed organizational costs of a V firm relative to an O firm
bull economies of scope in the management of diverse activities reduce the fixed organizational costs of a V firm relative to an O firm
bull Our ordering amounts to assuming that managerial overload is more important than managerial economies of scope Al- though we believe this assumption to be appropriate in many instances and we therefore maintain it in the main analysis we shall point out how some of the results change when fV
l lt fOl
II THE MODEL
bull The setting is one of incomplete contracts Final-good producers and manufacturing plant operators cannot sign ex ante enforceable contracts specifying the purchase of specialized intermediate inputs for a certain price
bull The parties cannot write enforceable contracts contingent on the amount of labor hired or on the volume of sales revenues obtained when the final good is sold
bull Hart and Moore (1999) and Segal (1999)bull The parties cannot commit not to renegotiate an initial contract and that the precise nature of
the required input is revealed only ex post and is not verifiable by a third party
bull To simplify the analysis we just impose these constraints on the contracting environment
bull Because no enforceable contract can be signed ex ante final-good producers and manufacturing plant operators bargain over the surplus from the relationship after the inputs have been produced We model this ex post bargaining as a generalized Nash bargaining game in which the final-good producer obtains a fraction β1113110E (0 1) of the ex post gains from the relationship
II THE MODEL
bull Following the property rights approach to the theory of the firm we assume that ex post bargaining takes place both under outsourcing and under integration The distribution of surplus is sensitive however to the mode of organization
bull More specifically the outside option of H is assumed to be different when it owns the manufacturing plant than when it does not In the latter case a failure to reach an agreement on the distribution of the surplus leaves both parties with no income because the inputs are tailored specifically to the other party in the transaction
bull However by vertically integrating the production of components H is effectively buying the right to fire M and seize the inputs mj(i) If there were no costs associated with firing the operator of the manufacturing plant the final-good producer would always have an incentive to seize the inputs mj(i) ex post and M wouldhave an incentive to choose mj(i) = 0 ex ante (which of course would imply xj(i) = 0)
bull In this case integration would never be chosen We therefore assume that firing M results in a loss of a fraction 1 1113110- δ of final-good production because H cannot use the intermediate inputs without M as effectively as it can with the cooperation of M
bull We also assume that δN ge δS This captures the notion that a contractual breach is likely to be more costly to H when M is in the South More figuratively we think of this assumption as reflecting less corruption and better legal protection in the North As is clear from the weak inequality however our results still hold when δN = δS
bull The location of M and the mode of ownership are chosen ex ante by H to maximize its profits There is an infinitely elastic supply of M agents in each one of the countries Each final-good producer H offers a contract that seeks to attract a plant operator M The contract includes an up-front fee for participation in the relationship that has to be paid by M This fee can be positive or negative that is the operator can make a payment to the final-good producer or vice versa The purpose of the fee is to secure the participation of M in the relationship at minimum cost to H When the supply of M is infinitely elastic Mrsquos profits from the relationship net of the participation fee are equal in equilibrium to its ex ante outside option For simplicity we set Mrsquos ex ante outside option equal to zero in both countries It is however easy to extend the analysis to cases in which these outside options are positive and different in the North and in the South
III EQUILIBRIUM
bull The organizational structure equilibrium will be determined bybull Incentives created by different organizationsbull Differences in their fixed costsbull Wage differentials across countries
bull Being in an incomplete contract framework it means that the contract will be renegotiated at some point in time Therefore a bargaining game specification is needed
bull If the parties agree in the bargaining the potential revenue from the sale of the final good is given by
(4)
bull The resulting payoffs implies that the final-good producer (henceforth H) appropriate higher fraction of the revenue under integration than under outsourcing with this fraction being higher when integration takes place in the North The payoffs ordering are the following
(5)
III EQUILIBRIUM
bull As we are in an incomplete contract framework both H and M will choose their quantities noncooperatively Each one will produce the quantity that maximises their individual profits Total operating profits are given by
(6)
where
(7)
bull As H has to attract an M agent whose outside option (ie if they fail to agree) is zero and the contract includes a participation fee (t) which can be positive or negative the final-good production (H) will be the one who decides the organizational form because he will have the incentive to increase t as much as he can (as long as the payoff of M is not negative) As a result
III EQUILIBRIUM
bull Thus upon observing its productivity level H will decide the ownership structure and the location of manufacturing that maximizes (6) The productivity threshold will determine whether H exits the industry or not This productivity threshold depends on the sectorrsquos aggregate consumption index X and implies that
(9)
bull In fact to solve this optimization program the final-good producer will have to choose the triplet that maximizes (6)
bull Equation (6) puts in evidence that profits are decreasing both with and Hence from a cost saving point of view H faces a trade-off as fixed costs are higher in the South and variable costs are lower there ( )
bull Next the final good producer cannot freely choose its fraction of revenue bull Although a higher gives H a larger fraction of revenue it also induces M to produce fewer
components Therefore H trades the choice of a larger fraction of the revenue for a smaller revenue level In fact this fraction of revenue will be determined as follows
(10)
III EQUILIBRIUM
bull Each partyrsquos severity of underinvestment is inversely related to the fraction of the surplus that it appropriates Therefore ex ante efficiency requires giving a larger share of revenue to the party undertaking the relatively more important investment
IV ORGANIZATIONAL FORMS
bull Firms face two types of tensions when choosing the organizational formbull Regarding the location decision variable costs are lower in the South but fixed costs are lower in
the Northbull For the ownership decision the firm has to take into account the fact that insourcing entails higher
fixed costs and gives H a larger fraction of the revenue However if the effect of Mrsquos incentives are strong enough Hrsquos profits may be lower under integration (because if H appropriates a large fraction of revenue M will have no incentive to produce the components)
bull In component-intensive sectors firms donrsquot integrate high-productivity firms outsource in the South low-productivity firms outsource in the North and least productive firms exit the industry
bull In headquarter-intensive sectors we can find the four different organizational forms The most productive firms integrate in the South and somewhat less productive firms outsource in the South Firms with even lower productivity acquire components in the North and among them the more productive integrate and the less productive outsource Finally the least productive firms exit
IV ORGANIZATIONAL FORMS
bull A low headquarter intensity is depicted when As indicated by the arrows profits decrease with increases in bull In this situation H prefers outsourcing to
insourcing regardless the manufacturing location because outsourcing has lower fixed costs and it gives H a lower fraction of revenue
bull Depending on whether the cross-county difference in the wage rate is small or large relative to the cross-country difference in the fixed organizational costs the resulting equilibrium can havebull outsourcing in both countriesbull outsourcing in the South only
Low headquarter intensity sector
IV ORGANIZATIONAL FORMS
bull When wage differential is small relative to to the fixed cost differential firms with a productivity higher than the productivity threshold will outsource in the North and firms with even higher productivity will outsource in the South
bull When wage differential is large relative to the fixed costs all firms with a productivity higher than the threshold will outsource in the South
bull With this threshold level being the intersection between the red line and the horizontal axis
(6)
Low headquarter intensity sector
IV ORGANIZATIONAL FORMS
High headquarter intensity sector bull A high headquarter intensity is depicted when As indicated by the arrows profits increase with increases in
bull The figure 4 shows us that is steeper than for
bull When wage differential is small relative to the fixed cost differential and when the sector is relatively more intensive in headquarter services the marginal return of headquarter services is high making underinvestment significantly costly for H Therefore in such a situation itrsquos always profitable for H to insource regardless the manufacturing location because
bull Integration gives H a larger share of revenue However variable costs are lower in the South For that reason can be steeper or flatter than This is to say that can be larger or smaller than
bull Depending on whether the cross-county difference in the wage rate is small or large relative to the difference between and the resulting equilibrium can have bull The four organizational formsbull Outsourcing in the North insourcing in the North and insourcing in the
Southbull Outsourcing in the North and insourcing in the North
(6)
IV ORGANIZATIONAL FORMS
High headquarter intensity sector
(6)
First case
bull It follows that
(14)
bull Given the orderings in (3) and (14) figure 4 shows us that all four organizational forms exist in equilibrium
IV ORGANIZATIONAL FORMS
High headquarter intensity sector
(6)
Second case
bull In this event (14) doesnrsquot hold anymore because and there are only two equilibrium possibilities
bull Either bull Integration in the North
dominates Consequently only 3 organizational forms can exist in equilibrium at best
bull Outsourcing in the North
bull Insourcing in the Northbull Insourcing in the South
IV ORGANIZATIONAL FORMS
High headquarter intensity sector Second case
bull In this event (14) doesnrsquot hold anymore because and there are only two equilibrium possibilities
bull Orbull Integration in the North
dominates outsourcing and insourcing in the South Consequently only two organizational forms can exist in equilibrium at most
bull Outsourcing in the North
bull Insourcing in the Northbull Hence there is no
international trade in inputs
(6)
V PREVALENCE OF ORGANIZATIONAL FORMS
Measure of prevalence the fraction of firms and market share
COMPONENT-INTENSIVE SECTOR
bull No firm integrates low η
The fraction of firms that outsource in the South
1 Lower wage in the south Raises the profit of outsourcing in the SouthRaises The minimal productivity to be active in the sector rises
SO
COMPONENT-INTENSIVE SECTOR
The fraction of firms that outsource in the South
2 Increase in the dispersion of productivity Raises
3 Higher headquarter intensity is less prevalent
4 Smaller fraction of the surplus from outsourcing in the south (β)Raises the profitability of outsourcing in the South is more prevalent
HEADQUARTER-INTENSIVE SECTOR
Organizational forms
HEADQUARTER-INTENSIVE SECTOR
1 Lower wage in the South
2 Increase of productivity dispersionDecline Increase and ambiguous effect in the others
3 Higher headquarter intensity (η) Domestic outsourcing is favored relative to foreign outsourcingIntegration is favored relative to outsourcingThe effects of η on the fraction of firms that insource in the south is ambiguous
HEADQUARTER-INTENSIVE SECTOR
4 Increase in the revenue shares4 Increase in (rises slope of the profit line)
SV
The fraction of outsourcing firms in the South declines and the fraction of insourcing firms in the South rises
HEADQUARTER-INTENSIVE SECTOR
4 Increase in the revenue shares5 Increase in (rises slope of the profit line)
NV The fraction of firms that
outsource in the north declines and these that insource in the north rises The fraction of firms that outsource in the south declines and these that insource in the south does not change
HEADQUARTER-INTENSIVE SECTOR
5 Increase in the primitive bargaining power parameter (β)
bull Shifts the bargaining power in favor of Hbull Outsourcing becomes more attractivebull ise bull The fraction of firms that import components
rises
VI CONCLUDING COMMENTS
1 The high-productivity firms -gt South2 In the same country high-productivity firms
insource 3 In sectors with very low intensity of headquarter
services no firm integrates 1 Low-productivity firms outsource at home 2 High-productivity firms outsource abroad
VI CONCLUDING COMMENTS
4 The prevalence of organizational forms depends on industry characteristics and on the degree of productivity dispersion across firms
1 Sectors with more productivity dispersion (lower z) more imported inputs
1 Within the headquarter-intensive sectors integration is more prevalent
2 Higher headquarter intensity less imported inputs 1 Within the headquarter-intensive sectors integration is more
prevalent
5 Lower wages in the south raises the fraction of firms that import intermediate inputs
1 It raises the fraction of firms that outsource in each country 2 Armrsquos length trade rises relative to intrafirm trade
I INTRODUCTION
bull Feenstra and Hanson (1996)bull The share of imported intermediates increased from 53 of
total US intermediate purchases in 1972 to 116 in 1990
bull Bureau of Economic Analysisbull The growth of foreign outsourcing by US firms have
outpaced the growth of their foreign intrafirm sourcing
bull Fan and Lang (2000)bull Decline in vertical integrationbull US manufacturing firms have become more specialized over
time
I INTRODUCTION
bull Issuesbull Outsourcing vs Integrationbull Home vs Foreign productionbull Conclusion need of a theoretical framework in which companies make
endogenous organizational choices
bull Melitz (2003)bull Helpman Melitz and Yeaple (2004)
bull Low-productivity firms serve only the domestic marketbull High-productivity firms also serve foreign markets
bull Among the high-productivity firms that serve foreign markets bull The more productive ones engage in FDIbull The less productive ones exportbull Affiliate sales relative to exports are larger in sectors with more productivity dispersion
bull PB their approach emphasizes variations across firms within industries without addressing the organizational choices of firs that need to acquire intermediate inputs
I INTRODUCTION
bull Grossman and Helpman (2002)bull Address the choice between outsourcing and integration in a one-input general equilibrium
frameworkbull HYP all firms of a given type are equally productivebull Their firms face the friction of incomplete contracts in armrsquos length relationships which they
weigh against the less efficient production of inputs in integrated companiesbull As a result some sectors have only vertically integrated firms whereas others have only
disintegrated firms
bull Antras (2003)bull Approach extended to a trading environment by introducing two new features
bull The friction of incomplete contracts also exists within integrated firmsbull Integration provides well-defined property rightsbull There are two inputs
bull 1 controlled by the final-good producerbull 1 controlled by another supplier inside or outside the firm
bull The sector that is relatively intensive in the input controlled by the final-good producer integrates
bull The sector that is relatively intensive in the other input outsourcesbull In the former sector there is intrafirm trade in inputs in the latter sector there is armrsquos-
length trade
I INTRODUCTION
bull Antras and Helpmanbull Develop a theoretical model that combinesbull The within-sectoral heterogeneity of Melitz (2003)bull With the structure of firms in Antras (2003)
bull The final-good producer controls the supply of headquarter services whereas a supplier of intermediate goods controls the quality and quantity of the intermediates
bull As a result they can study the impact of variations in productivity within sectors and of differences in technological and organizational characteristics across sectors on international trade FDI and the organizational choices of firms
bull In this framework trade investment and organization are interdependent
bull The incentives created by different organizations differences in their fixed costs and wage differentials across countries shape the equilibrium organizational structure
I INTRODUCTION
bull In a world of two countries North and South in which final-good producers are based in the North final-good producers that operate in the same sector but differ in productivity sort intobull integrated companies that produce inputs in the North (do not engage in foreign trade in inputs)bull Integrated companies that produce inputs in the South (engage in FDI and intrafirm trade)bull Disintegrated companies that outsource in the North (do not engage in foreign trade in inputs)bull Disintegrated companies that outsource in the South (import inputs at armrsquos-length trade)
bull in sectors with low headquarter intensity firms do not integrate low-productivity firms outsource in the North whereas high-productivity firms outsource in the South
bull In sectors with high headquarter intensity all four organizational forms may exist in equilibrium and as in sectors with low headquarter intensity high-productivity firms import inputs whereas low-productivity firms acquire them in the North
bull However among the firms that acquire inputs in the same country the low-productivity firms outsource whereas the high-productivity firms insource
bull This implies that the least productive firms outsource in the North whereas the most productive firms insource in the South via FDI
I INTRODUCTION
bull We use the model to study the relative prevalence of different organizational forms
bull We show how prevalence depends onbull the wage gap between the North and the Southbull the trading costs of intermediate inputsbull the degree of productivity dispersion within a sectorbull the distribution of bargaining powerbull the size of the ownership advantage (which may be different in the two countries)bull the intensity of headquarter services
bull Our model predictsbull relatively more final-good producers rely on imported intermediates in sectors with
higher productivity dispersion or lower headquarter intensitybull in sectors with integration and outsourcing which are the sectors with high
headquarter intensity industries with higher productivity dispersion have relatively more final-good producers that integrate
bull As a result such sectors have more intrafirm trade relative to armrsquos-length trade
II THE MODEL
bull Two countries the North and the Southbull A unique factor of production laborbull The world is populated by a unit measure of consumers with
identical preferences
bull x0 consumption of a homogenous good
bull Xj index of aggregate consumption in secor j
bull μ parameter
bull Inverse demand function for each variety i in sector j
II THE MODEL
bull Producers of differentiated products face a perfectly elastic supply of labor in each country
bull Wage rates are fixed and wN gt wS
bull The demand parameters μ and a are the same in every industrybull This helps focus attention on cross-sectoral differences in technology and organizational costs
bull Our aim to explore how differences in technology interact with organizational choices in shaping industrial structure trade flows and FDI
bull Only the North knows how to produce final-good varieties bull To start producing a variety in sector j a firm needs to bear a fixed cost of entry
consisting of fE units of northern labor Upon paying this fixed cost the unique producer of variety i in sector j draws a productivity level θ from a known distribution G(θ)
bull After observing this productivity level the final-good producer decides whether to exit the market or start producing in the latter case an additional fixed cost of organizing production needs to be incurred bull This additional fixed cost is a function of the structure of ownership and the location of
production
II THE MODEL
bull Production of any final-good variety requires a combination of two variety-specific inputsbull hj(i) headquarter services
bull Can be produced only in the North with one unit of labor per unit of outputbull mj(i) manufactured components
bull Can be produced in the North and in the South with one unit of labor per unit of output in each country
bull Output of every variety is a sector-specific Cobb-Douglas function of the inputs
bull θ firm-specific productivty parameterbull ηj sector-specific productivity parameter
bull The larger ηj is the more intensive the sector in headquarter services
bull Two types of agents engaged in productionbull H final-good producers who supply headquarter servicesbull M operators of manufacturing plants who supply intermediate inputs
bull Every H needs to contract with an M for the provision of components bull We allow international fragmentation of the production process so that H can choose
to trans- act with an M in the North or in the South
II THE MODEL
bull It follows from our assumptions that all H locate in the North bull Upon paying the fixed cost of entry wNfE and observing the productivity level θ the unique final-good
producer H of variety i in sector j seeks out a supplier of components M in the North or in the South
bull Simultaneously H chooses whether to insource or outsource intermediate inputs The joint management costs of final and intermediate goods production such as supervision quality control accounting and marketing depend on the organizational form and the location of M
bull All these costs the sum of which we term laquo fixed organizational costs raquo are denominated in terms of
northern labor bull We denote them by wNfk
l
bull k index of the ownership structurebull i index of the country in which M is located and the manufacturing of components takes place
bull The ownership structure takes one of two forms bull vertical integration Vbull outsourcing O
bull The supplier M is located in one of two sites bull in the North Nbull in the South S
bull Therefore k E1113110 V O and l E1113110 N S
bull An organizational form consists of an ownership structure and a location of M
II THE MODEL
bull We assume that the fixed organizational costs are higher when M is located in the South regardless of ownership structure because the fixed costs of search monitoring and communication are significantly higher in the foreign countrybull fk
S gt fVN and fk
S gt fON for k =V O
bull Given the location of M the fixed organizational costs of a V firm are higher than the fixed organizational costs of an O firm bull fV
l gt fOl for l = N S
bull As a result of these assumptions the fixed organizational costs are ranked as follows
bull We adopt this ordering in order to avoid a taxonomy of cases There exists a tension between two considerations that affect the ranking of fV
l and fOl
bull the need to supervise the production of intermediate inputs in addition to other managerial tasks raises man- agerial overload and the fixed organizational costs of a V firm relative to an O firm
bull economies of scope in the management of diverse activities reduce the fixed organizational costs of a V firm relative to an O firm
bull Our ordering amounts to assuming that managerial overload is more important than managerial economies of scope Al- though we believe this assumption to be appropriate in many instances and we therefore maintain it in the main analysis we shall point out how some of the results change when fV
l lt fOl
II THE MODEL
bull The setting is one of incomplete contracts Final-good producers and manufacturing plant operators cannot sign ex ante enforceable contracts specifying the purchase of specialized intermediate inputs for a certain price
bull The parties cannot write enforceable contracts contingent on the amount of labor hired or on the volume of sales revenues obtained when the final good is sold
bull Hart and Moore (1999) and Segal (1999)bull The parties cannot commit not to renegotiate an initial contract and that the precise nature of
the required input is revealed only ex post and is not verifiable by a third party
bull To simplify the analysis we just impose these constraints on the contracting environment
bull Because no enforceable contract can be signed ex ante final-good producers and manufacturing plant operators bargain over the surplus from the relationship after the inputs have been produced We model this ex post bargaining as a generalized Nash bargaining game in which the final-good producer obtains a fraction β1113110E (0 1) of the ex post gains from the relationship
II THE MODEL
bull Following the property rights approach to the theory of the firm we assume that ex post bargaining takes place both under outsourcing and under integration The distribution of surplus is sensitive however to the mode of organization
bull More specifically the outside option of H is assumed to be different when it owns the manufacturing plant than when it does not In the latter case a failure to reach an agreement on the distribution of the surplus leaves both parties with no income because the inputs are tailored specifically to the other party in the transaction
bull However by vertically integrating the production of components H is effectively buying the right to fire M and seize the inputs mj(i) If there were no costs associated with firing the operator of the manufacturing plant the final-good producer would always have an incentive to seize the inputs mj(i) ex post and M wouldhave an incentive to choose mj(i) = 0 ex ante (which of course would imply xj(i) = 0)
bull In this case integration would never be chosen We therefore assume that firing M results in a loss of a fraction 1 1113110- δ of final-good production because H cannot use the intermediate inputs without M as effectively as it can with the cooperation of M
bull We also assume that δN ge δS This captures the notion that a contractual breach is likely to be more costly to H when M is in the South More figuratively we think of this assumption as reflecting less corruption and better legal protection in the North As is clear from the weak inequality however our results still hold when δN = δS
bull The location of M and the mode of ownership are chosen ex ante by H to maximize its profits There is an infinitely elastic supply of M agents in each one of the countries Each final-good producer H offers a contract that seeks to attract a plant operator M The contract includes an up-front fee for participation in the relationship that has to be paid by M This fee can be positive or negative that is the operator can make a payment to the final-good producer or vice versa The purpose of the fee is to secure the participation of M in the relationship at minimum cost to H When the supply of M is infinitely elastic Mrsquos profits from the relationship net of the participation fee are equal in equilibrium to its ex ante outside option For simplicity we set Mrsquos ex ante outside option equal to zero in both countries It is however easy to extend the analysis to cases in which these outside options are positive and different in the North and in the South
III EQUILIBRIUM
bull The organizational structure equilibrium will be determined bybull Incentives created by different organizationsbull Differences in their fixed costsbull Wage differentials across countries
bull Being in an incomplete contract framework it means that the contract will be renegotiated at some point in time Therefore a bargaining game specification is needed
bull If the parties agree in the bargaining the potential revenue from the sale of the final good is given by
(4)
bull The resulting payoffs implies that the final-good producer (henceforth H) appropriate higher fraction of the revenue under integration than under outsourcing with this fraction being higher when integration takes place in the North The payoffs ordering are the following
(5)
III EQUILIBRIUM
bull As we are in an incomplete contract framework both H and M will choose their quantities noncooperatively Each one will produce the quantity that maximises their individual profits Total operating profits are given by
(6)
where
(7)
bull As H has to attract an M agent whose outside option (ie if they fail to agree) is zero and the contract includes a participation fee (t) which can be positive or negative the final-good production (H) will be the one who decides the organizational form because he will have the incentive to increase t as much as he can (as long as the payoff of M is not negative) As a result
III EQUILIBRIUM
bull Thus upon observing its productivity level H will decide the ownership structure and the location of manufacturing that maximizes (6) The productivity threshold will determine whether H exits the industry or not This productivity threshold depends on the sectorrsquos aggregate consumption index X and implies that
(9)
bull In fact to solve this optimization program the final-good producer will have to choose the triplet that maximizes (6)
bull Equation (6) puts in evidence that profits are decreasing both with and Hence from a cost saving point of view H faces a trade-off as fixed costs are higher in the South and variable costs are lower there ( )
bull Next the final good producer cannot freely choose its fraction of revenue bull Although a higher gives H a larger fraction of revenue it also induces M to produce fewer
components Therefore H trades the choice of a larger fraction of the revenue for a smaller revenue level In fact this fraction of revenue will be determined as follows
(10)
III EQUILIBRIUM
bull Each partyrsquos severity of underinvestment is inversely related to the fraction of the surplus that it appropriates Therefore ex ante efficiency requires giving a larger share of revenue to the party undertaking the relatively more important investment
IV ORGANIZATIONAL FORMS
bull Firms face two types of tensions when choosing the organizational formbull Regarding the location decision variable costs are lower in the South but fixed costs are lower in
the Northbull For the ownership decision the firm has to take into account the fact that insourcing entails higher
fixed costs and gives H a larger fraction of the revenue However if the effect of Mrsquos incentives are strong enough Hrsquos profits may be lower under integration (because if H appropriates a large fraction of revenue M will have no incentive to produce the components)
bull In component-intensive sectors firms donrsquot integrate high-productivity firms outsource in the South low-productivity firms outsource in the North and least productive firms exit the industry
bull In headquarter-intensive sectors we can find the four different organizational forms The most productive firms integrate in the South and somewhat less productive firms outsource in the South Firms with even lower productivity acquire components in the North and among them the more productive integrate and the less productive outsource Finally the least productive firms exit
IV ORGANIZATIONAL FORMS
bull A low headquarter intensity is depicted when As indicated by the arrows profits decrease with increases in bull In this situation H prefers outsourcing to
insourcing regardless the manufacturing location because outsourcing has lower fixed costs and it gives H a lower fraction of revenue
bull Depending on whether the cross-county difference in the wage rate is small or large relative to the cross-country difference in the fixed organizational costs the resulting equilibrium can havebull outsourcing in both countriesbull outsourcing in the South only
Low headquarter intensity sector
IV ORGANIZATIONAL FORMS
bull When wage differential is small relative to to the fixed cost differential firms with a productivity higher than the productivity threshold will outsource in the North and firms with even higher productivity will outsource in the South
bull When wage differential is large relative to the fixed costs all firms with a productivity higher than the threshold will outsource in the South
bull With this threshold level being the intersection between the red line and the horizontal axis
(6)
Low headquarter intensity sector
IV ORGANIZATIONAL FORMS
High headquarter intensity sector bull A high headquarter intensity is depicted when As indicated by the arrows profits increase with increases in
bull The figure 4 shows us that is steeper than for
bull When wage differential is small relative to the fixed cost differential and when the sector is relatively more intensive in headquarter services the marginal return of headquarter services is high making underinvestment significantly costly for H Therefore in such a situation itrsquos always profitable for H to insource regardless the manufacturing location because
bull Integration gives H a larger share of revenue However variable costs are lower in the South For that reason can be steeper or flatter than This is to say that can be larger or smaller than
bull Depending on whether the cross-county difference in the wage rate is small or large relative to the difference between and the resulting equilibrium can have bull The four organizational formsbull Outsourcing in the North insourcing in the North and insourcing in the
Southbull Outsourcing in the North and insourcing in the North
(6)
IV ORGANIZATIONAL FORMS
High headquarter intensity sector
(6)
First case
bull It follows that
(14)
bull Given the orderings in (3) and (14) figure 4 shows us that all four organizational forms exist in equilibrium
IV ORGANIZATIONAL FORMS
High headquarter intensity sector
(6)
Second case
bull In this event (14) doesnrsquot hold anymore because and there are only two equilibrium possibilities
bull Either bull Integration in the North
dominates Consequently only 3 organizational forms can exist in equilibrium at best
bull Outsourcing in the North
bull Insourcing in the Northbull Insourcing in the South
IV ORGANIZATIONAL FORMS
High headquarter intensity sector Second case
bull In this event (14) doesnrsquot hold anymore because and there are only two equilibrium possibilities
bull Orbull Integration in the North
dominates outsourcing and insourcing in the South Consequently only two organizational forms can exist in equilibrium at most
bull Outsourcing in the North
bull Insourcing in the Northbull Hence there is no
international trade in inputs
(6)
V PREVALENCE OF ORGANIZATIONAL FORMS
Measure of prevalence the fraction of firms and market share
COMPONENT-INTENSIVE SECTOR
bull No firm integrates low η
The fraction of firms that outsource in the South
1 Lower wage in the south Raises the profit of outsourcing in the SouthRaises The minimal productivity to be active in the sector rises
SO
COMPONENT-INTENSIVE SECTOR
The fraction of firms that outsource in the South
2 Increase in the dispersion of productivity Raises
3 Higher headquarter intensity is less prevalent
4 Smaller fraction of the surplus from outsourcing in the south (β)Raises the profitability of outsourcing in the South is more prevalent
HEADQUARTER-INTENSIVE SECTOR
Organizational forms
HEADQUARTER-INTENSIVE SECTOR
1 Lower wage in the South
2 Increase of productivity dispersionDecline Increase and ambiguous effect in the others
3 Higher headquarter intensity (η) Domestic outsourcing is favored relative to foreign outsourcingIntegration is favored relative to outsourcingThe effects of η on the fraction of firms that insource in the south is ambiguous
HEADQUARTER-INTENSIVE SECTOR
4 Increase in the revenue shares4 Increase in (rises slope of the profit line)
SV
The fraction of outsourcing firms in the South declines and the fraction of insourcing firms in the South rises
HEADQUARTER-INTENSIVE SECTOR
4 Increase in the revenue shares5 Increase in (rises slope of the profit line)
NV The fraction of firms that
outsource in the north declines and these that insource in the north rises The fraction of firms that outsource in the south declines and these that insource in the south does not change
HEADQUARTER-INTENSIVE SECTOR
5 Increase in the primitive bargaining power parameter (β)
bull Shifts the bargaining power in favor of Hbull Outsourcing becomes more attractivebull ise bull The fraction of firms that import components
rises
VI CONCLUDING COMMENTS
1 The high-productivity firms -gt South2 In the same country high-productivity firms
insource 3 In sectors with very low intensity of headquarter
services no firm integrates 1 Low-productivity firms outsource at home 2 High-productivity firms outsource abroad
VI CONCLUDING COMMENTS
4 The prevalence of organizational forms depends on industry characteristics and on the degree of productivity dispersion across firms
1 Sectors with more productivity dispersion (lower z) more imported inputs
1 Within the headquarter-intensive sectors integration is more prevalent
2 Higher headquarter intensity less imported inputs 1 Within the headquarter-intensive sectors integration is more
prevalent
5 Lower wages in the south raises the fraction of firms that import intermediate inputs
1 It raises the fraction of firms that outsource in each country 2 Armrsquos length trade rises relative to intrafirm trade
I INTRODUCTION
bull Issuesbull Outsourcing vs Integrationbull Home vs Foreign productionbull Conclusion need of a theoretical framework in which companies make
endogenous organizational choices
bull Melitz (2003)bull Helpman Melitz and Yeaple (2004)
bull Low-productivity firms serve only the domestic marketbull High-productivity firms also serve foreign markets
bull Among the high-productivity firms that serve foreign markets bull The more productive ones engage in FDIbull The less productive ones exportbull Affiliate sales relative to exports are larger in sectors with more productivity dispersion
bull PB their approach emphasizes variations across firms within industries without addressing the organizational choices of firs that need to acquire intermediate inputs
I INTRODUCTION
bull Grossman and Helpman (2002)bull Address the choice between outsourcing and integration in a one-input general equilibrium
frameworkbull HYP all firms of a given type are equally productivebull Their firms face the friction of incomplete contracts in armrsquos length relationships which they
weigh against the less efficient production of inputs in integrated companiesbull As a result some sectors have only vertically integrated firms whereas others have only
disintegrated firms
bull Antras (2003)bull Approach extended to a trading environment by introducing two new features
bull The friction of incomplete contracts also exists within integrated firmsbull Integration provides well-defined property rightsbull There are two inputs
bull 1 controlled by the final-good producerbull 1 controlled by another supplier inside or outside the firm
bull The sector that is relatively intensive in the input controlled by the final-good producer integrates
bull The sector that is relatively intensive in the other input outsourcesbull In the former sector there is intrafirm trade in inputs in the latter sector there is armrsquos-
length trade
I INTRODUCTION
bull Antras and Helpmanbull Develop a theoretical model that combinesbull The within-sectoral heterogeneity of Melitz (2003)bull With the structure of firms in Antras (2003)
bull The final-good producer controls the supply of headquarter services whereas a supplier of intermediate goods controls the quality and quantity of the intermediates
bull As a result they can study the impact of variations in productivity within sectors and of differences in technological and organizational characteristics across sectors on international trade FDI and the organizational choices of firms
bull In this framework trade investment and organization are interdependent
bull The incentives created by different organizations differences in their fixed costs and wage differentials across countries shape the equilibrium organizational structure
I INTRODUCTION
bull In a world of two countries North and South in which final-good producers are based in the North final-good producers that operate in the same sector but differ in productivity sort intobull integrated companies that produce inputs in the North (do not engage in foreign trade in inputs)bull Integrated companies that produce inputs in the South (engage in FDI and intrafirm trade)bull Disintegrated companies that outsource in the North (do not engage in foreign trade in inputs)bull Disintegrated companies that outsource in the South (import inputs at armrsquos-length trade)
bull in sectors with low headquarter intensity firms do not integrate low-productivity firms outsource in the North whereas high-productivity firms outsource in the South
bull In sectors with high headquarter intensity all four organizational forms may exist in equilibrium and as in sectors with low headquarter intensity high-productivity firms import inputs whereas low-productivity firms acquire them in the North
bull However among the firms that acquire inputs in the same country the low-productivity firms outsource whereas the high-productivity firms insource
bull This implies that the least productive firms outsource in the North whereas the most productive firms insource in the South via FDI
I INTRODUCTION
bull We use the model to study the relative prevalence of different organizational forms
bull We show how prevalence depends onbull the wage gap between the North and the Southbull the trading costs of intermediate inputsbull the degree of productivity dispersion within a sectorbull the distribution of bargaining powerbull the size of the ownership advantage (which may be different in the two countries)bull the intensity of headquarter services
bull Our model predictsbull relatively more final-good producers rely on imported intermediates in sectors with
higher productivity dispersion or lower headquarter intensitybull in sectors with integration and outsourcing which are the sectors with high
headquarter intensity industries with higher productivity dispersion have relatively more final-good producers that integrate
bull As a result such sectors have more intrafirm trade relative to armrsquos-length trade
II THE MODEL
bull Two countries the North and the Southbull A unique factor of production laborbull The world is populated by a unit measure of consumers with
identical preferences
bull x0 consumption of a homogenous good
bull Xj index of aggregate consumption in secor j
bull μ parameter
bull Inverse demand function for each variety i in sector j
II THE MODEL
bull Producers of differentiated products face a perfectly elastic supply of labor in each country
bull Wage rates are fixed and wN gt wS
bull The demand parameters μ and a are the same in every industrybull This helps focus attention on cross-sectoral differences in technology and organizational costs
bull Our aim to explore how differences in technology interact with organizational choices in shaping industrial structure trade flows and FDI
bull Only the North knows how to produce final-good varieties bull To start producing a variety in sector j a firm needs to bear a fixed cost of entry
consisting of fE units of northern labor Upon paying this fixed cost the unique producer of variety i in sector j draws a productivity level θ from a known distribution G(θ)
bull After observing this productivity level the final-good producer decides whether to exit the market or start producing in the latter case an additional fixed cost of organizing production needs to be incurred bull This additional fixed cost is a function of the structure of ownership and the location of
production
II THE MODEL
bull Production of any final-good variety requires a combination of two variety-specific inputsbull hj(i) headquarter services
bull Can be produced only in the North with one unit of labor per unit of outputbull mj(i) manufactured components
bull Can be produced in the North and in the South with one unit of labor per unit of output in each country
bull Output of every variety is a sector-specific Cobb-Douglas function of the inputs
bull θ firm-specific productivty parameterbull ηj sector-specific productivity parameter
bull The larger ηj is the more intensive the sector in headquarter services
bull Two types of agents engaged in productionbull H final-good producers who supply headquarter servicesbull M operators of manufacturing plants who supply intermediate inputs
bull Every H needs to contract with an M for the provision of components bull We allow international fragmentation of the production process so that H can choose
to trans- act with an M in the North or in the South
II THE MODEL
bull It follows from our assumptions that all H locate in the North bull Upon paying the fixed cost of entry wNfE and observing the productivity level θ the unique final-good
producer H of variety i in sector j seeks out a supplier of components M in the North or in the South
bull Simultaneously H chooses whether to insource or outsource intermediate inputs The joint management costs of final and intermediate goods production such as supervision quality control accounting and marketing depend on the organizational form and the location of M
bull All these costs the sum of which we term laquo fixed organizational costs raquo are denominated in terms of
northern labor bull We denote them by wNfk
l
bull k index of the ownership structurebull i index of the country in which M is located and the manufacturing of components takes place
bull The ownership structure takes one of two forms bull vertical integration Vbull outsourcing O
bull The supplier M is located in one of two sites bull in the North Nbull in the South S
bull Therefore k E1113110 V O and l E1113110 N S
bull An organizational form consists of an ownership structure and a location of M
II THE MODEL
bull We assume that the fixed organizational costs are higher when M is located in the South regardless of ownership structure because the fixed costs of search monitoring and communication are significantly higher in the foreign countrybull fk
S gt fVN and fk
S gt fON for k =V O
bull Given the location of M the fixed organizational costs of a V firm are higher than the fixed organizational costs of an O firm bull fV
l gt fOl for l = N S
bull As a result of these assumptions the fixed organizational costs are ranked as follows
bull We adopt this ordering in order to avoid a taxonomy of cases There exists a tension between two considerations that affect the ranking of fV
l and fOl
bull the need to supervise the production of intermediate inputs in addition to other managerial tasks raises man- agerial overload and the fixed organizational costs of a V firm relative to an O firm
bull economies of scope in the management of diverse activities reduce the fixed organizational costs of a V firm relative to an O firm
bull Our ordering amounts to assuming that managerial overload is more important than managerial economies of scope Al- though we believe this assumption to be appropriate in many instances and we therefore maintain it in the main analysis we shall point out how some of the results change when fV
l lt fOl
II THE MODEL
bull The setting is one of incomplete contracts Final-good producers and manufacturing plant operators cannot sign ex ante enforceable contracts specifying the purchase of specialized intermediate inputs for a certain price
bull The parties cannot write enforceable contracts contingent on the amount of labor hired or on the volume of sales revenues obtained when the final good is sold
bull Hart and Moore (1999) and Segal (1999)bull The parties cannot commit not to renegotiate an initial contract and that the precise nature of
the required input is revealed only ex post and is not verifiable by a third party
bull To simplify the analysis we just impose these constraints on the contracting environment
bull Because no enforceable contract can be signed ex ante final-good producers and manufacturing plant operators bargain over the surplus from the relationship after the inputs have been produced We model this ex post bargaining as a generalized Nash bargaining game in which the final-good producer obtains a fraction β1113110E (0 1) of the ex post gains from the relationship
II THE MODEL
bull Following the property rights approach to the theory of the firm we assume that ex post bargaining takes place both under outsourcing and under integration The distribution of surplus is sensitive however to the mode of organization
bull More specifically the outside option of H is assumed to be different when it owns the manufacturing plant than when it does not In the latter case a failure to reach an agreement on the distribution of the surplus leaves both parties with no income because the inputs are tailored specifically to the other party in the transaction
bull However by vertically integrating the production of components H is effectively buying the right to fire M and seize the inputs mj(i) If there were no costs associated with firing the operator of the manufacturing plant the final-good producer would always have an incentive to seize the inputs mj(i) ex post and M wouldhave an incentive to choose mj(i) = 0 ex ante (which of course would imply xj(i) = 0)
bull In this case integration would never be chosen We therefore assume that firing M results in a loss of a fraction 1 1113110- δ of final-good production because H cannot use the intermediate inputs without M as effectively as it can with the cooperation of M
bull We also assume that δN ge δS This captures the notion that a contractual breach is likely to be more costly to H when M is in the South More figuratively we think of this assumption as reflecting less corruption and better legal protection in the North As is clear from the weak inequality however our results still hold when δN = δS
bull The location of M and the mode of ownership are chosen ex ante by H to maximize its profits There is an infinitely elastic supply of M agents in each one of the countries Each final-good producer H offers a contract that seeks to attract a plant operator M The contract includes an up-front fee for participation in the relationship that has to be paid by M This fee can be positive or negative that is the operator can make a payment to the final-good producer or vice versa The purpose of the fee is to secure the participation of M in the relationship at minimum cost to H When the supply of M is infinitely elastic Mrsquos profits from the relationship net of the participation fee are equal in equilibrium to its ex ante outside option For simplicity we set Mrsquos ex ante outside option equal to zero in both countries It is however easy to extend the analysis to cases in which these outside options are positive and different in the North and in the South
III EQUILIBRIUM
bull The organizational structure equilibrium will be determined bybull Incentives created by different organizationsbull Differences in their fixed costsbull Wage differentials across countries
bull Being in an incomplete contract framework it means that the contract will be renegotiated at some point in time Therefore a bargaining game specification is needed
bull If the parties agree in the bargaining the potential revenue from the sale of the final good is given by
(4)
bull The resulting payoffs implies that the final-good producer (henceforth H) appropriate higher fraction of the revenue under integration than under outsourcing with this fraction being higher when integration takes place in the North The payoffs ordering are the following
(5)
III EQUILIBRIUM
bull As we are in an incomplete contract framework both H and M will choose their quantities noncooperatively Each one will produce the quantity that maximises their individual profits Total operating profits are given by
(6)
where
(7)
bull As H has to attract an M agent whose outside option (ie if they fail to agree) is zero and the contract includes a participation fee (t) which can be positive or negative the final-good production (H) will be the one who decides the organizational form because he will have the incentive to increase t as much as he can (as long as the payoff of M is not negative) As a result
III EQUILIBRIUM
bull Thus upon observing its productivity level H will decide the ownership structure and the location of manufacturing that maximizes (6) The productivity threshold will determine whether H exits the industry or not This productivity threshold depends on the sectorrsquos aggregate consumption index X and implies that
(9)
bull In fact to solve this optimization program the final-good producer will have to choose the triplet that maximizes (6)
bull Equation (6) puts in evidence that profits are decreasing both with and Hence from a cost saving point of view H faces a trade-off as fixed costs are higher in the South and variable costs are lower there ( )
bull Next the final good producer cannot freely choose its fraction of revenue bull Although a higher gives H a larger fraction of revenue it also induces M to produce fewer
components Therefore H trades the choice of a larger fraction of the revenue for a smaller revenue level In fact this fraction of revenue will be determined as follows
(10)
III EQUILIBRIUM
bull Each partyrsquos severity of underinvestment is inversely related to the fraction of the surplus that it appropriates Therefore ex ante efficiency requires giving a larger share of revenue to the party undertaking the relatively more important investment
IV ORGANIZATIONAL FORMS
bull Firms face two types of tensions when choosing the organizational formbull Regarding the location decision variable costs are lower in the South but fixed costs are lower in
the Northbull For the ownership decision the firm has to take into account the fact that insourcing entails higher
fixed costs and gives H a larger fraction of the revenue However if the effect of Mrsquos incentives are strong enough Hrsquos profits may be lower under integration (because if H appropriates a large fraction of revenue M will have no incentive to produce the components)
bull In component-intensive sectors firms donrsquot integrate high-productivity firms outsource in the South low-productivity firms outsource in the North and least productive firms exit the industry
bull In headquarter-intensive sectors we can find the four different organizational forms The most productive firms integrate in the South and somewhat less productive firms outsource in the South Firms with even lower productivity acquire components in the North and among them the more productive integrate and the less productive outsource Finally the least productive firms exit
IV ORGANIZATIONAL FORMS
bull A low headquarter intensity is depicted when As indicated by the arrows profits decrease with increases in bull In this situation H prefers outsourcing to
insourcing regardless the manufacturing location because outsourcing has lower fixed costs and it gives H a lower fraction of revenue
bull Depending on whether the cross-county difference in the wage rate is small or large relative to the cross-country difference in the fixed organizational costs the resulting equilibrium can havebull outsourcing in both countriesbull outsourcing in the South only
Low headquarter intensity sector
IV ORGANIZATIONAL FORMS
bull When wage differential is small relative to to the fixed cost differential firms with a productivity higher than the productivity threshold will outsource in the North and firms with even higher productivity will outsource in the South
bull When wage differential is large relative to the fixed costs all firms with a productivity higher than the threshold will outsource in the South
bull With this threshold level being the intersection between the red line and the horizontal axis
(6)
Low headquarter intensity sector
IV ORGANIZATIONAL FORMS
High headquarter intensity sector bull A high headquarter intensity is depicted when As indicated by the arrows profits increase with increases in
bull The figure 4 shows us that is steeper than for
bull When wage differential is small relative to the fixed cost differential and when the sector is relatively more intensive in headquarter services the marginal return of headquarter services is high making underinvestment significantly costly for H Therefore in such a situation itrsquos always profitable for H to insource regardless the manufacturing location because
bull Integration gives H a larger share of revenue However variable costs are lower in the South For that reason can be steeper or flatter than This is to say that can be larger or smaller than
bull Depending on whether the cross-county difference in the wage rate is small or large relative to the difference between and the resulting equilibrium can have bull The four organizational formsbull Outsourcing in the North insourcing in the North and insourcing in the
Southbull Outsourcing in the North and insourcing in the North
(6)
IV ORGANIZATIONAL FORMS
High headquarter intensity sector
(6)
First case
bull It follows that
(14)
bull Given the orderings in (3) and (14) figure 4 shows us that all four organizational forms exist in equilibrium
IV ORGANIZATIONAL FORMS
High headquarter intensity sector
(6)
Second case
bull In this event (14) doesnrsquot hold anymore because and there are only two equilibrium possibilities
bull Either bull Integration in the North
dominates Consequently only 3 organizational forms can exist in equilibrium at best
bull Outsourcing in the North
bull Insourcing in the Northbull Insourcing in the South
IV ORGANIZATIONAL FORMS
High headquarter intensity sector Second case
bull In this event (14) doesnrsquot hold anymore because and there are only two equilibrium possibilities
bull Orbull Integration in the North
dominates outsourcing and insourcing in the South Consequently only two organizational forms can exist in equilibrium at most
bull Outsourcing in the North
bull Insourcing in the Northbull Hence there is no
international trade in inputs
(6)
V PREVALENCE OF ORGANIZATIONAL FORMS
Measure of prevalence the fraction of firms and market share
COMPONENT-INTENSIVE SECTOR
bull No firm integrates low η
The fraction of firms that outsource in the South
1 Lower wage in the south Raises the profit of outsourcing in the SouthRaises The minimal productivity to be active in the sector rises
SO
COMPONENT-INTENSIVE SECTOR
The fraction of firms that outsource in the South
2 Increase in the dispersion of productivity Raises
3 Higher headquarter intensity is less prevalent
4 Smaller fraction of the surplus from outsourcing in the south (β)Raises the profitability of outsourcing in the South is more prevalent
HEADQUARTER-INTENSIVE SECTOR
Organizational forms
HEADQUARTER-INTENSIVE SECTOR
1 Lower wage in the South
2 Increase of productivity dispersionDecline Increase and ambiguous effect in the others
3 Higher headquarter intensity (η) Domestic outsourcing is favored relative to foreign outsourcingIntegration is favored relative to outsourcingThe effects of η on the fraction of firms that insource in the south is ambiguous
HEADQUARTER-INTENSIVE SECTOR
4 Increase in the revenue shares4 Increase in (rises slope of the profit line)
SV
The fraction of outsourcing firms in the South declines and the fraction of insourcing firms in the South rises
HEADQUARTER-INTENSIVE SECTOR
4 Increase in the revenue shares5 Increase in (rises slope of the profit line)
NV The fraction of firms that
outsource in the north declines and these that insource in the north rises The fraction of firms that outsource in the south declines and these that insource in the south does not change
HEADQUARTER-INTENSIVE SECTOR
5 Increase in the primitive bargaining power parameter (β)
bull Shifts the bargaining power in favor of Hbull Outsourcing becomes more attractivebull ise bull The fraction of firms that import components
rises
VI CONCLUDING COMMENTS
1 The high-productivity firms -gt South2 In the same country high-productivity firms
insource 3 In sectors with very low intensity of headquarter
services no firm integrates 1 Low-productivity firms outsource at home 2 High-productivity firms outsource abroad
VI CONCLUDING COMMENTS
4 The prevalence of organizational forms depends on industry characteristics and on the degree of productivity dispersion across firms
1 Sectors with more productivity dispersion (lower z) more imported inputs
1 Within the headquarter-intensive sectors integration is more prevalent
2 Higher headquarter intensity less imported inputs 1 Within the headquarter-intensive sectors integration is more
prevalent
5 Lower wages in the south raises the fraction of firms that import intermediate inputs
1 It raises the fraction of firms that outsource in each country 2 Armrsquos length trade rises relative to intrafirm trade
I INTRODUCTION
bull Grossman and Helpman (2002)bull Address the choice between outsourcing and integration in a one-input general equilibrium
frameworkbull HYP all firms of a given type are equally productivebull Their firms face the friction of incomplete contracts in armrsquos length relationships which they
weigh against the less efficient production of inputs in integrated companiesbull As a result some sectors have only vertically integrated firms whereas others have only
disintegrated firms
bull Antras (2003)bull Approach extended to a trading environment by introducing two new features
bull The friction of incomplete contracts also exists within integrated firmsbull Integration provides well-defined property rightsbull There are two inputs
bull 1 controlled by the final-good producerbull 1 controlled by another supplier inside or outside the firm
bull The sector that is relatively intensive in the input controlled by the final-good producer integrates
bull The sector that is relatively intensive in the other input outsourcesbull In the former sector there is intrafirm trade in inputs in the latter sector there is armrsquos-
length trade
I INTRODUCTION
bull Antras and Helpmanbull Develop a theoretical model that combinesbull The within-sectoral heterogeneity of Melitz (2003)bull With the structure of firms in Antras (2003)
bull The final-good producer controls the supply of headquarter services whereas a supplier of intermediate goods controls the quality and quantity of the intermediates
bull As a result they can study the impact of variations in productivity within sectors and of differences in technological and organizational characteristics across sectors on international trade FDI and the organizational choices of firms
bull In this framework trade investment and organization are interdependent
bull The incentives created by different organizations differences in their fixed costs and wage differentials across countries shape the equilibrium organizational structure
I INTRODUCTION
bull In a world of two countries North and South in which final-good producers are based in the North final-good producers that operate in the same sector but differ in productivity sort intobull integrated companies that produce inputs in the North (do not engage in foreign trade in inputs)bull Integrated companies that produce inputs in the South (engage in FDI and intrafirm trade)bull Disintegrated companies that outsource in the North (do not engage in foreign trade in inputs)bull Disintegrated companies that outsource in the South (import inputs at armrsquos-length trade)
bull in sectors with low headquarter intensity firms do not integrate low-productivity firms outsource in the North whereas high-productivity firms outsource in the South
bull In sectors with high headquarter intensity all four organizational forms may exist in equilibrium and as in sectors with low headquarter intensity high-productivity firms import inputs whereas low-productivity firms acquire them in the North
bull However among the firms that acquire inputs in the same country the low-productivity firms outsource whereas the high-productivity firms insource
bull This implies that the least productive firms outsource in the North whereas the most productive firms insource in the South via FDI
I INTRODUCTION
bull We use the model to study the relative prevalence of different organizational forms
bull We show how prevalence depends onbull the wage gap between the North and the Southbull the trading costs of intermediate inputsbull the degree of productivity dispersion within a sectorbull the distribution of bargaining powerbull the size of the ownership advantage (which may be different in the two countries)bull the intensity of headquarter services
bull Our model predictsbull relatively more final-good producers rely on imported intermediates in sectors with
higher productivity dispersion or lower headquarter intensitybull in sectors with integration and outsourcing which are the sectors with high
headquarter intensity industries with higher productivity dispersion have relatively more final-good producers that integrate
bull As a result such sectors have more intrafirm trade relative to armrsquos-length trade
II THE MODEL
bull Two countries the North and the Southbull A unique factor of production laborbull The world is populated by a unit measure of consumers with
identical preferences
bull x0 consumption of a homogenous good
bull Xj index of aggregate consumption in secor j
bull μ parameter
bull Inverse demand function for each variety i in sector j
II THE MODEL
bull Producers of differentiated products face a perfectly elastic supply of labor in each country
bull Wage rates are fixed and wN gt wS
bull The demand parameters μ and a are the same in every industrybull This helps focus attention on cross-sectoral differences in technology and organizational costs
bull Our aim to explore how differences in technology interact with organizational choices in shaping industrial structure trade flows and FDI
bull Only the North knows how to produce final-good varieties bull To start producing a variety in sector j a firm needs to bear a fixed cost of entry
consisting of fE units of northern labor Upon paying this fixed cost the unique producer of variety i in sector j draws a productivity level θ from a known distribution G(θ)
bull After observing this productivity level the final-good producer decides whether to exit the market or start producing in the latter case an additional fixed cost of organizing production needs to be incurred bull This additional fixed cost is a function of the structure of ownership and the location of
production
II THE MODEL
bull Production of any final-good variety requires a combination of two variety-specific inputsbull hj(i) headquarter services
bull Can be produced only in the North with one unit of labor per unit of outputbull mj(i) manufactured components
bull Can be produced in the North and in the South with one unit of labor per unit of output in each country
bull Output of every variety is a sector-specific Cobb-Douglas function of the inputs
bull θ firm-specific productivty parameterbull ηj sector-specific productivity parameter
bull The larger ηj is the more intensive the sector in headquarter services
bull Two types of agents engaged in productionbull H final-good producers who supply headquarter servicesbull M operators of manufacturing plants who supply intermediate inputs
bull Every H needs to contract with an M for the provision of components bull We allow international fragmentation of the production process so that H can choose
to trans- act with an M in the North or in the South
II THE MODEL
bull It follows from our assumptions that all H locate in the North bull Upon paying the fixed cost of entry wNfE and observing the productivity level θ the unique final-good
producer H of variety i in sector j seeks out a supplier of components M in the North or in the South
bull Simultaneously H chooses whether to insource or outsource intermediate inputs The joint management costs of final and intermediate goods production such as supervision quality control accounting and marketing depend on the organizational form and the location of M
bull All these costs the sum of which we term laquo fixed organizational costs raquo are denominated in terms of
northern labor bull We denote them by wNfk
l
bull k index of the ownership structurebull i index of the country in which M is located and the manufacturing of components takes place
bull The ownership structure takes one of two forms bull vertical integration Vbull outsourcing O
bull The supplier M is located in one of two sites bull in the North Nbull in the South S
bull Therefore k E1113110 V O and l E1113110 N S
bull An organizational form consists of an ownership structure and a location of M
II THE MODEL
bull We assume that the fixed organizational costs are higher when M is located in the South regardless of ownership structure because the fixed costs of search monitoring and communication are significantly higher in the foreign countrybull fk
S gt fVN and fk
S gt fON for k =V O
bull Given the location of M the fixed organizational costs of a V firm are higher than the fixed organizational costs of an O firm bull fV
l gt fOl for l = N S
bull As a result of these assumptions the fixed organizational costs are ranked as follows
bull We adopt this ordering in order to avoid a taxonomy of cases There exists a tension between two considerations that affect the ranking of fV
l and fOl
bull the need to supervise the production of intermediate inputs in addition to other managerial tasks raises man- agerial overload and the fixed organizational costs of a V firm relative to an O firm
bull economies of scope in the management of diverse activities reduce the fixed organizational costs of a V firm relative to an O firm
bull Our ordering amounts to assuming that managerial overload is more important than managerial economies of scope Al- though we believe this assumption to be appropriate in many instances and we therefore maintain it in the main analysis we shall point out how some of the results change when fV
l lt fOl
II THE MODEL
bull The setting is one of incomplete contracts Final-good producers and manufacturing plant operators cannot sign ex ante enforceable contracts specifying the purchase of specialized intermediate inputs for a certain price
bull The parties cannot write enforceable contracts contingent on the amount of labor hired or on the volume of sales revenues obtained when the final good is sold
bull Hart and Moore (1999) and Segal (1999)bull The parties cannot commit not to renegotiate an initial contract and that the precise nature of
the required input is revealed only ex post and is not verifiable by a third party
bull To simplify the analysis we just impose these constraints on the contracting environment
bull Because no enforceable contract can be signed ex ante final-good producers and manufacturing plant operators bargain over the surplus from the relationship after the inputs have been produced We model this ex post bargaining as a generalized Nash bargaining game in which the final-good producer obtains a fraction β1113110E (0 1) of the ex post gains from the relationship
II THE MODEL
bull Following the property rights approach to the theory of the firm we assume that ex post bargaining takes place both under outsourcing and under integration The distribution of surplus is sensitive however to the mode of organization
bull More specifically the outside option of H is assumed to be different when it owns the manufacturing plant than when it does not In the latter case a failure to reach an agreement on the distribution of the surplus leaves both parties with no income because the inputs are tailored specifically to the other party in the transaction
bull However by vertically integrating the production of components H is effectively buying the right to fire M and seize the inputs mj(i) If there were no costs associated with firing the operator of the manufacturing plant the final-good producer would always have an incentive to seize the inputs mj(i) ex post and M wouldhave an incentive to choose mj(i) = 0 ex ante (which of course would imply xj(i) = 0)
bull In this case integration would never be chosen We therefore assume that firing M results in a loss of a fraction 1 1113110- δ of final-good production because H cannot use the intermediate inputs without M as effectively as it can with the cooperation of M
bull We also assume that δN ge δS This captures the notion that a contractual breach is likely to be more costly to H when M is in the South More figuratively we think of this assumption as reflecting less corruption and better legal protection in the North As is clear from the weak inequality however our results still hold when δN = δS
bull The location of M and the mode of ownership are chosen ex ante by H to maximize its profits There is an infinitely elastic supply of M agents in each one of the countries Each final-good producer H offers a contract that seeks to attract a plant operator M The contract includes an up-front fee for participation in the relationship that has to be paid by M This fee can be positive or negative that is the operator can make a payment to the final-good producer or vice versa The purpose of the fee is to secure the participation of M in the relationship at minimum cost to H When the supply of M is infinitely elastic Mrsquos profits from the relationship net of the participation fee are equal in equilibrium to its ex ante outside option For simplicity we set Mrsquos ex ante outside option equal to zero in both countries It is however easy to extend the analysis to cases in which these outside options are positive and different in the North and in the South
III EQUILIBRIUM
bull The organizational structure equilibrium will be determined bybull Incentives created by different organizationsbull Differences in their fixed costsbull Wage differentials across countries
bull Being in an incomplete contract framework it means that the contract will be renegotiated at some point in time Therefore a bargaining game specification is needed
bull If the parties agree in the bargaining the potential revenue from the sale of the final good is given by
(4)
bull The resulting payoffs implies that the final-good producer (henceforth H) appropriate higher fraction of the revenue under integration than under outsourcing with this fraction being higher when integration takes place in the North The payoffs ordering are the following
(5)
III EQUILIBRIUM
bull As we are in an incomplete contract framework both H and M will choose their quantities noncooperatively Each one will produce the quantity that maximises their individual profits Total operating profits are given by
(6)
where
(7)
bull As H has to attract an M agent whose outside option (ie if they fail to agree) is zero and the contract includes a participation fee (t) which can be positive or negative the final-good production (H) will be the one who decides the organizational form because he will have the incentive to increase t as much as he can (as long as the payoff of M is not negative) As a result
III EQUILIBRIUM
bull Thus upon observing its productivity level H will decide the ownership structure and the location of manufacturing that maximizes (6) The productivity threshold will determine whether H exits the industry or not This productivity threshold depends on the sectorrsquos aggregate consumption index X and implies that
(9)
bull In fact to solve this optimization program the final-good producer will have to choose the triplet that maximizes (6)
bull Equation (6) puts in evidence that profits are decreasing both with and Hence from a cost saving point of view H faces a trade-off as fixed costs are higher in the South and variable costs are lower there ( )
bull Next the final good producer cannot freely choose its fraction of revenue bull Although a higher gives H a larger fraction of revenue it also induces M to produce fewer
components Therefore H trades the choice of a larger fraction of the revenue for a smaller revenue level In fact this fraction of revenue will be determined as follows
(10)
III EQUILIBRIUM
bull Each partyrsquos severity of underinvestment is inversely related to the fraction of the surplus that it appropriates Therefore ex ante efficiency requires giving a larger share of revenue to the party undertaking the relatively more important investment
IV ORGANIZATIONAL FORMS
bull Firms face two types of tensions when choosing the organizational formbull Regarding the location decision variable costs are lower in the South but fixed costs are lower in
the Northbull For the ownership decision the firm has to take into account the fact that insourcing entails higher
fixed costs and gives H a larger fraction of the revenue However if the effect of Mrsquos incentives are strong enough Hrsquos profits may be lower under integration (because if H appropriates a large fraction of revenue M will have no incentive to produce the components)
bull In component-intensive sectors firms donrsquot integrate high-productivity firms outsource in the South low-productivity firms outsource in the North and least productive firms exit the industry
bull In headquarter-intensive sectors we can find the four different organizational forms The most productive firms integrate in the South and somewhat less productive firms outsource in the South Firms with even lower productivity acquire components in the North and among them the more productive integrate and the less productive outsource Finally the least productive firms exit
IV ORGANIZATIONAL FORMS
bull A low headquarter intensity is depicted when As indicated by the arrows profits decrease with increases in bull In this situation H prefers outsourcing to
insourcing regardless the manufacturing location because outsourcing has lower fixed costs and it gives H a lower fraction of revenue
bull Depending on whether the cross-county difference in the wage rate is small or large relative to the cross-country difference in the fixed organizational costs the resulting equilibrium can havebull outsourcing in both countriesbull outsourcing in the South only
Low headquarter intensity sector
IV ORGANIZATIONAL FORMS
bull When wage differential is small relative to to the fixed cost differential firms with a productivity higher than the productivity threshold will outsource in the North and firms with even higher productivity will outsource in the South
bull When wage differential is large relative to the fixed costs all firms with a productivity higher than the threshold will outsource in the South
bull With this threshold level being the intersection between the red line and the horizontal axis
(6)
Low headquarter intensity sector
IV ORGANIZATIONAL FORMS
High headquarter intensity sector bull A high headquarter intensity is depicted when As indicated by the arrows profits increase with increases in
bull The figure 4 shows us that is steeper than for
bull When wage differential is small relative to the fixed cost differential and when the sector is relatively more intensive in headquarter services the marginal return of headquarter services is high making underinvestment significantly costly for H Therefore in such a situation itrsquos always profitable for H to insource regardless the manufacturing location because
bull Integration gives H a larger share of revenue However variable costs are lower in the South For that reason can be steeper or flatter than This is to say that can be larger or smaller than
bull Depending on whether the cross-county difference in the wage rate is small or large relative to the difference between and the resulting equilibrium can have bull The four organizational formsbull Outsourcing in the North insourcing in the North and insourcing in the
Southbull Outsourcing in the North and insourcing in the North
(6)
IV ORGANIZATIONAL FORMS
High headquarter intensity sector
(6)
First case
bull It follows that
(14)
bull Given the orderings in (3) and (14) figure 4 shows us that all four organizational forms exist in equilibrium
IV ORGANIZATIONAL FORMS
High headquarter intensity sector
(6)
Second case
bull In this event (14) doesnrsquot hold anymore because and there are only two equilibrium possibilities
bull Either bull Integration in the North
dominates Consequently only 3 organizational forms can exist in equilibrium at best
bull Outsourcing in the North
bull Insourcing in the Northbull Insourcing in the South
IV ORGANIZATIONAL FORMS
High headquarter intensity sector Second case
bull In this event (14) doesnrsquot hold anymore because and there are only two equilibrium possibilities
bull Orbull Integration in the North
dominates outsourcing and insourcing in the South Consequently only two organizational forms can exist in equilibrium at most
bull Outsourcing in the North
bull Insourcing in the Northbull Hence there is no
international trade in inputs
(6)
V PREVALENCE OF ORGANIZATIONAL FORMS
Measure of prevalence the fraction of firms and market share
COMPONENT-INTENSIVE SECTOR
bull No firm integrates low η
The fraction of firms that outsource in the South
1 Lower wage in the south Raises the profit of outsourcing in the SouthRaises The minimal productivity to be active in the sector rises
SO
COMPONENT-INTENSIVE SECTOR
The fraction of firms that outsource in the South
2 Increase in the dispersion of productivity Raises
3 Higher headquarter intensity is less prevalent
4 Smaller fraction of the surplus from outsourcing in the south (β)Raises the profitability of outsourcing in the South is more prevalent
HEADQUARTER-INTENSIVE SECTOR
Organizational forms
HEADQUARTER-INTENSIVE SECTOR
1 Lower wage in the South
2 Increase of productivity dispersionDecline Increase and ambiguous effect in the others
3 Higher headquarter intensity (η) Domestic outsourcing is favored relative to foreign outsourcingIntegration is favored relative to outsourcingThe effects of η on the fraction of firms that insource in the south is ambiguous
HEADQUARTER-INTENSIVE SECTOR
4 Increase in the revenue shares4 Increase in (rises slope of the profit line)
SV
The fraction of outsourcing firms in the South declines and the fraction of insourcing firms in the South rises
HEADQUARTER-INTENSIVE SECTOR
4 Increase in the revenue shares5 Increase in (rises slope of the profit line)
NV The fraction of firms that
outsource in the north declines and these that insource in the north rises The fraction of firms that outsource in the south declines and these that insource in the south does not change
HEADQUARTER-INTENSIVE SECTOR
5 Increase in the primitive bargaining power parameter (β)
bull Shifts the bargaining power in favor of Hbull Outsourcing becomes more attractivebull ise bull The fraction of firms that import components
rises
VI CONCLUDING COMMENTS
1 The high-productivity firms -gt South2 In the same country high-productivity firms
insource 3 In sectors with very low intensity of headquarter
services no firm integrates 1 Low-productivity firms outsource at home 2 High-productivity firms outsource abroad
VI CONCLUDING COMMENTS
4 The prevalence of organizational forms depends on industry characteristics and on the degree of productivity dispersion across firms
1 Sectors with more productivity dispersion (lower z) more imported inputs
1 Within the headquarter-intensive sectors integration is more prevalent
2 Higher headquarter intensity less imported inputs 1 Within the headquarter-intensive sectors integration is more
prevalent
5 Lower wages in the south raises the fraction of firms that import intermediate inputs
1 It raises the fraction of firms that outsource in each country 2 Armrsquos length trade rises relative to intrafirm trade
I INTRODUCTION
bull Antras and Helpmanbull Develop a theoretical model that combinesbull The within-sectoral heterogeneity of Melitz (2003)bull With the structure of firms in Antras (2003)
bull The final-good producer controls the supply of headquarter services whereas a supplier of intermediate goods controls the quality and quantity of the intermediates
bull As a result they can study the impact of variations in productivity within sectors and of differences in technological and organizational characteristics across sectors on international trade FDI and the organizational choices of firms
bull In this framework trade investment and organization are interdependent
bull The incentives created by different organizations differences in their fixed costs and wage differentials across countries shape the equilibrium organizational structure
I INTRODUCTION
bull In a world of two countries North and South in which final-good producers are based in the North final-good producers that operate in the same sector but differ in productivity sort intobull integrated companies that produce inputs in the North (do not engage in foreign trade in inputs)bull Integrated companies that produce inputs in the South (engage in FDI and intrafirm trade)bull Disintegrated companies that outsource in the North (do not engage in foreign trade in inputs)bull Disintegrated companies that outsource in the South (import inputs at armrsquos-length trade)
bull in sectors with low headquarter intensity firms do not integrate low-productivity firms outsource in the North whereas high-productivity firms outsource in the South
bull In sectors with high headquarter intensity all four organizational forms may exist in equilibrium and as in sectors with low headquarter intensity high-productivity firms import inputs whereas low-productivity firms acquire them in the North
bull However among the firms that acquire inputs in the same country the low-productivity firms outsource whereas the high-productivity firms insource
bull This implies that the least productive firms outsource in the North whereas the most productive firms insource in the South via FDI
I INTRODUCTION
bull We use the model to study the relative prevalence of different organizational forms
bull We show how prevalence depends onbull the wage gap between the North and the Southbull the trading costs of intermediate inputsbull the degree of productivity dispersion within a sectorbull the distribution of bargaining powerbull the size of the ownership advantage (which may be different in the two countries)bull the intensity of headquarter services
bull Our model predictsbull relatively more final-good producers rely on imported intermediates in sectors with
higher productivity dispersion or lower headquarter intensitybull in sectors with integration and outsourcing which are the sectors with high
headquarter intensity industries with higher productivity dispersion have relatively more final-good producers that integrate
bull As a result such sectors have more intrafirm trade relative to armrsquos-length trade
II THE MODEL
bull Two countries the North and the Southbull A unique factor of production laborbull The world is populated by a unit measure of consumers with
identical preferences
bull x0 consumption of a homogenous good
bull Xj index of aggregate consumption in secor j
bull μ parameter
bull Inverse demand function for each variety i in sector j
II THE MODEL
bull Producers of differentiated products face a perfectly elastic supply of labor in each country
bull Wage rates are fixed and wN gt wS
bull The demand parameters μ and a are the same in every industrybull This helps focus attention on cross-sectoral differences in technology and organizational costs
bull Our aim to explore how differences in technology interact with organizational choices in shaping industrial structure trade flows and FDI
bull Only the North knows how to produce final-good varieties bull To start producing a variety in sector j a firm needs to bear a fixed cost of entry
consisting of fE units of northern labor Upon paying this fixed cost the unique producer of variety i in sector j draws a productivity level θ from a known distribution G(θ)
bull After observing this productivity level the final-good producer decides whether to exit the market or start producing in the latter case an additional fixed cost of organizing production needs to be incurred bull This additional fixed cost is a function of the structure of ownership and the location of
production
II THE MODEL
bull Production of any final-good variety requires a combination of two variety-specific inputsbull hj(i) headquarter services
bull Can be produced only in the North with one unit of labor per unit of outputbull mj(i) manufactured components
bull Can be produced in the North and in the South with one unit of labor per unit of output in each country
bull Output of every variety is a sector-specific Cobb-Douglas function of the inputs
bull θ firm-specific productivty parameterbull ηj sector-specific productivity parameter
bull The larger ηj is the more intensive the sector in headquarter services
bull Two types of agents engaged in productionbull H final-good producers who supply headquarter servicesbull M operators of manufacturing plants who supply intermediate inputs
bull Every H needs to contract with an M for the provision of components bull We allow international fragmentation of the production process so that H can choose
to trans- act with an M in the North or in the South
II THE MODEL
bull It follows from our assumptions that all H locate in the North bull Upon paying the fixed cost of entry wNfE and observing the productivity level θ the unique final-good
producer H of variety i in sector j seeks out a supplier of components M in the North or in the South
bull Simultaneously H chooses whether to insource or outsource intermediate inputs The joint management costs of final and intermediate goods production such as supervision quality control accounting and marketing depend on the organizational form and the location of M
bull All these costs the sum of which we term laquo fixed organizational costs raquo are denominated in terms of
northern labor bull We denote them by wNfk
l
bull k index of the ownership structurebull i index of the country in which M is located and the manufacturing of components takes place
bull The ownership structure takes one of two forms bull vertical integration Vbull outsourcing O
bull The supplier M is located in one of two sites bull in the North Nbull in the South S
bull Therefore k E1113110 V O and l E1113110 N S
bull An organizational form consists of an ownership structure and a location of M
II THE MODEL
bull We assume that the fixed organizational costs are higher when M is located in the South regardless of ownership structure because the fixed costs of search monitoring and communication are significantly higher in the foreign countrybull fk
S gt fVN and fk
S gt fON for k =V O
bull Given the location of M the fixed organizational costs of a V firm are higher than the fixed organizational costs of an O firm bull fV
l gt fOl for l = N S
bull As a result of these assumptions the fixed organizational costs are ranked as follows
bull We adopt this ordering in order to avoid a taxonomy of cases There exists a tension between two considerations that affect the ranking of fV
l and fOl
bull the need to supervise the production of intermediate inputs in addition to other managerial tasks raises man- agerial overload and the fixed organizational costs of a V firm relative to an O firm
bull economies of scope in the management of diverse activities reduce the fixed organizational costs of a V firm relative to an O firm
bull Our ordering amounts to assuming that managerial overload is more important than managerial economies of scope Al- though we believe this assumption to be appropriate in many instances and we therefore maintain it in the main analysis we shall point out how some of the results change when fV
l lt fOl
II THE MODEL
bull The setting is one of incomplete contracts Final-good producers and manufacturing plant operators cannot sign ex ante enforceable contracts specifying the purchase of specialized intermediate inputs for a certain price
bull The parties cannot write enforceable contracts contingent on the amount of labor hired or on the volume of sales revenues obtained when the final good is sold
bull Hart and Moore (1999) and Segal (1999)bull The parties cannot commit not to renegotiate an initial contract and that the precise nature of
the required input is revealed only ex post and is not verifiable by a third party
bull To simplify the analysis we just impose these constraints on the contracting environment
bull Because no enforceable contract can be signed ex ante final-good producers and manufacturing plant operators bargain over the surplus from the relationship after the inputs have been produced We model this ex post bargaining as a generalized Nash bargaining game in which the final-good producer obtains a fraction β1113110E (0 1) of the ex post gains from the relationship
II THE MODEL
bull Following the property rights approach to the theory of the firm we assume that ex post bargaining takes place both under outsourcing and under integration The distribution of surplus is sensitive however to the mode of organization
bull More specifically the outside option of H is assumed to be different when it owns the manufacturing plant than when it does not In the latter case a failure to reach an agreement on the distribution of the surplus leaves both parties with no income because the inputs are tailored specifically to the other party in the transaction
bull However by vertically integrating the production of components H is effectively buying the right to fire M and seize the inputs mj(i) If there were no costs associated with firing the operator of the manufacturing plant the final-good producer would always have an incentive to seize the inputs mj(i) ex post and M wouldhave an incentive to choose mj(i) = 0 ex ante (which of course would imply xj(i) = 0)
bull In this case integration would never be chosen We therefore assume that firing M results in a loss of a fraction 1 1113110- δ of final-good production because H cannot use the intermediate inputs without M as effectively as it can with the cooperation of M
bull We also assume that δN ge δS This captures the notion that a contractual breach is likely to be more costly to H when M is in the South More figuratively we think of this assumption as reflecting less corruption and better legal protection in the North As is clear from the weak inequality however our results still hold when δN = δS
bull The location of M and the mode of ownership are chosen ex ante by H to maximize its profits There is an infinitely elastic supply of M agents in each one of the countries Each final-good producer H offers a contract that seeks to attract a plant operator M The contract includes an up-front fee for participation in the relationship that has to be paid by M This fee can be positive or negative that is the operator can make a payment to the final-good producer or vice versa The purpose of the fee is to secure the participation of M in the relationship at minimum cost to H When the supply of M is infinitely elastic Mrsquos profits from the relationship net of the participation fee are equal in equilibrium to its ex ante outside option For simplicity we set Mrsquos ex ante outside option equal to zero in both countries It is however easy to extend the analysis to cases in which these outside options are positive and different in the North and in the South
III EQUILIBRIUM
bull The organizational structure equilibrium will be determined bybull Incentives created by different organizationsbull Differences in their fixed costsbull Wage differentials across countries
bull Being in an incomplete contract framework it means that the contract will be renegotiated at some point in time Therefore a bargaining game specification is needed
bull If the parties agree in the bargaining the potential revenue from the sale of the final good is given by
(4)
bull The resulting payoffs implies that the final-good producer (henceforth H) appropriate higher fraction of the revenue under integration than under outsourcing with this fraction being higher when integration takes place in the North The payoffs ordering are the following
(5)
III EQUILIBRIUM
bull As we are in an incomplete contract framework both H and M will choose their quantities noncooperatively Each one will produce the quantity that maximises their individual profits Total operating profits are given by
(6)
where
(7)
bull As H has to attract an M agent whose outside option (ie if they fail to agree) is zero and the contract includes a participation fee (t) which can be positive or negative the final-good production (H) will be the one who decides the organizational form because he will have the incentive to increase t as much as he can (as long as the payoff of M is not negative) As a result
III EQUILIBRIUM
bull Thus upon observing its productivity level H will decide the ownership structure and the location of manufacturing that maximizes (6) The productivity threshold will determine whether H exits the industry or not This productivity threshold depends on the sectorrsquos aggregate consumption index X and implies that
(9)
bull In fact to solve this optimization program the final-good producer will have to choose the triplet that maximizes (6)
bull Equation (6) puts in evidence that profits are decreasing both with and Hence from a cost saving point of view H faces a trade-off as fixed costs are higher in the South and variable costs are lower there ( )
bull Next the final good producer cannot freely choose its fraction of revenue bull Although a higher gives H a larger fraction of revenue it also induces M to produce fewer
components Therefore H trades the choice of a larger fraction of the revenue for a smaller revenue level In fact this fraction of revenue will be determined as follows
(10)
III EQUILIBRIUM
bull Each partyrsquos severity of underinvestment is inversely related to the fraction of the surplus that it appropriates Therefore ex ante efficiency requires giving a larger share of revenue to the party undertaking the relatively more important investment
IV ORGANIZATIONAL FORMS
bull Firms face two types of tensions when choosing the organizational formbull Regarding the location decision variable costs are lower in the South but fixed costs are lower in
the Northbull For the ownership decision the firm has to take into account the fact that insourcing entails higher
fixed costs and gives H a larger fraction of the revenue However if the effect of Mrsquos incentives are strong enough Hrsquos profits may be lower under integration (because if H appropriates a large fraction of revenue M will have no incentive to produce the components)
bull In component-intensive sectors firms donrsquot integrate high-productivity firms outsource in the South low-productivity firms outsource in the North and least productive firms exit the industry
bull In headquarter-intensive sectors we can find the four different organizational forms The most productive firms integrate in the South and somewhat less productive firms outsource in the South Firms with even lower productivity acquire components in the North and among them the more productive integrate and the less productive outsource Finally the least productive firms exit
IV ORGANIZATIONAL FORMS
bull A low headquarter intensity is depicted when As indicated by the arrows profits decrease with increases in bull In this situation H prefers outsourcing to
insourcing regardless the manufacturing location because outsourcing has lower fixed costs and it gives H a lower fraction of revenue
bull Depending on whether the cross-county difference in the wage rate is small or large relative to the cross-country difference in the fixed organizational costs the resulting equilibrium can havebull outsourcing in both countriesbull outsourcing in the South only
Low headquarter intensity sector
IV ORGANIZATIONAL FORMS
bull When wage differential is small relative to to the fixed cost differential firms with a productivity higher than the productivity threshold will outsource in the North and firms with even higher productivity will outsource in the South
bull When wage differential is large relative to the fixed costs all firms with a productivity higher than the threshold will outsource in the South
bull With this threshold level being the intersection between the red line and the horizontal axis
(6)
Low headquarter intensity sector
IV ORGANIZATIONAL FORMS
High headquarter intensity sector bull A high headquarter intensity is depicted when As indicated by the arrows profits increase with increases in
bull The figure 4 shows us that is steeper than for
bull When wage differential is small relative to the fixed cost differential and when the sector is relatively more intensive in headquarter services the marginal return of headquarter services is high making underinvestment significantly costly for H Therefore in such a situation itrsquos always profitable for H to insource regardless the manufacturing location because
bull Integration gives H a larger share of revenue However variable costs are lower in the South For that reason can be steeper or flatter than This is to say that can be larger or smaller than
bull Depending on whether the cross-county difference in the wage rate is small or large relative to the difference between and the resulting equilibrium can have bull The four organizational formsbull Outsourcing in the North insourcing in the North and insourcing in the
Southbull Outsourcing in the North and insourcing in the North
(6)
IV ORGANIZATIONAL FORMS
High headquarter intensity sector
(6)
First case
bull It follows that
(14)
bull Given the orderings in (3) and (14) figure 4 shows us that all four organizational forms exist in equilibrium
IV ORGANIZATIONAL FORMS
High headquarter intensity sector
(6)
Second case
bull In this event (14) doesnrsquot hold anymore because and there are only two equilibrium possibilities
bull Either bull Integration in the North
dominates Consequently only 3 organizational forms can exist in equilibrium at best
bull Outsourcing in the North
bull Insourcing in the Northbull Insourcing in the South
IV ORGANIZATIONAL FORMS
High headquarter intensity sector Second case
bull In this event (14) doesnrsquot hold anymore because and there are only two equilibrium possibilities
bull Orbull Integration in the North
dominates outsourcing and insourcing in the South Consequently only two organizational forms can exist in equilibrium at most
bull Outsourcing in the North
bull Insourcing in the Northbull Hence there is no
international trade in inputs
(6)
V PREVALENCE OF ORGANIZATIONAL FORMS
Measure of prevalence the fraction of firms and market share
COMPONENT-INTENSIVE SECTOR
bull No firm integrates low η
The fraction of firms that outsource in the South
1 Lower wage in the south Raises the profit of outsourcing in the SouthRaises The minimal productivity to be active in the sector rises
SO
COMPONENT-INTENSIVE SECTOR
The fraction of firms that outsource in the South
2 Increase in the dispersion of productivity Raises
3 Higher headquarter intensity is less prevalent
4 Smaller fraction of the surplus from outsourcing in the south (β)Raises the profitability of outsourcing in the South is more prevalent
HEADQUARTER-INTENSIVE SECTOR
Organizational forms
HEADQUARTER-INTENSIVE SECTOR
1 Lower wage in the South
2 Increase of productivity dispersionDecline Increase and ambiguous effect in the others
3 Higher headquarter intensity (η) Domestic outsourcing is favored relative to foreign outsourcingIntegration is favored relative to outsourcingThe effects of η on the fraction of firms that insource in the south is ambiguous
HEADQUARTER-INTENSIVE SECTOR
4 Increase in the revenue shares4 Increase in (rises slope of the profit line)
SV
The fraction of outsourcing firms in the South declines and the fraction of insourcing firms in the South rises
HEADQUARTER-INTENSIVE SECTOR
4 Increase in the revenue shares5 Increase in (rises slope of the profit line)
NV The fraction of firms that
outsource in the north declines and these that insource in the north rises The fraction of firms that outsource in the south declines and these that insource in the south does not change
HEADQUARTER-INTENSIVE SECTOR
5 Increase in the primitive bargaining power parameter (β)
bull Shifts the bargaining power in favor of Hbull Outsourcing becomes more attractivebull ise bull The fraction of firms that import components
rises
VI CONCLUDING COMMENTS
1 The high-productivity firms -gt South2 In the same country high-productivity firms
insource 3 In sectors with very low intensity of headquarter
services no firm integrates 1 Low-productivity firms outsource at home 2 High-productivity firms outsource abroad
VI CONCLUDING COMMENTS
4 The prevalence of organizational forms depends on industry characteristics and on the degree of productivity dispersion across firms
1 Sectors with more productivity dispersion (lower z) more imported inputs
1 Within the headquarter-intensive sectors integration is more prevalent
2 Higher headquarter intensity less imported inputs 1 Within the headquarter-intensive sectors integration is more
prevalent
5 Lower wages in the south raises the fraction of firms that import intermediate inputs
1 It raises the fraction of firms that outsource in each country 2 Armrsquos length trade rises relative to intrafirm trade
I INTRODUCTION
bull In a world of two countries North and South in which final-good producers are based in the North final-good producers that operate in the same sector but differ in productivity sort intobull integrated companies that produce inputs in the North (do not engage in foreign trade in inputs)bull Integrated companies that produce inputs in the South (engage in FDI and intrafirm trade)bull Disintegrated companies that outsource in the North (do not engage in foreign trade in inputs)bull Disintegrated companies that outsource in the South (import inputs at armrsquos-length trade)
bull in sectors with low headquarter intensity firms do not integrate low-productivity firms outsource in the North whereas high-productivity firms outsource in the South
bull In sectors with high headquarter intensity all four organizational forms may exist in equilibrium and as in sectors with low headquarter intensity high-productivity firms import inputs whereas low-productivity firms acquire them in the North
bull However among the firms that acquire inputs in the same country the low-productivity firms outsource whereas the high-productivity firms insource
bull This implies that the least productive firms outsource in the North whereas the most productive firms insource in the South via FDI
I INTRODUCTION
bull We use the model to study the relative prevalence of different organizational forms
bull We show how prevalence depends onbull the wage gap between the North and the Southbull the trading costs of intermediate inputsbull the degree of productivity dispersion within a sectorbull the distribution of bargaining powerbull the size of the ownership advantage (which may be different in the two countries)bull the intensity of headquarter services
bull Our model predictsbull relatively more final-good producers rely on imported intermediates in sectors with
higher productivity dispersion or lower headquarter intensitybull in sectors with integration and outsourcing which are the sectors with high
headquarter intensity industries with higher productivity dispersion have relatively more final-good producers that integrate
bull As a result such sectors have more intrafirm trade relative to armrsquos-length trade
II THE MODEL
bull Two countries the North and the Southbull A unique factor of production laborbull The world is populated by a unit measure of consumers with
identical preferences
bull x0 consumption of a homogenous good
bull Xj index of aggregate consumption in secor j
bull μ parameter
bull Inverse demand function for each variety i in sector j
II THE MODEL
bull Producers of differentiated products face a perfectly elastic supply of labor in each country
bull Wage rates are fixed and wN gt wS
bull The demand parameters μ and a are the same in every industrybull This helps focus attention on cross-sectoral differences in technology and organizational costs
bull Our aim to explore how differences in technology interact with organizational choices in shaping industrial structure trade flows and FDI
bull Only the North knows how to produce final-good varieties bull To start producing a variety in sector j a firm needs to bear a fixed cost of entry
consisting of fE units of northern labor Upon paying this fixed cost the unique producer of variety i in sector j draws a productivity level θ from a known distribution G(θ)
bull After observing this productivity level the final-good producer decides whether to exit the market or start producing in the latter case an additional fixed cost of organizing production needs to be incurred bull This additional fixed cost is a function of the structure of ownership and the location of
production
II THE MODEL
bull Production of any final-good variety requires a combination of two variety-specific inputsbull hj(i) headquarter services
bull Can be produced only in the North with one unit of labor per unit of outputbull mj(i) manufactured components
bull Can be produced in the North and in the South with one unit of labor per unit of output in each country
bull Output of every variety is a sector-specific Cobb-Douglas function of the inputs
bull θ firm-specific productivty parameterbull ηj sector-specific productivity parameter
bull The larger ηj is the more intensive the sector in headquarter services
bull Two types of agents engaged in productionbull H final-good producers who supply headquarter servicesbull M operators of manufacturing plants who supply intermediate inputs
bull Every H needs to contract with an M for the provision of components bull We allow international fragmentation of the production process so that H can choose
to trans- act with an M in the North or in the South
II THE MODEL
bull It follows from our assumptions that all H locate in the North bull Upon paying the fixed cost of entry wNfE and observing the productivity level θ the unique final-good
producer H of variety i in sector j seeks out a supplier of components M in the North or in the South
bull Simultaneously H chooses whether to insource or outsource intermediate inputs The joint management costs of final and intermediate goods production such as supervision quality control accounting and marketing depend on the organizational form and the location of M
bull All these costs the sum of which we term laquo fixed organizational costs raquo are denominated in terms of
northern labor bull We denote them by wNfk
l
bull k index of the ownership structurebull i index of the country in which M is located and the manufacturing of components takes place
bull The ownership structure takes one of two forms bull vertical integration Vbull outsourcing O
bull The supplier M is located in one of two sites bull in the North Nbull in the South S
bull Therefore k E1113110 V O and l E1113110 N S
bull An organizational form consists of an ownership structure and a location of M
II THE MODEL
bull We assume that the fixed organizational costs are higher when M is located in the South regardless of ownership structure because the fixed costs of search monitoring and communication are significantly higher in the foreign countrybull fk
S gt fVN and fk
S gt fON for k =V O
bull Given the location of M the fixed organizational costs of a V firm are higher than the fixed organizational costs of an O firm bull fV
l gt fOl for l = N S
bull As a result of these assumptions the fixed organizational costs are ranked as follows
bull We adopt this ordering in order to avoid a taxonomy of cases There exists a tension between two considerations that affect the ranking of fV
l and fOl
bull the need to supervise the production of intermediate inputs in addition to other managerial tasks raises man- agerial overload and the fixed organizational costs of a V firm relative to an O firm
bull economies of scope in the management of diverse activities reduce the fixed organizational costs of a V firm relative to an O firm
bull Our ordering amounts to assuming that managerial overload is more important than managerial economies of scope Al- though we believe this assumption to be appropriate in many instances and we therefore maintain it in the main analysis we shall point out how some of the results change when fV
l lt fOl
II THE MODEL
bull The setting is one of incomplete contracts Final-good producers and manufacturing plant operators cannot sign ex ante enforceable contracts specifying the purchase of specialized intermediate inputs for a certain price
bull The parties cannot write enforceable contracts contingent on the amount of labor hired or on the volume of sales revenues obtained when the final good is sold
bull Hart and Moore (1999) and Segal (1999)bull The parties cannot commit not to renegotiate an initial contract and that the precise nature of
the required input is revealed only ex post and is not verifiable by a third party
bull To simplify the analysis we just impose these constraints on the contracting environment
bull Because no enforceable contract can be signed ex ante final-good producers and manufacturing plant operators bargain over the surplus from the relationship after the inputs have been produced We model this ex post bargaining as a generalized Nash bargaining game in which the final-good producer obtains a fraction β1113110E (0 1) of the ex post gains from the relationship
II THE MODEL
bull Following the property rights approach to the theory of the firm we assume that ex post bargaining takes place both under outsourcing and under integration The distribution of surplus is sensitive however to the mode of organization
bull More specifically the outside option of H is assumed to be different when it owns the manufacturing plant than when it does not In the latter case a failure to reach an agreement on the distribution of the surplus leaves both parties with no income because the inputs are tailored specifically to the other party in the transaction
bull However by vertically integrating the production of components H is effectively buying the right to fire M and seize the inputs mj(i) If there were no costs associated with firing the operator of the manufacturing plant the final-good producer would always have an incentive to seize the inputs mj(i) ex post and M wouldhave an incentive to choose mj(i) = 0 ex ante (which of course would imply xj(i) = 0)
bull In this case integration would never be chosen We therefore assume that firing M results in a loss of a fraction 1 1113110- δ of final-good production because H cannot use the intermediate inputs without M as effectively as it can with the cooperation of M
bull We also assume that δN ge δS This captures the notion that a contractual breach is likely to be more costly to H when M is in the South More figuratively we think of this assumption as reflecting less corruption and better legal protection in the North As is clear from the weak inequality however our results still hold when δN = δS
bull The location of M and the mode of ownership are chosen ex ante by H to maximize its profits There is an infinitely elastic supply of M agents in each one of the countries Each final-good producer H offers a contract that seeks to attract a plant operator M The contract includes an up-front fee for participation in the relationship that has to be paid by M This fee can be positive or negative that is the operator can make a payment to the final-good producer or vice versa The purpose of the fee is to secure the participation of M in the relationship at minimum cost to H When the supply of M is infinitely elastic Mrsquos profits from the relationship net of the participation fee are equal in equilibrium to its ex ante outside option For simplicity we set Mrsquos ex ante outside option equal to zero in both countries It is however easy to extend the analysis to cases in which these outside options are positive and different in the North and in the South
III EQUILIBRIUM
bull The organizational structure equilibrium will be determined bybull Incentives created by different organizationsbull Differences in their fixed costsbull Wage differentials across countries
bull Being in an incomplete contract framework it means that the contract will be renegotiated at some point in time Therefore a bargaining game specification is needed
bull If the parties agree in the bargaining the potential revenue from the sale of the final good is given by
(4)
bull The resulting payoffs implies that the final-good producer (henceforth H) appropriate higher fraction of the revenue under integration than under outsourcing with this fraction being higher when integration takes place in the North The payoffs ordering are the following
(5)
III EQUILIBRIUM
bull As we are in an incomplete contract framework both H and M will choose their quantities noncooperatively Each one will produce the quantity that maximises their individual profits Total operating profits are given by
(6)
where
(7)
bull As H has to attract an M agent whose outside option (ie if they fail to agree) is zero and the contract includes a participation fee (t) which can be positive or negative the final-good production (H) will be the one who decides the organizational form because he will have the incentive to increase t as much as he can (as long as the payoff of M is not negative) As a result
III EQUILIBRIUM
bull Thus upon observing its productivity level H will decide the ownership structure and the location of manufacturing that maximizes (6) The productivity threshold will determine whether H exits the industry or not This productivity threshold depends on the sectorrsquos aggregate consumption index X and implies that
(9)
bull In fact to solve this optimization program the final-good producer will have to choose the triplet that maximizes (6)
bull Equation (6) puts in evidence that profits are decreasing both with and Hence from a cost saving point of view H faces a trade-off as fixed costs are higher in the South and variable costs are lower there ( )
bull Next the final good producer cannot freely choose its fraction of revenue bull Although a higher gives H a larger fraction of revenue it also induces M to produce fewer
components Therefore H trades the choice of a larger fraction of the revenue for a smaller revenue level In fact this fraction of revenue will be determined as follows
(10)
III EQUILIBRIUM
bull Each partyrsquos severity of underinvestment is inversely related to the fraction of the surplus that it appropriates Therefore ex ante efficiency requires giving a larger share of revenue to the party undertaking the relatively more important investment
IV ORGANIZATIONAL FORMS
bull Firms face two types of tensions when choosing the organizational formbull Regarding the location decision variable costs are lower in the South but fixed costs are lower in
the Northbull For the ownership decision the firm has to take into account the fact that insourcing entails higher
fixed costs and gives H a larger fraction of the revenue However if the effect of Mrsquos incentives are strong enough Hrsquos profits may be lower under integration (because if H appropriates a large fraction of revenue M will have no incentive to produce the components)
bull In component-intensive sectors firms donrsquot integrate high-productivity firms outsource in the South low-productivity firms outsource in the North and least productive firms exit the industry
bull In headquarter-intensive sectors we can find the four different organizational forms The most productive firms integrate in the South and somewhat less productive firms outsource in the South Firms with even lower productivity acquire components in the North and among them the more productive integrate and the less productive outsource Finally the least productive firms exit
IV ORGANIZATIONAL FORMS
bull A low headquarter intensity is depicted when As indicated by the arrows profits decrease with increases in bull In this situation H prefers outsourcing to
insourcing regardless the manufacturing location because outsourcing has lower fixed costs and it gives H a lower fraction of revenue
bull Depending on whether the cross-county difference in the wage rate is small or large relative to the cross-country difference in the fixed organizational costs the resulting equilibrium can havebull outsourcing in both countriesbull outsourcing in the South only
Low headquarter intensity sector
IV ORGANIZATIONAL FORMS
bull When wage differential is small relative to to the fixed cost differential firms with a productivity higher than the productivity threshold will outsource in the North and firms with even higher productivity will outsource in the South
bull When wage differential is large relative to the fixed costs all firms with a productivity higher than the threshold will outsource in the South
bull With this threshold level being the intersection between the red line and the horizontal axis
(6)
Low headquarter intensity sector
IV ORGANIZATIONAL FORMS
High headquarter intensity sector bull A high headquarter intensity is depicted when As indicated by the arrows profits increase with increases in
bull The figure 4 shows us that is steeper than for
bull When wage differential is small relative to the fixed cost differential and when the sector is relatively more intensive in headquarter services the marginal return of headquarter services is high making underinvestment significantly costly for H Therefore in such a situation itrsquos always profitable for H to insource regardless the manufacturing location because
bull Integration gives H a larger share of revenue However variable costs are lower in the South For that reason can be steeper or flatter than This is to say that can be larger or smaller than
bull Depending on whether the cross-county difference in the wage rate is small or large relative to the difference between and the resulting equilibrium can have bull The four organizational formsbull Outsourcing in the North insourcing in the North and insourcing in the
Southbull Outsourcing in the North and insourcing in the North
(6)
IV ORGANIZATIONAL FORMS
High headquarter intensity sector
(6)
First case
bull It follows that
(14)
bull Given the orderings in (3) and (14) figure 4 shows us that all four organizational forms exist in equilibrium
IV ORGANIZATIONAL FORMS
High headquarter intensity sector
(6)
Second case
bull In this event (14) doesnrsquot hold anymore because and there are only two equilibrium possibilities
bull Either bull Integration in the North
dominates Consequently only 3 organizational forms can exist in equilibrium at best
bull Outsourcing in the North
bull Insourcing in the Northbull Insourcing in the South
IV ORGANIZATIONAL FORMS
High headquarter intensity sector Second case
bull In this event (14) doesnrsquot hold anymore because and there are only two equilibrium possibilities
bull Orbull Integration in the North
dominates outsourcing and insourcing in the South Consequently only two organizational forms can exist in equilibrium at most
bull Outsourcing in the North
bull Insourcing in the Northbull Hence there is no
international trade in inputs
(6)
V PREVALENCE OF ORGANIZATIONAL FORMS
Measure of prevalence the fraction of firms and market share
COMPONENT-INTENSIVE SECTOR
bull No firm integrates low η
The fraction of firms that outsource in the South
1 Lower wage in the south Raises the profit of outsourcing in the SouthRaises The minimal productivity to be active in the sector rises
SO
COMPONENT-INTENSIVE SECTOR
The fraction of firms that outsource in the South
2 Increase in the dispersion of productivity Raises
3 Higher headquarter intensity is less prevalent
4 Smaller fraction of the surplus from outsourcing in the south (β)Raises the profitability of outsourcing in the South is more prevalent
HEADQUARTER-INTENSIVE SECTOR
Organizational forms
HEADQUARTER-INTENSIVE SECTOR
1 Lower wage in the South
2 Increase of productivity dispersionDecline Increase and ambiguous effect in the others
3 Higher headquarter intensity (η) Domestic outsourcing is favored relative to foreign outsourcingIntegration is favored relative to outsourcingThe effects of η on the fraction of firms that insource in the south is ambiguous
HEADQUARTER-INTENSIVE SECTOR
4 Increase in the revenue shares4 Increase in (rises slope of the profit line)
SV
The fraction of outsourcing firms in the South declines and the fraction of insourcing firms in the South rises
HEADQUARTER-INTENSIVE SECTOR
4 Increase in the revenue shares5 Increase in (rises slope of the profit line)
NV The fraction of firms that
outsource in the north declines and these that insource in the north rises The fraction of firms that outsource in the south declines and these that insource in the south does not change
HEADQUARTER-INTENSIVE SECTOR
5 Increase in the primitive bargaining power parameter (β)
bull Shifts the bargaining power in favor of Hbull Outsourcing becomes more attractivebull ise bull The fraction of firms that import components
rises
VI CONCLUDING COMMENTS
1 The high-productivity firms -gt South2 In the same country high-productivity firms
insource 3 In sectors with very low intensity of headquarter
services no firm integrates 1 Low-productivity firms outsource at home 2 High-productivity firms outsource abroad
VI CONCLUDING COMMENTS
4 The prevalence of organizational forms depends on industry characteristics and on the degree of productivity dispersion across firms
1 Sectors with more productivity dispersion (lower z) more imported inputs
1 Within the headquarter-intensive sectors integration is more prevalent
2 Higher headquarter intensity less imported inputs 1 Within the headquarter-intensive sectors integration is more
prevalent
5 Lower wages in the south raises the fraction of firms that import intermediate inputs
1 It raises the fraction of firms that outsource in each country 2 Armrsquos length trade rises relative to intrafirm trade
I INTRODUCTION
bull We use the model to study the relative prevalence of different organizational forms
bull We show how prevalence depends onbull the wage gap between the North and the Southbull the trading costs of intermediate inputsbull the degree of productivity dispersion within a sectorbull the distribution of bargaining powerbull the size of the ownership advantage (which may be different in the two countries)bull the intensity of headquarter services
bull Our model predictsbull relatively more final-good producers rely on imported intermediates in sectors with
higher productivity dispersion or lower headquarter intensitybull in sectors with integration and outsourcing which are the sectors with high
headquarter intensity industries with higher productivity dispersion have relatively more final-good producers that integrate
bull As a result such sectors have more intrafirm trade relative to armrsquos-length trade
II THE MODEL
bull Two countries the North and the Southbull A unique factor of production laborbull The world is populated by a unit measure of consumers with
identical preferences
bull x0 consumption of a homogenous good
bull Xj index of aggregate consumption in secor j
bull μ parameter
bull Inverse demand function for each variety i in sector j
II THE MODEL
bull Producers of differentiated products face a perfectly elastic supply of labor in each country
bull Wage rates are fixed and wN gt wS
bull The demand parameters μ and a are the same in every industrybull This helps focus attention on cross-sectoral differences in technology and organizational costs
bull Our aim to explore how differences in technology interact with organizational choices in shaping industrial structure trade flows and FDI
bull Only the North knows how to produce final-good varieties bull To start producing a variety in sector j a firm needs to bear a fixed cost of entry
consisting of fE units of northern labor Upon paying this fixed cost the unique producer of variety i in sector j draws a productivity level θ from a known distribution G(θ)
bull After observing this productivity level the final-good producer decides whether to exit the market or start producing in the latter case an additional fixed cost of organizing production needs to be incurred bull This additional fixed cost is a function of the structure of ownership and the location of
production
II THE MODEL
bull Production of any final-good variety requires a combination of two variety-specific inputsbull hj(i) headquarter services
bull Can be produced only in the North with one unit of labor per unit of outputbull mj(i) manufactured components
bull Can be produced in the North and in the South with one unit of labor per unit of output in each country
bull Output of every variety is a sector-specific Cobb-Douglas function of the inputs
bull θ firm-specific productivty parameterbull ηj sector-specific productivity parameter
bull The larger ηj is the more intensive the sector in headquarter services
bull Two types of agents engaged in productionbull H final-good producers who supply headquarter servicesbull M operators of manufacturing plants who supply intermediate inputs
bull Every H needs to contract with an M for the provision of components bull We allow international fragmentation of the production process so that H can choose
to trans- act with an M in the North or in the South
II THE MODEL
bull It follows from our assumptions that all H locate in the North bull Upon paying the fixed cost of entry wNfE and observing the productivity level θ the unique final-good
producer H of variety i in sector j seeks out a supplier of components M in the North or in the South
bull Simultaneously H chooses whether to insource or outsource intermediate inputs The joint management costs of final and intermediate goods production such as supervision quality control accounting and marketing depend on the organizational form and the location of M
bull All these costs the sum of which we term laquo fixed organizational costs raquo are denominated in terms of
northern labor bull We denote them by wNfk
l
bull k index of the ownership structurebull i index of the country in which M is located and the manufacturing of components takes place
bull The ownership structure takes one of two forms bull vertical integration Vbull outsourcing O
bull The supplier M is located in one of two sites bull in the North Nbull in the South S
bull Therefore k E1113110 V O and l E1113110 N S
bull An organizational form consists of an ownership structure and a location of M
II THE MODEL
bull We assume that the fixed organizational costs are higher when M is located in the South regardless of ownership structure because the fixed costs of search monitoring and communication are significantly higher in the foreign countrybull fk
S gt fVN and fk
S gt fON for k =V O
bull Given the location of M the fixed organizational costs of a V firm are higher than the fixed organizational costs of an O firm bull fV
l gt fOl for l = N S
bull As a result of these assumptions the fixed organizational costs are ranked as follows
bull We adopt this ordering in order to avoid a taxonomy of cases There exists a tension between two considerations that affect the ranking of fV
l and fOl
bull the need to supervise the production of intermediate inputs in addition to other managerial tasks raises man- agerial overload and the fixed organizational costs of a V firm relative to an O firm
bull economies of scope in the management of diverse activities reduce the fixed organizational costs of a V firm relative to an O firm
bull Our ordering amounts to assuming that managerial overload is more important than managerial economies of scope Al- though we believe this assumption to be appropriate in many instances and we therefore maintain it in the main analysis we shall point out how some of the results change when fV
l lt fOl
II THE MODEL
bull The setting is one of incomplete contracts Final-good producers and manufacturing plant operators cannot sign ex ante enforceable contracts specifying the purchase of specialized intermediate inputs for a certain price
bull The parties cannot write enforceable contracts contingent on the amount of labor hired or on the volume of sales revenues obtained when the final good is sold
bull Hart and Moore (1999) and Segal (1999)bull The parties cannot commit not to renegotiate an initial contract and that the precise nature of
the required input is revealed only ex post and is not verifiable by a third party
bull To simplify the analysis we just impose these constraints on the contracting environment
bull Because no enforceable contract can be signed ex ante final-good producers and manufacturing plant operators bargain over the surplus from the relationship after the inputs have been produced We model this ex post bargaining as a generalized Nash bargaining game in which the final-good producer obtains a fraction β1113110E (0 1) of the ex post gains from the relationship
II THE MODEL
bull Following the property rights approach to the theory of the firm we assume that ex post bargaining takes place both under outsourcing and under integration The distribution of surplus is sensitive however to the mode of organization
bull More specifically the outside option of H is assumed to be different when it owns the manufacturing plant than when it does not In the latter case a failure to reach an agreement on the distribution of the surplus leaves both parties with no income because the inputs are tailored specifically to the other party in the transaction
bull However by vertically integrating the production of components H is effectively buying the right to fire M and seize the inputs mj(i) If there were no costs associated with firing the operator of the manufacturing plant the final-good producer would always have an incentive to seize the inputs mj(i) ex post and M wouldhave an incentive to choose mj(i) = 0 ex ante (which of course would imply xj(i) = 0)
bull In this case integration would never be chosen We therefore assume that firing M results in a loss of a fraction 1 1113110- δ of final-good production because H cannot use the intermediate inputs without M as effectively as it can with the cooperation of M
bull We also assume that δN ge δS This captures the notion that a contractual breach is likely to be more costly to H when M is in the South More figuratively we think of this assumption as reflecting less corruption and better legal protection in the North As is clear from the weak inequality however our results still hold when δN = δS
bull The location of M and the mode of ownership are chosen ex ante by H to maximize its profits There is an infinitely elastic supply of M agents in each one of the countries Each final-good producer H offers a contract that seeks to attract a plant operator M The contract includes an up-front fee for participation in the relationship that has to be paid by M This fee can be positive or negative that is the operator can make a payment to the final-good producer or vice versa The purpose of the fee is to secure the participation of M in the relationship at minimum cost to H When the supply of M is infinitely elastic Mrsquos profits from the relationship net of the participation fee are equal in equilibrium to its ex ante outside option For simplicity we set Mrsquos ex ante outside option equal to zero in both countries It is however easy to extend the analysis to cases in which these outside options are positive and different in the North and in the South
III EQUILIBRIUM
bull The organizational structure equilibrium will be determined bybull Incentives created by different organizationsbull Differences in their fixed costsbull Wage differentials across countries
bull Being in an incomplete contract framework it means that the contract will be renegotiated at some point in time Therefore a bargaining game specification is needed
bull If the parties agree in the bargaining the potential revenue from the sale of the final good is given by
(4)
bull The resulting payoffs implies that the final-good producer (henceforth H) appropriate higher fraction of the revenue under integration than under outsourcing with this fraction being higher when integration takes place in the North The payoffs ordering are the following
(5)
III EQUILIBRIUM
bull As we are in an incomplete contract framework both H and M will choose their quantities noncooperatively Each one will produce the quantity that maximises their individual profits Total operating profits are given by
(6)
where
(7)
bull As H has to attract an M agent whose outside option (ie if they fail to agree) is zero and the contract includes a participation fee (t) which can be positive or negative the final-good production (H) will be the one who decides the organizational form because he will have the incentive to increase t as much as he can (as long as the payoff of M is not negative) As a result
III EQUILIBRIUM
bull Thus upon observing its productivity level H will decide the ownership structure and the location of manufacturing that maximizes (6) The productivity threshold will determine whether H exits the industry or not This productivity threshold depends on the sectorrsquos aggregate consumption index X and implies that
(9)
bull In fact to solve this optimization program the final-good producer will have to choose the triplet that maximizes (6)
bull Equation (6) puts in evidence that profits are decreasing both with and Hence from a cost saving point of view H faces a trade-off as fixed costs are higher in the South and variable costs are lower there ( )
bull Next the final good producer cannot freely choose its fraction of revenue bull Although a higher gives H a larger fraction of revenue it also induces M to produce fewer
components Therefore H trades the choice of a larger fraction of the revenue for a smaller revenue level In fact this fraction of revenue will be determined as follows
(10)
III EQUILIBRIUM
bull Each partyrsquos severity of underinvestment is inversely related to the fraction of the surplus that it appropriates Therefore ex ante efficiency requires giving a larger share of revenue to the party undertaking the relatively more important investment
IV ORGANIZATIONAL FORMS
bull Firms face two types of tensions when choosing the organizational formbull Regarding the location decision variable costs are lower in the South but fixed costs are lower in
the Northbull For the ownership decision the firm has to take into account the fact that insourcing entails higher
fixed costs and gives H a larger fraction of the revenue However if the effect of Mrsquos incentives are strong enough Hrsquos profits may be lower under integration (because if H appropriates a large fraction of revenue M will have no incentive to produce the components)
bull In component-intensive sectors firms donrsquot integrate high-productivity firms outsource in the South low-productivity firms outsource in the North and least productive firms exit the industry
bull In headquarter-intensive sectors we can find the four different organizational forms The most productive firms integrate in the South and somewhat less productive firms outsource in the South Firms with even lower productivity acquire components in the North and among them the more productive integrate and the less productive outsource Finally the least productive firms exit
IV ORGANIZATIONAL FORMS
bull A low headquarter intensity is depicted when As indicated by the arrows profits decrease with increases in bull In this situation H prefers outsourcing to
insourcing regardless the manufacturing location because outsourcing has lower fixed costs and it gives H a lower fraction of revenue
bull Depending on whether the cross-county difference in the wage rate is small or large relative to the cross-country difference in the fixed organizational costs the resulting equilibrium can havebull outsourcing in both countriesbull outsourcing in the South only
Low headquarter intensity sector
IV ORGANIZATIONAL FORMS
bull When wage differential is small relative to to the fixed cost differential firms with a productivity higher than the productivity threshold will outsource in the North and firms with even higher productivity will outsource in the South
bull When wage differential is large relative to the fixed costs all firms with a productivity higher than the threshold will outsource in the South
bull With this threshold level being the intersection between the red line and the horizontal axis
(6)
Low headquarter intensity sector
IV ORGANIZATIONAL FORMS
High headquarter intensity sector bull A high headquarter intensity is depicted when As indicated by the arrows profits increase with increases in
bull The figure 4 shows us that is steeper than for
bull When wage differential is small relative to the fixed cost differential and when the sector is relatively more intensive in headquarter services the marginal return of headquarter services is high making underinvestment significantly costly for H Therefore in such a situation itrsquos always profitable for H to insource regardless the manufacturing location because
bull Integration gives H a larger share of revenue However variable costs are lower in the South For that reason can be steeper or flatter than This is to say that can be larger or smaller than
bull Depending on whether the cross-county difference in the wage rate is small or large relative to the difference between and the resulting equilibrium can have bull The four organizational formsbull Outsourcing in the North insourcing in the North and insourcing in the
Southbull Outsourcing in the North and insourcing in the North
(6)
IV ORGANIZATIONAL FORMS
High headquarter intensity sector
(6)
First case
bull It follows that
(14)
bull Given the orderings in (3) and (14) figure 4 shows us that all four organizational forms exist in equilibrium
IV ORGANIZATIONAL FORMS
High headquarter intensity sector
(6)
Second case
bull In this event (14) doesnrsquot hold anymore because and there are only two equilibrium possibilities
bull Either bull Integration in the North
dominates Consequently only 3 organizational forms can exist in equilibrium at best
bull Outsourcing in the North
bull Insourcing in the Northbull Insourcing in the South
IV ORGANIZATIONAL FORMS
High headquarter intensity sector Second case
bull In this event (14) doesnrsquot hold anymore because and there are only two equilibrium possibilities
bull Orbull Integration in the North
dominates outsourcing and insourcing in the South Consequently only two organizational forms can exist in equilibrium at most
bull Outsourcing in the North
bull Insourcing in the Northbull Hence there is no
international trade in inputs
(6)
V PREVALENCE OF ORGANIZATIONAL FORMS
Measure of prevalence the fraction of firms and market share
COMPONENT-INTENSIVE SECTOR
bull No firm integrates low η
The fraction of firms that outsource in the South
1 Lower wage in the south Raises the profit of outsourcing in the SouthRaises The minimal productivity to be active in the sector rises
SO
COMPONENT-INTENSIVE SECTOR
The fraction of firms that outsource in the South
2 Increase in the dispersion of productivity Raises
3 Higher headquarter intensity is less prevalent
4 Smaller fraction of the surplus from outsourcing in the south (β)Raises the profitability of outsourcing in the South is more prevalent
HEADQUARTER-INTENSIVE SECTOR
Organizational forms
HEADQUARTER-INTENSIVE SECTOR
1 Lower wage in the South
2 Increase of productivity dispersionDecline Increase and ambiguous effect in the others
3 Higher headquarter intensity (η) Domestic outsourcing is favored relative to foreign outsourcingIntegration is favored relative to outsourcingThe effects of η on the fraction of firms that insource in the south is ambiguous
HEADQUARTER-INTENSIVE SECTOR
4 Increase in the revenue shares4 Increase in (rises slope of the profit line)
SV
The fraction of outsourcing firms in the South declines and the fraction of insourcing firms in the South rises
HEADQUARTER-INTENSIVE SECTOR
4 Increase in the revenue shares5 Increase in (rises slope of the profit line)
NV The fraction of firms that
outsource in the north declines and these that insource in the north rises The fraction of firms that outsource in the south declines and these that insource in the south does not change
HEADQUARTER-INTENSIVE SECTOR
5 Increase in the primitive bargaining power parameter (β)
bull Shifts the bargaining power in favor of Hbull Outsourcing becomes more attractivebull ise bull The fraction of firms that import components
rises
VI CONCLUDING COMMENTS
1 The high-productivity firms -gt South2 In the same country high-productivity firms
insource 3 In sectors with very low intensity of headquarter
services no firm integrates 1 Low-productivity firms outsource at home 2 High-productivity firms outsource abroad
VI CONCLUDING COMMENTS
4 The prevalence of organizational forms depends on industry characteristics and on the degree of productivity dispersion across firms
1 Sectors with more productivity dispersion (lower z) more imported inputs
1 Within the headquarter-intensive sectors integration is more prevalent
2 Higher headquarter intensity less imported inputs 1 Within the headquarter-intensive sectors integration is more
prevalent
5 Lower wages in the south raises the fraction of firms that import intermediate inputs
1 It raises the fraction of firms that outsource in each country 2 Armrsquos length trade rises relative to intrafirm trade
II THE MODEL
bull Two countries the North and the Southbull A unique factor of production laborbull The world is populated by a unit measure of consumers with
identical preferences
bull x0 consumption of a homogenous good
bull Xj index of aggregate consumption in secor j
bull μ parameter
bull Inverse demand function for each variety i in sector j
II THE MODEL
bull Producers of differentiated products face a perfectly elastic supply of labor in each country
bull Wage rates are fixed and wN gt wS
bull The demand parameters μ and a are the same in every industrybull This helps focus attention on cross-sectoral differences in technology and organizational costs
bull Our aim to explore how differences in technology interact with organizational choices in shaping industrial structure trade flows and FDI
bull Only the North knows how to produce final-good varieties bull To start producing a variety in sector j a firm needs to bear a fixed cost of entry
consisting of fE units of northern labor Upon paying this fixed cost the unique producer of variety i in sector j draws a productivity level θ from a known distribution G(θ)
bull After observing this productivity level the final-good producer decides whether to exit the market or start producing in the latter case an additional fixed cost of organizing production needs to be incurred bull This additional fixed cost is a function of the structure of ownership and the location of
production
II THE MODEL
bull Production of any final-good variety requires a combination of two variety-specific inputsbull hj(i) headquarter services
bull Can be produced only in the North with one unit of labor per unit of outputbull mj(i) manufactured components
bull Can be produced in the North and in the South with one unit of labor per unit of output in each country
bull Output of every variety is a sector-specific Cobb-Douglas function of the inputs
bull θ firm-specific productivty parameterbull ηj sector-specific productivity parameter
bull The larger ηj is the more intensive the sector in headquarter services
bull Two types of agents engaged in productionbull H final-good producers who supply headquarter servicesbull M operators of manufacturing plants who supply intermediate inputs
bull Every H needs to contract with an M for the provision of components bull We allow international fragmentation of the production process so that H can choose
to trans- act with an M in the North or in the South
II THE MODEL
bull It follows from our assumptions that all H locate in the North bull Upon paying the fixed cost of entry wNfE and observing the productivity level θ the unique final-good
producer H of variety i in sector j seeks out a supplier of components M in the North or in the South
bull Simultaneously H chooses whether to insource or outsource intermediate inputs The joint management costs of final and intermediate goods production such as supervision quality control accounting and marketing depend on the organizational form and the location of M
bull All these costs the sum of which we term laquo fixed organizational costs raquo are denominated in terms of
northern labor bull We denote them by wNfk
l
bull k index of the ownership structurebull i index of the country in which M is located and the manufacturing of components takes place
bull The ownership structure takes one of two forms bull vertical integration Vbull outsourcing O
bull The supplier M is located in one of two sites bull in the North Nbull in the South S
bull Therefore k E1113110 V O and l E1113110 N S
bull An organizational form consists of an ownership structure and a location of M
II THE MODEL
bull We assume that the fixed organizational costs are higher when M is located in the South regardless of ownership structure because the fixed costs of search monitoring and communication are significantly higher in the foreign countrybull fk
S gt fVN and fk
S gt fON for k =V O
bull Given the location of M the fixed organizational costs of a V firm are higher than the fixed organizational costs of an O firm bull fV
l gt fOl for l = N S
bull As a result of these assumptions the fixed organizational costs are ranked as follows
bull We adopt this ordering in order to avoid a taxonomy of cases There exists a tension between two considerations that affect the ranking of fV
l and fOl
bull the need to supervise the production of intermediate inputs in addition to other managerial tasks raises man- agerial overload and the fixed organizational costs of a V firm relative to an O firm
bull economies of scope in the management of diverse activities reduce the fixed organizational costs of a V firm relative to an O firm
bull Our ordering amounts to assuming that managerial overload is more important than managerial economies of scope Al- though we believe this assumption to be appropriate in many instances and we therefore maintain it in the main analysis we shall point out how some of the results change when fV
l lt fOl
II THE MODEL
bull The setting is one of incomplete contracts Final-good producers and manufacturing plant operators cannot sign ex ante enforceable contracts specifying the purchase of specialized intermediate inputs for a certain price
bull The parties cannot write enforceable contracts contingent on the amount of labor hired or on the volume of sales revenues obtained when the final good is sold
bull Hart and Moore (1999) and Segal (1999)bull The parties cannot commit not to renegotiate an initial contract and that the precise nature of
the required input is revealed only ex post and is not verifiable by a third party
bull To simplify the analysis we just impose these constraints on the contracting environment
bull Because no enforceable contract can be signed ex ante final-good producers and manufacturing plant operators bargain over the surplus from the relationship after the inputs have been produced We model this ex post bargaining as a generalized Nash bargaining game in which the final-good producer obtains a fraction β1113110E (0 1) of the ex post gains from the relationship
II THE MODEL
bull Following the property rights approach to the theory of the firm we assume that ex post bargaining takes place both under outsourcing and under integration The distribution of surplus is sensitive however to the mode of organization
bull More specifically the outside option of H is assumed to be different when it owns the manufacturing plant than when it does not In the latter case a failure to reach an agreement on the distribution of the surplus leaves both parties with no income because the inputs are tailored specifically to the other party in the transaction
bull However by vertically integrating the production of components H is effectively buying the right to fire M and seize the inputs mj(i) If there were no costs associated with firing the operator of the manufacturing plant the final-good producer would always have an incentive to seize the inputs mj(i) ex post and M wouldhave an incentive to choose mj(i) = 0 ex ante (which of course would imply xj(i) = 0)
bull In this case integration would never be chosen We therefore assume that firing M results in a loss of a fraction 1 1113110- δ of final-good production because H cannot use the intermediate inputs without M as effectively as it can with the cooperation of M
bull We also assume that δN ge δS This captures the notion that a contractual breach is likely to be more costly to H when M is in the South More figuratively we think of this assumption as reflecting less corruption and better legal protection in the North As is clear from the weak inequality however our results still hold when δN = δS
bull The location of M and the mode of ownership are chosen ex ante by H to maximize its profits There is an infinitely elastic supply of M agents in each one of the countries Each final-good producer H offers a contract that seeks to attract a plant operator M The contract includes an up-front fee for participation in the relationship that has to be paid by M This fee can be positive or negative that is the operator can make a payment to the final-good producer or vice versa The purpose of the fee is to secure the participation of M in the relationship at minimum cost to H When the supply of M is infinitely elastic Mrsquos profits from the relationship net of the participation fee are equal in equilibrium to its ex ante outside option For simplicity we set Mrsquos ex ante outside option equal to zero in both countries It is however easy to extend the analysis to cases in which these outside options are positive and different in the North and in the South
III EQUILIBRIUM
bull The organizational structure equilibrium will be determined bybull Incentives created by different organizationsbull Differences in their fixed costsbull Wage differentials across countries
bull Being in an incomplete contract framework it means that the contract will be renegotiated at some point in time Therefore a bargaining game specification is needed
bull If the parties agree in the bargaining the potential revenue from the sale of the final good is given by
(4)
bull The resulting payoffs implies that the final-good producer (henceforth H) appropriate higher fraction of the revenue under integration than under outsourcing with this fraction being higher when integration takes place in the North The payoffs ordering are the following
(5)
III EQUILIBRIUM
bull As we are in an incomplete contract framework both H and M will choose their quantities noncooperatively Each one will produce the quantity that maximises their individual profits Total operating profits are given by
(6)
where
(7)
bull As H has to attract an M agent whose outside option (ie if they fail to agree) is zero and the contract includes a participation fee (t) which can be positive or negative the final-good production (H) will be the one who decides the organizational form because he will have the incentive to increase t as much as he can (as long as the payoff of M is not negative) As a result
III EQUILIBRIUM
bull Thus upon observing its productivity level H will decide the ownership structure and the location of manufacturing that maximizes (6) The productivity threshold will determine whether H exits the industry or not This productivity threshold depends on the sectorrsquos aggregate consumption index X and implies that
(9)
bull In fact to solve this optimization program the final-good producer will have to choose the triplet that maximizes (6)
bull Equation (6) puts in evidence that profits are decreasing both with and Hence from a cost saving point of view H faces a trade-off as fixed costs are higher in the South and variable costs are lower there ( )
bull Next the final good producer cannot freely choose its fraction of revenue bull Although a higher gives H a larger fraction of revenue it also induces M to produce fewer
components Therefore H trades the choice of a larger fraction of the revenue for a smaller revenue level In fact this fraction of revenue will be determined as follows
(10)
III EQUILIBRIUM
bull Each partyrsquos severity of underinvestment is inversely related to the fraction of the surplus that it appropriates Therefore ex ante efficiency requires giving a larger share of revenue to the party undertaking the relatively more important investment
IV ORGANIZATIONAL FORMS
bull Firms face two types of tensions when choosing the organizational formbull Regarding the location decision variable costs are lower in the South but fixed costs are lower in
the Northbull For the ownership decision the firm has to take into account the fact that insourcing entails higher
fixed costs and gives H a larger fraction of the revenue However if the effect of Mrsquos incentives are strong enough Hrsquos profits may be lower under integration (because if H appropriates a large fraction of revenue M will have no incentive to produce the components)
bull In component-intensive sectors firms donrsquot integrate high-productivity firms outsource in the South low-productivity firms outsource in the North and least productive firms exit the industry
bull In headquarter-intensive sectors we can find the four different organizational forms The most productive firms integrate in the South and somewhat less productive firms outsource in the South Firms with even lower productivity acquire components in the North and among them the more productive integrate and the less productive outsource Finally the least productive firms exit
IV ORGANIZATIONAL FORMS
bull A low headquarter intensity is depicted when As indicated by the arrows profits decrease with increases in bull In this situation H prefers outsourcing to
insourcing regardless the manufacturing location because outsourcing has lower fixed costs and it gives H a lower fraction of revenue
bull Depending on whether the cross-county difference in the wage rate is small or large relative to the cross-country difference in the fixed organizational costs the resulting equilibrium can havebull outsourcing in both countriesbull outsourcing in the South only
Low headquarter intensity sector
IV ORGANIZATIONAL FORMS
bull When wage differential is small relative to to the fixed cost differential firms with a productivity higher than the productivity threshold will outsource in the North and firms with even higher productivity will outsource in the South
bull When wage differential is large relative to the fixed costs all firms with a productivity higher than the threshold will outsource in the South
bull With this threshold level being the intersection between the red line and the horizontal axis
(6)
Low headquarter intensity sector
IV ORGANIZATIONAL FORMS
High headquarter intensity sector bull A high headquarter intensity is depicted when As indicated by the arrows profits increase with increases in
bull The figure 4 shows us that is steeper than for
bull When wage differential is small relative to the fixed cost differential and when the sector is relatively more intensive in headquarter services the marginal return of headquarter services is high making underinvestment significantly costly for H Therefore in such a situation itrsquos always profitable for H to insource regardless the manufacturing location because
bull Integration gives H a larger share of revenue However variable costs are lower in the South For that reason can be steeper or flatter than This is to say that can be larger or smaller than
bull Depending on whether the cross-county difference in the wage rate is small or large relative to the difference between and the resulting equilibrium can have bull The four organizational formsbull Outsourcing in the North insourcing in the North and insourcing in the
Southbull Outsourcing in the North and insourcing in the North
(6)
IV ORGANIZATIONAL FORMS
High headquarter intensity sector
(6)
First case
bull It follows that
(14)
bull Given the orderings in (3) and (14) figure 4 shows us that all four organizational forms exist in equilibrium
IV ORGANIZATIONAL FORMS
High headquarter intensity sector
(6)
Second case
bull In this event (14) doesnrsquot hold anymore because and there are only two equilibrium possibilities
bull Either bull Integration in the North
dominates Consequently only 3 organizational forms can exist in equilibrium at best
bull Outsourcing in the North
bull Insourcing in the Northbull Insourcing in the South
IV ORGANIZATIONAL FORMS
High headquarter intensity sector Second case
bull In this event (14) doesnrsquot hold anymore because and there are only two equilibrium possibilities
bull Orbull Integration in the North
dominates outsourcing and insourcing in the South Consequently only two organizational forms can exist in equilibrium at most
bull Outsourcing in the North
bull Insourcing in the Northbull Hence there is no
international trade in inputs
(6)
V PREVALENCE OF ORGANIZATIONAL FORMS
Measure of prevalence the fraction of firms and market share
COMPONENT-INTENSIVE SECTOR
bull No firm integrates low η
The fraction of firms that outsource in the South
1 Lower wage in the south Raises the profit of outsourcing in the SouthRaises The minimal productivity to be active in the sector rises
SO
COMPONENT-INTENSIVE SECTOR
The fraction of firms that outsource in the South
2 Increase in the dispersion of productivity Raises
3 Higher headquarter intensity is less prevalent
4 Smaller fraction of the surplus from outsourcing in the south (β)Raises the profitability of outsourcing in the South is more prevalent
HEADQUARTER-INTENSIVE SECTOR
Organizational forms
HEADQUARTER-INTENSIVE SECTOR
1 Lower wage in the South
2 Increase of productivity dispersionDecline Increase and ambiguous effect in the others
3 Higher headquarter intensity (η) Domestic outsourcing is favored relative to foreign outsourcingIntegration is favored relative to outsourcingThe effects of η on the fraction of firms that insource in the south is ambiguous
HEADQUARTER-INTENSIVE SECTOR
4 Increase in the revenue shares4 Increase in (rises slope of the profit line)
SV
The fraction of outsourcing firms in the South declines and the fraction of insourcing firms in the South rises
HEADQUARTER-INTENSIVE SECTOR
4 Increase in the revenue shares5 Increase in (rises slope of the profit line)
NV The fraction of firms that
outsource in the north declines and these that insource in the north rises The fraction of firms that outsource in the south declines and these that insource in the south does not change
HEADQUARTER-INTENSIVE SECTOR
5 Increase in the primitive bargaining power parameter (β)
bull Shifts the bargaining power in favor of Hbull Outsourcing becomes more attractivebull ise bull The fraction of firms that import components
rises
VI CONCLUDING COMMENTS
1 The high-productivity firms -gt South2 In the same country high-productivity firms
insource 3 In sectors with very low intensity of headquarter
services no firm integrates 1 Low-productivity firms outsource at home 2 High-productivity firms outsource abroad
VI CONCLUDING COMMENTS
4 The prevalence of organizational forms depends on industry characteristics and on the degree of productivity dispersion across firms
1 Sectors with more productivity dispersion (lower z) more imported inputs
1 Within the headquarter-intensive sectors integration is more prevalent
2 Higher headquarter intensity less imported inputs 1 Within the headquarter-intensive sectors integration is more
prevalent
5 Lower wages in the south raises the fraction of firms that import intermediate inputs
1 It raises the fraction of firms that outsource in each country 2 Armrsquos length trade rises relative to intrafirm trade
II THE MODEL
bull Producers of differentiated products face a perfectly elastic supply of labor in each country
bull Wage rates are fixed and wN gt wS
bull The demand parameters μ and a are the same in every industrybull This helps focus attention on cross-sectoral differences in technology and organizational costs
bull Our aim to explore how differences in technology interact with organizational choices in shaping industrial structure trade flows and FDI
bull Only the North knows how to produce final-good varieties bull To start producing a variety in sector j a firm needs to bear a fixed cost of entry
consisting of fE units of northern labor Upon paying this fixed cost the unique producer of variety i in sector j draws a productivity level θ from a known distribution G(θ)
bull After observing this productivity level the final-good producer decides whether to exit the market or start producing in the latter case an additional fixed cost of organizing production needs to be incurred bull This additional fixed cost is a function of the structure of ownership and the location of
production
II THE MODEL
bull Production of any final-good variety requires a combination of two variety-specific inputsbull hj(i) headquarter services
bull Can be produced only in the North with one unit of labor per unit of outputbull mj(i) manufactured components
bull Can be produced in the North and in the South with one unit of labor per unit of output in each country
bull Output of every variety is a sector-specific Cobb-Douglas function of the inputs
bull θ firm-specific productivty parameterbull ηj sector-specific productivity parameter
bull The larger ηj is the more intensive the sector in headquarter services
bull Two types of agents engaged in productionbull H final-good producers who supply headquarter servicesbull M operators of manufacturing plants who supply intermediate inputs
bull Every H needs to contract with an M for the provision of components bull We allow international fragmentation of the production process so that H can choose
to trans- act with an M in the North or in the South
II THE MODEL
bull It follows from our assumptions that all H locate in the North bull Upon paying the fixed cost of entry wNfE and observing the productivity level θ the unique final-good
producer H of variety i in sector j seeks out a supplier of components M in the North or in the South
bull Simultaneously H chooses whether to insource or outsource intermediate inputs The joint management costs of final and intermediate goods production such as supervision quality control accounting and marketing depend on the organizational form and the location of M
bull All these costs the sum of which we term laquo fixed organizational costs raquo are denominated in terms of
northern labor bull We denote them by wNfk
l
bull k index of the ownership structurebull i index of the country in which M is located and the manufacturing of components takes place
bull The ownership structure takes one of two forms bull vertical integration Vbull outsourcing O
bull The supplier M is located in one of two sites bull in the North Nbull in the South S
bull Therefore k E1113110 V O and l E1113110 N S
bull An organizational form consists of an ownership structure and a location of M
II THE MODEL
bull We assume that the fixed organizational costs are higher when M is located in the South regardless of ownership structure because the fixed costs of search monitoring and communication are significantly higher in the foreign countrybull fk
S gt fVN and fk
S gt fON for k =V O
bull Given the location of M the fixed organizational costs of a V firm are higher than the fixed organizational costs of an O firm bull fV
l gt fOl for l = N S
bull As a result of these assumptions the fixed organizational costs are ranked as follows
bull We adopt this ordering in order to avoid a taxonomy of cases There exists a tension between two considerations that affect the ranking of fV
l and fOl
bull the need to supervise the production of intermediate inputs in addition to other managerial tasks raises man- agerial overload and the fixed organizational costs of a V firm relative to an O firm
bull economies of scope in the management of diverse activities reduce the fixed organizational costs of a V firm relative to an O firm
bull Our ordering amounts to assuming that managerial overload is more important than managerial economies of scope Al- though we believe this assumption to be appropriate in many instances and we therefore maintain it in the main analysis we shall point out how some of the results change when fV
l lt fOl
II THE MODEL
bull The setting is one of incomplete contracts Final-good producers and manufacturing plant operators cannot sign ex ante enforceable contracts specifying the purchase of specialized intermediate inputs for a certain price
bull The parties cannot write enforceable contracts contingent on the amount of labor hired or on the volume of sales revenues obtained when the final good is sold
bull Hart and Moore (1999) and Segal (1999)bull The parties cannot commit not to renegotiate an initial contract and that the precise nature of
the required input is revealed only ex post and is not verifiable by a third party
bull To simplify the analysis we just impose these constraints on the contracting environment
bull Because no enforceable contract can be signed ex ante final-good producers and manufacturing plant operators bargain over the surplus from the relationship after the inputs have been produced We model this ex post bargaining as a generalized Nash bargaining game in which the final-good producer obtains a fraction β1113110E (0 1) of the ex post gains from the relationship
II THE MODEL
bull Following the property rights approach to the theory of the firm we assume that ex post bargaining takes place both under outsourcing and under integration The distribution of surplus is sensitive however to the mode of organization
bull More specifically the outside option of H is assumed to be different when it owns the manufacturing plant than when it does not In the latter case a failure to reach an agreement on the distribution of the surplus leaves both parties with no income because the inputs are tailored specifically to the other party in the transaction
bull However by vertically integrating the production of components H is effectively buying the right to fire M and seize the inputs mj(i) If there were no costs associated with firing the operator of the manufacturing plant the final-good producer would always have an incentive to seize the inputs mj(i) ex post and M wouldhave an incentive to choose mj(i) = 0 ex ante (which of course would imply xj(i) = 0)
bull In this case integration would never be chosen We therefore assume that firing M results in a loss of a fraction 1 1113110- δ of final-good production because H cannot use the intermediate inputs without M as effectively as it can with the cooperation of M
bull We also assume that δN ge δS This captures the notion that a contractual breach is likely to be more costly to H when M is in the South More figuratively we think of this assumption as reflecting less corruption and better legal protection in the North As is clear from the weak inequality however our results still hold when δN = δS
bull The location of M and the mode of ownership are chosen ex ante by H to maximize its profits There is an infinitely elastic supply of M agents in each one of the countries Each final-good producer H offers a contract that seeks to attract a plant operator M The contract includes an up-front fee for participation in the relationship that has to be paid by M This fee can be positive or negative that is the operator can make a payment to the final-good producer or vice versa The purpose of the fee is to secure the participation of M in the relationship at minimum cost to H When the supply of M is infinitely elastic Mrsquos profits from the relationship net of the participation fee are equal in equilibrium to its ex ante outside option For simplicity we set Mrsquos ex ante outside option equal to zero in both countries It is however easy to extend the analysis to cases in which these outside options are positive and different in the North and in the South
III EQUILIBRIUM
bull The organizational structure equilibrium will be determined bybull Incentives created by different organizationsbull Differences in their fixed costsbull Wage differentials across countries
bull Being in an incomplete contract framework it means that the contract will be renegotiated at some point in time Therefore a bargaining game specification is needed
bull If the parties agree in the bargaining the potential revenue from the sale of the final good is given by
(4)
bull The resulting payoffs implies that the final-good producer (henceforth H) appropriate higher fraction of the revenue under integration than under outsourcing with this fraction being higher when integration takes place in the North The payoffs ordering are the following
(5)
III EQUILIBRIUM
bull As we are in an incomplete contract framework both H and M will choose their quantities noncooperatively Each one will produce the quantity that maximises their individual profits Total operating profits are given by
(6)
where
(7)
bull As H has to attract an M agent whose outside option (ie if they fail to agree) is zero and the contract includes a participation fee (t) which can be positive or negative the final-good production (H) will be the one who decides the organizational form because he will have the incentive to increase t as much as he can (as long as the payoff of M is not negative) As a result
III EQUILIBRIUM
bull Thus upon observing its productivity level H will decide the ownership structure and the location of manufacturing that maximizes (6) The productivity threshold will determine whether H exits the industry or not This productivity threshold depends on the sectorrsquos aggregate consumption index X and implies that
(9)
bull In fact to solve this optimization program the final-good producer will have to choose the triplet that maximizes (6)
bull Equation (6) puts in evidence that profits are decreasing both with and Hence from a cost saving point of view H faces a trade-off as fixed costs are higher in the South and variable costs are lower there ( )
bull Next the final good producer cannot freely choose its fraction of revenue bull Although a higher gives H a larger fraction of revenue it also induces M to produce fewer
components Therefore H trades the choice of a larger fraction of the revenue for a smaller revenue level In fact this fraction of revenue will be determined as follows
(10)
III EQUILIBRIUM
bull Each partyrsquos severity of underinvestment is inversely related to the fraction of the surplus that it appropriates Therefore ex ante efficiency requires giving a larger share of revenue to the party undertaking the relatively more important investment
IV ORGANIZATIONAL FORMS
bull Firms face two types of tensions when choosing the organizational formbull Regarding the location decision variable costs are lower in the South but fixed costs are lower in
the Northbull For the ownership decision the firm has to take into account the fact that insourcing entails higher
fixed costs and gives H a larger fraction of the revenue However if the effect of Mrsquos incentives are strong enough Hrsquos profits may be lower under integration (because if H appropriates a large fraction of revenue M will have no incentive to produce the components)
bull In component-intensive sectors firms donrsquot integrate high-productivity firms outsource in the South low-productivity firms outsource in the North and least productive firms exit the industry
bull In headquarter-intensive sectors we can find the four different organizational forms The most productive firms integrate in the South and somewhat less productive firms outsource in the South Firms with even lower productivity acquire components in the North and among them the more productive integrate and the less productive outsource Finally the least productive firms exit
IV ORGANIZATIONAL FORMS
bull A low headquarter intensity is depicted when As indicated by the arrows profits decrease with increases in bull In this situation H prefers outsourcing to
insourcing regardless the manufacturing location because outsourcing has lower fixed costs and it gives H a lower fraction of revenue
bull Depending on whether the cross-county difference in the wage rate is small or large relative to the cross-country difference in the fixed organizational costs the resulting equilibrium can havebull outsourcing in both countriesbull outsourcing in the South only
Low headquarter intensity sector
IV ORGANIZATIONAL FORMS
bull When wage differential is small relative to to the fixed cost differential firms with a productivity higher than the productivity threshold will outsource in the North and firms with even higher productivity will outsource in the South
bull When wage differential is large relative to the fixed costs all firms with a productivity higher than the threshold will outsource in the South
bull With this threshold level being the intersection between the red line and the horizontal axis
(6)
Low headquarter intensity sector
IV ORGANIZATIONAL FORMS
High headquarter intensity sector bull A high headquarter intensity is depicted when As indicated by the arrows profits increase with increases in
bull The figure 4 shows us that is steeper than for
bull When wage differential is small relative to the fixed cost differential and when the sector is relatively more intensive in headquarter services the marginal return of headquarter services is high making underinvestment significantly costly for H Therefore in such a situation itrsquos always profitable for H to insource regardless the manufacturing location because
bull Integration gives H a larger share of revenue However variable costs are lower in the South For that reason can be steeper or flatter than This is to say that can be larger or smaller than
bull Depending on whether the cross-county difference in the wage rate is small or large relative to the difference between and the resulting equilibrium can have bull The four organizational formsbull Outsourcing in the North insourcing in the North and insourcing in the
Southbull Outsourcing in the North and insourcing in the North
(6)
IV ORGANIZATIONAL FORMS
High headquarter intensity sector
(6)
First case
bull It follows that
(14)
bull Given the orderings in (3) and (14) figure 4 shows us that all four organizational forms exist in equilibrium
IV ORGANIZATIONAL FORMS
High headquarter intensity sector
(6)
Second case
bull In this event (14) doesnrsquot hold anymore because and there are only two equilibrium possibilities
bull Either bull Integration in the North
dominates Consequently only 3 organizational forms can exist in equilibrium at best
bull Outsourcing in the North
bull Insourcing in the Northbull Insourcing in the South
IV ORGANIZATIONAL FORMS
High headquarter intensity sector Second case
bull In this event (14) doesnrsquot hold anymore because and there are only two equilibrium possibilities
bull Orbull Integration in the North
dominates outsourcing and insourcing in the South Consequently only two organizational forms can exist in equilibrium at most
bull Outsourcing in the North
bull Insourcing in the Northbull Hence there is no
international trade in inputs
(6)
V PREVALENCE OF ORGANIZATIONAL FORMS
Measure of prevalence the fraction of firms and market share
COMPONENT-INTENSIVE SECTOR
bull No firm integrates low η
The fraction of firms that outsource in the South
1 Lower wage in the south Raises the profit of outsourcing in the SouthRaises The minimal productivity to be active in the sector rises
SO
COMPONENT-INTENSIVE SECTOR
The fraction of firms that outsource in the South
2 Increase in the dispersion of productivity Raises
3 Higher headquarter intensity is less prevalent
4 Smaller fraction of the surplus from outsourcing in the south (β)Raises the profitability of outsourcing in the South is more prevalent
HEADQUARTER-INTENSIVE SECTOR
Organizational forms
HEADQUARTER-INTENSIVE SECTOR
1 Lower wage in the South
2 Increase of productivity dispersionDecline Increase and ambiguous effect in the others
3 Higher headquarter intensity (η) Domestic outsourcing is favored relative to foreign outsourcingIntegration is favored relative to outsourcingThe effects of η on the fraction of firms that insource in the south is ambiguous
HEADQUARTER-INTENSIVE SECTOR
4 Increase in the revenue shares4 Increase in (rises slope of the profit line)
SV
The fraction of outsourcing firms in the South declines and the fraction of insourcing firms in the South rises
HEADQUARTER-INTENSIVE SECTOR
4 Increase in the revenue shares5 Increase in (rises slope of the profit line)
NV The fraction of firms that
outsource in the north declines and these that insource in the north rises The fraction of firms that outsource in the south declines and these that insource in the south does not change
HEADQUARTER-INTENSIVE SECTOR
5 Increase in the primitive bargaining power parameter (β)
bull Shifts the bargaining power in favor of Hbull Outsourcing becomes more attractivebull ise bull The fraction of firms that import components
rises
VI CONCLUDING COMMENTS
1 The high-productivity firms -gt South2 In the same country high-productivity firms
insource 3 In sectors with very low intensity of headquarter
services no firm integrates 1 Low-productivity firms outsource at home 2 High-productivity firms outsource abroad
VI CONCLUDING COMMENTS
4 The prevalence of organizational forms depends on industry characteristics and on the degree of productivity dispersion across firms
1 Sectors with more productivity dispersion (lower z) more imported inputs
1 Within the headquarter-intensive sectors integration is more prevalent
2 Higher headquarter intensity less imported inputs 1 Within the headquarter-intensive sectors integration is more
prevalent
5 Lower wages in the south raises the fraction of firms that import intermediate inputs
1 It raises the fraction of firms that outsource in each country 2 Armrsquos length trade rises relative to intrafirm trade
II THE MODEL
bull Production of any final-good variety requires a combination of two variety-specific inputsbull hj(i) headquarter services
bull Can be produced only in the North with one unit of labor per unit of outputbull mj(i) manufactured components
bull Can be produced in the North and in the South with one unit of labor per unit of output in each country
bull Output of every variety is a sector-specific Cobb-Douglas function of the inputs
bull θ firm-specific productivty parameterbull ηj sector-specific productivity parameter
bull The larger ηj is the more intensive the sector in headquarter services
bull Two types of agents engaged in productionbull H final-good producers who supply headquarter servicesbull M operators of manufacturing plants who supply intermediate inputs
bull Every H needs to contract with an M for the provision of components bull We allow international fragmentation of the production process so that H can choose
to trans- act with an M in the North or in the South
II THE MODEL
bull It follows from our assumptions that all H locate in the North bull Upon paying the fixed cost of entry wNfE and observing the productivity level θ the unique final-good
producer H of variety i in sector j seeks out a supplier of components M in the North or in the South
bull Simultaneously H chooses whether to insource or outsource intermediate inputs The joint management costs of final and intermediate goods production such as supervision quality control accounting and marketing depend on the organizational form and the location of M
bull All these costs the sum of which we term laquo fixed organizational costs raquo are denominated in terms of
northern labor bull We denote them by wNfk
l
bull k index of the ownership structurebull i index of the country in which M is located and the manufacturing of components takes place
bull The ownership structure takes one of two forms bull vertical integration Vbull outsourcing O
bull The supplier M is located in one of two sites bull in the North Nbull in the South S
bull Therefore k E1113110 V O and l E1113110 N S
bull An organizational form consists of an ownership structure and a location of M
II THE MODEL
bull We assume that the fixed organizational costs are higher when M is located in the South regardless of ownership structure because the fixed costs of search monitoring and communication are significantly higher in the foreign countrybull fk
S gt fVN and fk
S gt fON for k =V O
bull Given the location of M the fixed organizational costs of a V firm are higher than the fixed organizational costs of an O firm bull fV
l gt fOl for l = N S
bull As a result of these assumptions the fixed organizational costs are ranked as follows
bull We adopt this ordering in order to avoid a taxonomy of cases There exists a tension between two considerations that affect the ranking of fV
l and fOl
bull the need to supervise the production of intermediate inputs in addition to other managerial tasks raises man- agerial overload and the fixed organizational costs of a V firm relative to an O firm
bull economies of scope in the management of diverse activities reduce the fixed organizational costs of a V firm relative to an O firm
bull Our ordering amounts to assuming that managerial overload is more important than managerial economies of scope Al- though we believe this assumption to be appropriate in many instances and we therefore maintain it in the main analysis we shall point out how some of the results change when fV
l lt fOl
II THE MODEL
bull The setting is one of incomplete contracts Final-good producers and manufacturing plant operators cannot sign ex ante enforceable contracts specifying the purchase of specialized intermediate inputs for a certain price
bull The parties cannot write enforceable contracts contingent on the amount of labor hired or on the volume of sales revenues obtained when the final good is sold
bull Hart and Moore (1999) and Segal (1999)bull The parties cannot commit not to renegotiate an initial contract and that the precise nature of
the required input is revealed only ex post and is not verifiable by a third party
bull To simplify the analysis we just impose these constraints on the contracting environment
bull Because no enforceable contract can be signed ex ante final-good producers and manufacturing plant operators bargain over the surplus from the relationship after the inputs have been produced We model this ex post bargaining as a generalized Nash bargaining game in which the final-good producer obtains a fraction β1113110E (0 1) of the ex post gains from the relationship
II THE MODEL
bull Following the property rights approach to the theory of the firm we assume that ex post bargaining takes place both under outsourcing and under integration The distribution of surplus is sensitive however to the mode of organization
bull More specifically the outside option of H is assumed to be different when it owns the manufacturing plant than when it does not In the latter case a failure to reach an agreement on the distribution of the surplus leaves both parties with no income because the inputs are tailored specifically to the other party in the transaction
bull However by vertically integrating the production of components H is effectively buying the right to fire M and seize the inputs mj(i) If there were no costs associated with firing the operator of the manufacturing plant the final-good producer would always have an incentive to seize the inputs mj(i) ex post and M wouldhave an incentive to choose mj(i) = 0 ex ante (which of course would imply xj(i) = 0)
bull In this case integration would never be chosen We therefore assume that firing M results in a loss of a fraction 1 1113110- δ of final-good production because H cannot use the intermediate inputs without M as effectively as it can with the cooperation of M
bull We also assume that δN ge δS This captures the notion that a contractual breach is likely to be more costly to H when M is in the South More figuratively we think of this assumption as reflecting less corruption and better legal protection in the North As is clear from the weak inequality however our results still hold when δN = δS
bull The location of M and the mode of ownership are chosen ex ante by H to maximize its profits There is an infinitely elastic supply of M agents in each one of the countries Each final-good producer H offers a contract that seeks to attract a plant operator M The contract includes an up-front fee for participation in the relationship that has to be paid by M This fee can be positive or negative that is the operator can make a payment to the final-good producer or vice versa The purpose of the fee is to secure the participation of M in the relationship at minimum cost to H When the supply of M is infinitely elastic Mrsquos profits from the relationship net of the participation fee are equal in equilibrium to its ex ante outside option For simplicity we set Mrsquos ex ante outside option equal to zero in both countries It is however easy to extend the analysis to cases in which these outside options are positive and different in the North and in the South
III EQUILIBRIUM
bull The organizational structure equilibrium will be determined bybull Incentives created by different organizationsbull Differences in their fixed costsbull Wage differentials across countries
bull Being in an incomplete contract framework it means that the contract will be renegotiated at some point in time Therefore a bargaining game specification is needed
bull If the parties agree in the bargaining the potential revenue from the sale of the final good is given by
(4)
bull The resulting payoffs implies that the final-good producer (henceforth H) appropriate higher fraction of the revenue under integration than under outsourcing with this fraction being higher when integration takes place in the North The payoffs ordering are the following
(5)
III EQUILIBRIUM
bull As we are in an incomplete contract framework both H and M will choose their quantities noncooperatively Each one will produce the quantity that maximises their individual profits Total operating profits are given by
(6)
where
(7)
bull As H has to attract an M agent whose outside option (ie if they fail to agree) is zero and the contract includes a participation fee (t) which can be positive or negative the final-good production (H) will be the one who decides the organizational form because he will have the incentive to increase t as much as he can (as long as the payoff of M is not negative) As a result
III EQUILIBRIUM
bull Thus upon observing its productivity level H will decide the ownership structure and the location of manufacturing that maximizes (6) The productivity threshold will determine whether H exits the industry or not This productivity threshold depends on the sectorrsquos aggregate consumption index X and implies that
(9)
bull In fact to solve this optimization program the final-good producer will have to choose the triplet that maximizes (6)
bull Equation (6) puts in evidence that profits are decreasing both with and Hence from a cost saving point of view H faces a trade-off as fixed costs are higher in the South and variable costs are lower there ( )
bull Next the final good producer cannot freely choose its fraction of revenue bull Although a higher gives H a larger fraction of revenue it also induces M to produce fewer
components Therefore H trades the choice of a larger fraction of the revenue for a smaller revenue level In fact this fraction of revenue will be determined as follows
(10)
III EQUILIBRIUM
bull Each partyrsquos severity of underinvestment is inversely related to the fraction of the surplus that it appropriates Therefore ex ante efficiency requires giving a larger share of revenue to the party undertaking the relatively more important investment
IV ORGANIZATIONAL FORMS
bull Firms face two types of tensions when choosing the organizational formbull Regarding the location decision variable costs are lower in the South but fixed costs are lower in
the Northbull For the ownership decision the firm has to take into account the fact that insourcing entails higher
fixed costs and gives H a larger fraction of the revenue However if the effect of Mrsquos incentives are strong enough Hrsquos profits may be lower under integration (because if H appropriates a large fraction of revenue M will have no incentive to produce the components)
bull In component-intensive sectors firms donrsquot integrate high-productivity firms outsource in the South low-productivity firms outsource in the North and least productive firms exit the industry
bull In headquarter-intensive sectors we can find the four different organizational forms The most productive firms integrate in the South and somewhat less productive firms outsource in the South Firms with even lower productivity acquire components in the North and among them the more productive integrate and the less productive outsource Finally the least productive firms exit
IV ORGANIZATIONAL FORMS
bull A low headquarter intensity is depicted when As indicated by the arrows profits decrease with increases in bull In this situation H prefers outsourcing to
insourcing regardless the manufacturing location because outsourcing has lower fixed costs and it gives H a lower fraction of revenue
bull Depending on whether the cross-county difference in the wage rate is small or large relative to the cross-country difference in the fixed organizational costs the resulting equilibrium can havebull outsourcing in both countriesbull outsourcing in the South only
Low headquarter intensity sector
IV ORGANIZATIONAL FORMS
bull When wage differential is small relative to to the fixed cost differential firms with a productivity higher than the productivity threshold will outsource in the North and firms with even higher productivity will outsource in the South
bull When wage differential is large relative to the fixed costs all firms with a productivity higher than the threshold will outsource in the South
bull With this threshold level being the intersection between the red line and the horizontal axis
(6)
Low headquarter intensity sector
IV ORGANIZATIONAL FORMS
High headquarter intensity sector bull A high headquarter intensity is depicted when As indicated by the arrows profits increase with increases in
bull The figure 4 shows us that is steeper than for
bull When wage differential is small relative to the fixed cost differential and when the sector is relatively more intensive in headquarter services the marginal return of headquarter services is high making underinvestment significantly costly for H Therefore in such a situation itrsquos always profitable for H to insource regardless the manufacturing location because
bull Integration gives H a larger share of revenue However variable costs are lower in the South For that reason can be steeper or flatter than This is to say that can be larger or smaller than
bull Depending on whether the cross-county difference in the wage rate is small or large relative to the difference between and the resulting equilibrium can have bull The four organizational formsbull Outsourcing in the North insourcing in the North and insourcing in the
Southbull Outsourcing in the North and insourcing in the North
(6)
IV ORGANIZATIONAL FORMS
High headquarter intensity sector
(6)
First case
bull It follows that
(14)
bull Given the orderings in (3) and (14) figure 4 shows us that all four organizational forms exist in equilibrium
IV ORGANIZATIONAL FORMS
High headquarter intensity sector
(6)
Second case
bull In this event (14) doesnrsquot hold anymore because and there are only two equilibrium possibilities
bull Either bull Integration in the North
dominates Consequently only 3 organizational forms can exist in equilibrium at best
bull Outsourcing in the North
bull Insourcing in the Northbull Insourcing in the South
IV ORGANIZATIONAL FORMS
High headquarter intensity sector Second case
bull In this event (14) doesnrsquot hold anymore because and there are only two equilibrium possibilities
bull Orbull Integration in the North
dominates outsourcing and insourcing in the South Consequently only two organizational forms can exist in equilibrium at most
bull Outsourcing in the North
bull Insourcing in the Northbull Hence there is no
international trade in inputs
(6)
V PREVALENCE OF ORGANIZATIONAL FORMS
Measure of prevalence the fraction of firms and market share
COMPONENT-INTENSIVE SECTOR
bull No firm integrates low η
The fraction of firms that outsource in the South
1 Lower wage in the south Raises the profit of outsourcing in the SouthRaises The minimal productivity to be active in the sector rises
SO
COMPONENT-INTENSIVE SECTOR
The fraction of firms that outsource in the South
2 Increase in the dispersion of productivity Raises
3 Higher headquarter intensity is less prevalent
4 Smaller fraction of the surplus from outsourcing in the south (β)Raises the profitability of outsourcing in the South is more prevalent
HEADQUARTER-INTENSIVE SECTOR
Organizational forms
HEADQUARTER-INTENSIVE SECTOR
1 Lower wage in the South
2 Increase of productivity dispersionDecline Increase and ambiguous effect in the others
3 Higher headquarter intensity (η) Domestic outsourcing is favored relative to foreign outsourcingIntegration is favored relative to outsourcingThe effects of η on the fraction of firms that insource in the south is ambiguous
HEADQUARTER-INTENSIVE SECTOR
4 Increase in the revenue shares4 Increase in (rises slope of the profit line)
SV
The fraction of outsourcing firms in the South declines and the fraction of insourcing firms in the South rises
HEADQUARTER-INTENSIVE SECTOR
4 Increase in the revenue shares5 Increase in (rises slope of the profit line)
NV The fraction of firms that
outsource in the north declines and these that insource in the north rises The fraction of firms that outsource in the south declines and these that insource in the south does not change
HEADQUARTER-INTENSIVE SECTOR
5 Increase in the primitive bargaining power parameter (β)
bull Shifts the bargaining power in favor of Hbull Outsourcing becomes more attractivebull ise bull The fraction of firms that import components
rises
VI CONCLUDING COMMENTS
1 The high-productivity firms -gt South2 In the same country high-productivity firms
insource 3 In sectors with very low intensity of headquarter
services no firm integrates 1 Low-productivity firms outsource at home 2 High-productivity firms outsource abroad
VI CONCLUDING COMMENTS
4 The prevalence of organizational forms depends on industry characteristics and on the degree of productivity dispersion across firms
1 Sectors with more productivity dispersion (lower z) more imported inputs
1 Within the headquarter-intensive sectors integration is more prevalent
2 Higher headquarter intensity less imported inputs 1 Within the headquarter-intensive sectors integration is more
prevalent
5 Lower wages in the south raises the fraction of firms that import intermediate inputs
1 It raises the fraction of firms that outsource in each country 2 Armrsquos length trade rises relative to intrafirm trade
II THE MODEL
bull It follows from our assumptions that all H locate in the North bull Upon paying the fixed cost of entry wNfE and observing the productivity level θ the unique final-good
producer H of variety i in sector j seeks out a supplier of components M in the North or in the South
bull Simultaneously H chooses whether to insource or outsource intermediate inputs The joint management costs of final and intermediate goods production such as supervision quality control accounting and marketing depend on the organizational form and the location of M
bull All these costs the sum of which we term laquo fixed organizational costs raquo are denominated in terms of
northern labor bull We denote them by wNfk
l
bull k index of the ownership structurebull i index of the country in which M is located and the manufacturing of components takes place
bull The ownership structure takes one of two forms bull vertical integration Vbull outsourcing O
bull The supplier M is located in one of two sites bull in the North Nbull in the South S
bull Therefore k E1113110 V O and l E1113110 N S
bull An organizational form consists of an ownership structure and a location of M
II THE MODEL
bull We assume that the fixed organizational costs are higher when M is located in the South regardless of ownership structure because the fixed costs of search monitoring and communication are significantly higher in the foreign countrybull fk
S gt fVN and fk
S gt fON for k =V O
bull Given the location of M the fixed organizational costs of a V firm are higher than the fixed organizational costs of an O firm bull fV
l gt fOl for l = N S
bull As a result of these assumptions the fixed organizational costs are ranked as follows
bull We adopt this ordering in order to avoid a taxonomy of cases There exists a tension between two considerations that affect the ranking of fV
l and fOl
bull the need to supervise the production of intermediate inputs in addition to other managerial tasks raises man- agerial overload and the fixed organizational costs of a V firm relative to an O firm
bull economies of scope in the management of diverse activities reduce the fixed organizational costs of a V firm relative to an O firm
bull Our ordering amounts to assuming that managerial overload is more important than managerial economies of scope Al- though we believe this assumption to be appropriate in many instances and we therefore maintain it in the main analysis we shall point out how some of the results change when fV
l lt fOl
II THE MODEL
bull The setting is one of incomplete contracts Final-good producers and manufacturing plant operators cannot sign ex ante enforceable contracts specifying the purchase of specialized intermediate inputs for a certain price
bull The parties cannot write enforceable contracts contingent on the amount of labor hired or on the volume of sales revenues obtained when the final good is sold
bull Hart and Moore (1999) and Segal (1999)bull The parties cannot commit not to renegotiate an initial contract and that the precise nature of
the required input is revealed only ex post and is not verifiable by a third party
bull To simplify the analysis we just impose these constraints on the contracting environment
bull Because no enforceable contract can be signed ex ante final-good producers and manufacturing plant operators bargain over the surplus from the relationship after the inputs have been produced We model this ex post bargaining as a generalized Nash bargaining game in which the final-good producer obtains a fraction β1113110E (0 1) of the ex post gains from the relationship
II THE MODEL
bull Following the property rights approach to the theory of the firm we assume that ex post bargaining takes place both under outsourcing and under integration The distribution of surplus is sensitive however to the mode of organization
bull More specifically the outside option of H is assumed to be different when it owns the manufacturing plant than when it does not In the latter case a failure to reach an agreement on the distribution of the surplus leaves both parties with no income because the inputs are tailored specifically to the other party in the transaction
bull However by vertically integrating the production of components H is effectively buying the right to fire M and seize the inputs mj(i) If there were no costs associated with firing the operator of the manufacturing plant the final-good producer would always have an incentive to seize the inputs mj(i) ex post and M wouldhave an incentive to choose mj(i) = 0 ex ante (which of course would imply xj(i) = 0)
bull In this case integration would never be chosen We therefore assume that firing M results in a loss of a fraction 1 1113110- δ of final-good production because H cannot use the intermediate inputs without M as effectively as it can with the cooperation of M
bull We also assume that δN ge δS This captures the notion that a contractual breach is likely to be more costly to H when M is in the South More figuratively we think of this assumption as reflecting less corruption and better legal protection in the North As is clear from the weak inequality however our results still hold when δN = δS
bull The location of M and the mode of ownership are chosen ex ante by H to maximize its profits There is an infinitely elastic supply of M agents in each one of the countries Each final-good producer H offers a contract that seeks to attract a plant operator M The contract includes an up-front fee for participation in the relationship that has to be paid by M This fee can be positive or negative that is the operator can make a payment to the final-good producer or vice versa The purpose of the fee is to secure the participation of M in the relationship at minimum cost to H When the supply of M is infinitely elastic Mrsquos profits from the relationship net of the participation fee are equal in equilibrium to its ex ante outside option For simplicity we set Mrsquos ex ante outside option equal to zero in both countries It is however easy to extend the analysis to cases in which these outside options are positive and different in the North and in the South
III EQUILIBRIUM
bull The organizational structure equilibrium will be determined bybull Incentives created by different organizationsbull Differences in their fixed costsbull Wage differentials across countries
bull Being in an incomplete contract framework it means that the contract will be renegotiated at some point in time Therefore a bargaining game specification is needed
bull If the parties agree in the bargaining the potential revenue from the sale of the final good is given by
(4)
bull The resulting payoffs implies that the final-good producer (henceforth H) appropriate higher fraction of the revenue under integration than under outsourcing with this fraction being higher when integration takes place in the North The payoffs ordering are the following
(5)
III EQUILIBRIUM
bull As we are in an incomplete contract framework both H and M will choose their quantities noncooperatively Each one will produce the quantity that maximises their individual profits Total operating profits are given by
(6)
where
(7)
bull As H has to attract an M agent whose outside option (ie if they fail to agree) is zero and the contract includes a participation fee (t) which can be positive or negative the final-good production (H) will be the one who decides the organizational form because he will have the incentive to increase t as much as he can (as long as the payoff of M is not negative) As a result
III EQUILIBRIUM
bull Thus upon observing its productivity level H will decide the ownership structure and the location of manufacturing that maximizes (6) The productivity threshold will determine whether H exits the industry or not This productivity threshold depends on the sectorrsquos aggregate consumption index X and implies that
(9)
bull In fact to solve this optimization program the final-good producer will have to choose the triplet that maximizes (6)
bull Equation (6) puts in evidence that profits are decreasing both with and Hence from a cost saving point of view H faces a trade-off as fixed costs are higher in the South and variable costs are lower there ( )
bull Next the final good producer cannot freely choose its fraction of revenue bull Although a higher gives H a larger fraction of revenue it also induces M to produce fewer
components Therefore H trades the choice of a larger fraction of the revenue for a smaller revenue level In fact this fraction of revenue will be determined as follows
(10)
III EQUILIBRIUM
bull Each partyrsquos severity of underinvestment is inversely related to the fraction of the surplus that it appropriates Therefore ex ante efficiency requires giving a larger share of revenue to the party undertaking the relatively more important investment
IV ORGANIZATIONAL FORMS
bull Firms face two types of tensions when choosing the organizational formbull Regarding the location decision variable costs are lower in the South but fixed costs are lower in
the Northbull For the ownership decision the firm has to take into account the fact that insourcing entails higher
fixed costs and gives H a larger fraction of the revenue However if the effect of Mrsquos incentives are strong enough Hrsquos profits may be lower under integration (because if H appropriates a large fraction of revenue M will have no incentive to produce the components)
bull In component-intensive sectors firms donrsquot integrate high-productivity firms outsource in the South low-productivity firms outsource in the North and least productive firms exit the industry
bull In headquarter-intensive sectors we can find the four different organizational forms The most productive firms integrate in the South and somewhat less productive firms outsource in the South Firms with even lower productivity acquire components in the North and among them the more productive integrate and the less productive outsource Finally the least productive firms exit
IV ORGANIZATIONAL FORMS
bull A low headquarter intensity is depicted when As indicated by the arrows profits decrease with increases in bull In this situation H prefers outsourcing to
insourcing regardless the manufacturing location because outsourcing has lower fixed costs and it gives H a lower fraction of revenue
bull Depending on whether the cross-county difference in the wage rate is small or large relative to the cross-country difference in the fixed organizational costs the resulting equilibrium can havebull outsourcing in both countriesbull outsourcing in the South only
Low headquarter intensity sector
IV ORGANIZATIONAL FORMS
bull When wage differential is small relative to to the fixed cost differential firms with a productivity higher than the productivity threshold will outsource in the North and firms with even higher productivity will outsource in the South
bull When wage differential is large relative to the fixed costs all firms with a productivity higher than the threshold will outsource in the South
bull With this threshold level being the intersection between the red line and the horizontal axis
(6)
Low headquarter intensity sector
IV ORGANIZATIONAL FORMS
High headquarter intensity sector bull A high headquarter intensity is depicted when As indicated by the arrows profits increase with increases in
bull The figure 4 shows us that is steeper than for
bull When wage differential is small relative to the fixed cost differential and when the sector is relatively more intensive in headquarter services the marginal return of headquarter services is high making underinvestment significantly costly for H Therefore in such a situation itrsquos always profitable for H to insource regardless the manufacturing location because
bull Integration gives H a larger share of revenue However variable costs are lower in the South For that reason can be steeper or flatter than This is to say that can be larger or smaller than
bull Depending on whether the cross-county difference in the wage rate is small or large relative to the difference between and the resulting equilibrium can have bull The four organizational formsbull Outsourcing in the North insourcing in the North and insourcing in the
Southbull Outsourcing in the North and insourcing in the North
(6)
IV ORGANIZATIONAL FORMS
High headquarter intensity sector
(6)
First case
bull It follows that
(14)
bull Given the orderings in (3) and (14) figure 4 shows us that all four organizational forms exist in equilibrium
IV ORGANIZATIONAL FORMS
High headquarter intensity sector
(6)
Second case
bull In this event (14) doesnrsquot hold anymore because and there are only two equilibrium possibilities
bull Either bull Integration in the North
dominates Consequently only 3 organizational forms can exist in equilibrium at best
bull Outsourcing in the North
bull Insourcing in the Northbull Insourcing in the South
IV ORGANIZATIONAL FORMS
High headquarter intensity sector Second case
bull In this event (14) doesnrsquot hold anymore because and there are only two equilibrium possibilities
bull Orbull Integration in the North
dominates outsourcing and insourcing in the South Consequently only two organizational forms can exist in equilibrium at most
bull Outsourcing in the North
bull Insourcing in the Northbull Hence there is no
international trade in inputs
(6)
V PREVALENCE OF ORGANIZATIONAL FORMS
Measure of prevalence the fraction of firms and market share
COMPONENT-INTENSIVE SECTOR
bull No firm integrates low η
The fraction of firms that outsource in the South
1 Lower wage in the south Raises the profit of outsourcing in the SouthRaises The minimal productivity to be active in the sector rises
SO
COMPONENT-INTENSIVE SECTOR
The fraction of firms that outsource in the South
2 Increase in the dispersion of productivity Raises
3 Higher headquarter intensity is less prevalent
4 Smaller fraction of the surplus from outsourcing in the south (β)Raises the profitability of outsourcing in the South is more prevalent
HEADQUARTER-INTENSIVE SECTOR
Organizational forms
HEADQUARTER-INTENSIVE SECTOR
1 Lower wage in the South
2 Increase of productivity dispersionDecline Increase and ambiguous effect in the others
3 Higher headquarter intensity (η) Domestic outsourcing is favored relative to foreign outsourcingIntegration is favored relative to outsourcingThe effects of η on the fraction of firms that insource in the south is ambiguous
HEADQUARTER-INTENSIVE SECTOR
4 Increase in the revenue shares4 Increase in (rises slope of the profit line)
SV
The fraction of outsourcing firms in the South declines and the fraction of insourcing firms in the South rises
HEADQUARTER-INTENSIVE SECTOR
4 Increase in the revenue shares5 Increase in (rises slope of the profit line)
NV The fraction of firms that
outsource in the north declines and these that insource in the north rises The fraction of firms that outsource in the south declines and these that insource in the south does not change
HEADQUARTER-INTENSIVE SECTOR
5 Increase in the primitive bargaining power parameter (β)
bull Shifts the bargaining power in favor of Hbull Outsourcing becomes more attractivebull ise bull The fraction of firms that import components
rises
VI CONCLUDING COMMENTS
1 The high-productivity firms -gt South2 In the same country high-productivity firms
insource 3 In sectors with very low intensity of headquarter
services no firm integrates 1 Low-productivity firms outsource at home 2 High-productivity firms outsource abroad
VI CONCLUDING COMMENTS
4 The prevalence of organizational forms depends on industry characteristics and on the degree of productivity dispersion across firms
1 Sectors with more productivity dispersion (lower z) more imported inputs
1 Within the headquarter-intensive sectors integration is more prevalent
2 Higher headquarter intensity less imported inputs 1 Within the headquarter-intensive sectors integration is more
prevalent
5 Lower wages in the south raises the fraction of firms that import intermediate inputs
1 It raises the fraction of firms that outsource in each country 2 Armrsquos length trade rises relative to intrafirm trade
II THE MODEL
bull We assume that the fixed organizational costs are higher when M is located in the South regardless of ownership structure because the fixed costs of search monitoring and communication are significantly higher in the foreign countrybull fk
S gt fVN and fk
S gt fON for k =V O
bull Given the location of M the fixed organizational costs of a V firm are higher than the fixed organizational costs of an O firm bull fV
l gt fOl for l = N S
bull As a result of these assumptions the fixed organizational costs are ranked as follows
bull We adopt this ordering in order to avoid a taxonomy of cases There exists a tension between two considerations that affect the ranking of fV
l and fOl
bull the need to supervise the production of intermediate inputs in addition to other managerial tasks raises man- agerial overload and the fixed organizational costs of a V firm relative to an O firm
bull economies of scope in the management of diverse activities reduce the fixed organizational costs of a V firm relative to an O firm
bull Our ordering amounts to assuming that managerial overload is more important than managerial economies of scope Al- though we believe this assumption to be appropriate in many instances and we therefore maintain it in the main analysis we shall point out how some of the results change when fV
l lt fOl
II THE MODEL
bull The setting is one of incomplete contracts Final-good producers and manufacturing plant operators cannot sign ex ante enforceable contracts specifying the purchase of specialized intermediate inputs for a certain price
bull The parties cannot write enforceable contracts contingent on the amount of labor hired or on the volume of sales revenues obtained when the final good is sold
bull Hart and Moore (1999) and Segal (1999)bull The parties cannot commit not to renegotiate an initial contract and that the precise nature of
the required input is revealed only ex post and is not verifiable by a third party
bull To simplify the analysis we just impose these constraints on the contracting environment
bull Because no enforceable contract can be signed ex ante final-good producers and manufacturing plant operators bargain over the surplus from the relationship after the inputs have been produced We model this ex post bargaining as a generalized Nash bargaining game in which the final-good producer obtains a fraction β1113110E (0 1) of the ex post gains from the relationship
II THE MODEL
bull Following the property rights approach to the theory of the firm we assume that ex post bargaining takes place both under outsourcing and under integration The distribution of surplus is sensitive however to the mode of organization
bull More specifically the outside option of H is assumed to be different when it owns the manufacturing plant than when it does not In the latter case a failure to reach an agreement on the distribution of the surplus leaves both parties with no income because the inputs are tailored specifically to the other party in the transaction
bull However by vertically integrating the production of components H is effectively buying the right to fire M and seize the inputs mj(i) If there were no costs associated with firing the operator of the manufacturing plant the final-good producer would always have an incentive to seize the inputs mj(i) ex post and M wouldhave an incentive to choose mj(i) = 0 ex ante (which of course would imply xj(i) = 0)
bull In this case integration would never be chosen We therefore assume that firing M results in a loss of a fraction 1 1113110- δ of final-good production because H cannot use the intermediate inputs without M as effectively as it can with the cooperation of M
bull We also assume that δN ge δS This captures the notion that a contractual breach is likely to be more costly to H when M is in the South More figuratively we think of this assumption as reflecting less corruption and better legal protection in the North As is clear from the weak inequality however our results still hold when δN = δS
bull The location of M and the mode of ownership are chosen ex ante by H to maximize its profits There is an infinitely elastic supply of M agents in each one of the countries Each final-good producer H offers a contract that seeks to attract a plant operator M The contract includes an up-front fee for participation in the relationship that has to be paid by M This fee can be positive or negative that is the operator can make a payment to the final-good producer or vice versa The purpose of the fee is to secure the participation of M in the relationship at minimum cost to H When the supply of M is infinitely elastic Mrsquos profits from the relationship net of the participation fee are equal in equilibrium to its ex ante outside option For simplicity we set Mrsquos ex ante outside option equal to zero in both countries It is however easy to extend the analysis to cases in which these outside options are positive and different in the North and in the South
III EQUILIBRIUM
bull The organizational structure equilibrium will be determined bybull Incentives created by different organizationsbull Differences in their fixed costsbull Wage differentials across countries
bull Being in an incomplete contract framework it means that the contract will be renegotiated at some point in time Therefore a bargaining game specification is needed
bull If the parties agree in the bargaining the potential revenue from the sale of the final good is given by
(4)
bull The resulting payoffs implies that the final-good producer (henceforth H) appropriate higher fraction of the revenue under integration than under outsourcing with this fraction being higher when integration takes place in the North The payoffs ordering are the following
(5)
III EQUILIBRIUM
bull As we are in an incomplete contract framework both H and M will choose their quantities noncooperatively Each one will produce the quantity that maximises their individual profits Total operating profits are given by
(6)
where
(7)
bull As H has to attract an M agent whose outside option (ie if they fail to agree) is zero and the contract includes a participation fee (t) which can be positive or negative the final-good production (H) will be the one who decides the organizational form because he will have the incentive to increase t as much as he can (as long as the payoff of M is not negative) As a result
III EQUILIBRIUM
bull Thus upon observing its productivity level H will decide the ownership structure and the location of manufacturing that maximizes (6) The productivity threshold will determine whether H exits the industry or not This productivity threshold depends on the sectorrsquos aggregate consumption index X and implies that
(9)
bull In fact to solve this optimization program the final-good producer will have to choose the triplet that maximizes (6)
bull Equation (6) puts in evidence that profits are decreasing both with and Hence from a cost saving point of view H faces a trade-off as fixed costs are higher in the South and variable costs are lower there ( )
bull Next the final good producer cannot freely choose its fraction of revenue bull Although a higher gives H a larger fraction of revenue it also induces M to produce fewer
components Therefore H trades the choice of a larger fraction of the revenue for a smaller revenue level In fact this fraction of revenue will be determined as follows
(10)
III EQUILIBRIUM
bull Each partyrsquos severity of underinvestment is inversely related to the fraction of the surplus that it appropriates Therefore ex ante efficiency requires giving a larger share of revenue to the party undertaking the relatively more important investment
IV ORGANIZATIONAL FORMS
bull Firms face two types of tensions when choosing the organizational formbull Regarding the location decision variable costs are lower in the South but fixed costs are lower in
the Northbull For the ownership decision the firm has to take into account the fact that insourcing entails higher
fixed costs and gives H a larger fraction of the revenue However if the effect of Mrsquos incentives are strong enough Hrsquos profits may be lower under integration (because if H appropriates a large fraction of revenue M will have no incentive to produce the components)
bull In component-intensive sectors firms donrsquot integrate high-productivity firms outsource in the South low-productivity firms outsource in the North and least productive firms exit the industry
bull In headquarter-intensive sectors we can find the four different organizational forms The most productive firms integrate in the South and somewhat less productive firms outsource in the South Firms with even lower productivity acquire components in the North and among them the more productive integrate and the less productive outsource Finally the least productive firms exit
IV ORGANIZATIONAL FORMS
bull A low headquarter intensity is depicted when As indicated by the arrows profits decrease with increases in bull In this situation H prefers outsourcing to
insourcing regardless the manufacturing location because outsourcing has lower fixed costs and it gives H a lower fraction of revenue
bull Depending on whether the cross-county difference in the wage rate is small or large relative to the cross-country difference in the fixed organizational costs the resulting equilibrium can havebull outsourcing in both countriesbull outsourcing in the South only
Low headquarter intensity sector
IV ORGANIZATIONAL FORMS
bull When wage differential is small relative to to the fixed cost differential firms with a productivity higher than the productivity threshold will outsource in the North and firms with even higher productivity will outsource in the South
bull When wage differential is large relative to the fixed costs all firms with a productivity higher than the threshold will outsource in the South
bull With this threshold level being the intersection between the red line and the horizontal axis
(6)
Low headquarter intensity sector
IV ORGANIZATIONAL FORMS
High headquarter intensity sector bull A high headquarter intensity is depicted when As indicated by the arrows profits increase with increases in
bull The figure 4 shows us that is steeper than for
bull When wage differential is small relative to the fixed cost differential and when the sector is relatively more intensive in headquarter services the marginal return of headquarter services is high making underinvestment significantly costly for H Therefore in such a situation itrsquos always profitable for H to insource regardless the manufacturing location because
bull Integration gives H a larger share of revenue However variable costs are lower in the South For that reason can be steeper or flatter than This is to say that can be larger or smaller than
bull Depending on whether the cross-county difference in the wage rate is small or large relative to the difference between and the resulting equilibrium can have bull The four organizational formsbull Outsourcing in the North insourcing in the North and insourcing in the
Southbull Outsourcing in the North and insourcing in the North
(6)
IV ORGANIZATIONAL FORMS
High headquarter intensity sector
(6)
First case
bull It follows that
(14)
bull Given the orderings in (3) and (14) figure 4 shows us that all four organizational forms exist in equilibrium
IV ORGANIZATIONAL FORMS
High headquarter intensity sector
(6)
Second case
bull In this event (14) doesnrsquot hold anymore because and there are only two equilibrium possibilities
bull Either bull Integration in the North
dominates Consequently only 3 organizational forms can exist in equilibrium at best
bull Outsourcing in the North
bull Insourcing in the Northbull Insourcing in the South
IV ORGANIZATIONAL FORMS
High headquarter intensity sector Second case
bull In this event (14) doesnrsquot hold anymore because and there are only two equilibrium possibilities
bull Orbull Integration in the North
dominates outsourcing and insourcing in the South Consequently only two organizational forms can exist in equilibrium at most
bull Outsourcing in the North
bull Insourcing in the Northbull Hence there is no
international trade in inputs
(6)
V PREVALENCE OF ORGANIZATIONAL FORMS
Measure of prevalence the fraction of firms and market share
COMPONENT-INTENSIVE SECTOR
bull No firm integrates low η
The fraction of firms that outsource in the South
1 Lower wage in the south Raises the profit of outsourcing in the SouthRaises The minimal productivity to be active in the sector rises
SO
COMPONENT-INTENSIVE SECTOR
The fraction of firms that outsource in the South
2 Increase in the dispersion of productivity Raises
3 Higher headquarter intensity is less prevalent
4 Smaller fraction of the surplus from outsourcing in the south (β)Raises the profitability of outsourcing in the South is more prevalent
HEADQUARTER-INTENSIVE SECTOR
Organizational forms
HEADQUARTER-INTENSIVE SECTOR
1 Lower wage in the South
2 Increase of productivity dispersionDecline Increase and ambiguous effect in the others
3 Higher headquarter intensity (η) Domestic outsourcing is favored relative to foreign outsourcingIntegration is favored relative to outsourcingThe effects of η on the fraction of firms that insource in the south is ambiguous
HEADQUARTER-INTENSIVE SECTOR
4 Increase in the revenue shares4 Increase in (rises slope of the profit line)
SV
The fraction of outsourcing firms in the South declines and the fraction of insourcing firms in the South rises
HEADQUARTER-INTENSIVE SECTOR
4 Increase in the revenue shares5 Increase in (rises slope of the profit line)
NV The fraction of firms that
outsource in the north declines and these that insource in the north rises The fraction of firms that outsource in the south declines and these that insource in the south does not change
HEADQUARTER-INTENSIVE SECTOR
5 Increase in the primitive bargaining power parameter (β)
bull Shifts the bargaining power in favor of Hbull Outsourcing becomes more attractivebull ise bull The fraction of firms that import components
rises
VI CONCLUDING COMMENTS
1 The high-productivity firms -gt South2 In the same country high-productivity firms
insource 3 In sectors with very low intensity of headquarter
services no firm integrates 1 Low-productivity firms outsource at home 2 High-productivity firms outsource abroad
VI CONCLUDING COMMENTS
4 The prevalence of organizational forms depends on industry characteristics and on the degree of productivity dispersion across firms
1 Sectors with more productivity dispersion (lower z) more imported inputs
1 Within the headquarter-intensive sectors integration is more prevalent
2 Higher headquarter intensity less imported inputs 1 Within the headquarter-intensive sectors integration is more
prevalent
5 Lower wages in the south raises the fraction of firms that import intermediate inputs
1 It raises the fraction of firms that outsource in each country 2 Armrsquos length trade rises relative to intrafirm trade
II THE MODEL
bull The setting is one of incomplete contracts Final-good producers and manufacturing plant operators cannot sign ex ante enforceable contracts specifying the purchase of specialized intermediate inputs for a certain price
bull The parties cannot write enforceable contracts contingent on the amount of labor hired or on the volume of sales revenues obtained when the final good is sold
bull Hart and Moore (1999) and Segal (1999)bull The parties cannot commit not to renegotiate an initial contract and that the precise nature of
the required input is revealed only ex post and is not verifiable by a third party
bull To simplify the analysis we just impose these constraints on the contracting environment
bull Because no enforceable contract can be signed ex ante final-good producers and manufacturing plant operators bargain over the surplus from the relationship after the inputs have been produced We model this ex post bargaining as a generalized Nash bargaining game in which the final-good producer obtains a fraction β1113110E (0 1) of the ex post gains from the relationship
II THE MODEL
bull Following the property rights approach to the theory of the firm we assume that ex post bargaining takes place both under outsourcing and under integration The distribution of surplus is sensitive however to the mode of organization
bull More specifically the outside option of H is assumed to be different when it owns the manufacturing plant than when it does not In the latter case a failure to reach an agreement on the distribution of the surplus leaves both parties with no income because the inputs are tailored specifically to the other party in the transaction
bull However by vertically integrating the production of components H is effectively buying the right to fire M and seize the inputs mj(i) If there were no costs associated with firing the operator of the manufacturing plant the final-good producer would always have an incentive to seize the inputs mj(i) ex post and M wouldhave an incentive to choose mj(i) = 0 ex ante (which of course would imply xj(i) = 0)
bull In this case integration would never be chosen We therefore assume that firing M results in a loss of a fraction 1 1113110- δ of final-good production because H cannot use the intermediate inputs without M as effectively as it can with the cooperation of M
bull We also assume that δN ge δS This captures the notion that a contractual breach is likely to be more costly to H when M is in the South More figuratively we think of this assumption as reflecting less corruption and better legal protection in the North As is clear from the weak inequality however our results still hold when δN = δS
bull The location of M and the mode of ownership are chosen ex ante by H to maximize its profits There is an infinitely elastic supply of M agents in each one of the countries Each final-good producer H offers a contract that seeks to attract a plant operator M The contract includes an up-front fee for participation in the relationship that has to be paid by M This fee can be positive or negative that is the operator can make a payment to the final-good producer or vice versa The purpose of the fee is to secure the participation of M in the relationship at minimum cost to H When the supply of M is infinitely elastic Mrsquos profits from the relationship net of the participation fee are equal in equilibrium to its ex ante outside option For simplicity we set Mrsquos ex ante outside option equal to zero in both countries It is however easy to extend the analysis to cases in which these outside options are positive and different in the North and in the South
III EQUILIBRIUM
bull The organizational structure equilibrium will be determined bybull Incentives created by different organizationsbull Differences in their fixed costsbull Wage differentials across countries
bull Being in an incomplete contract framework it means that the contract will be renegotiated at some point in time Therefore a bargaining game specification is needed
bull If the parties agree in the bargaining the potential revenue from the sale of the final good is given by
(4)
bull The resulting payoffs implies that the final-good producer (henceforth H) appropriate higher fraction of the revenue under integration than under outsourcing with this fraction being higher when integration takes place in the North The payoffs ordering are the following
(5)
III EQUILIBRIUM
bull As we are in an incomplete contract framework both H and M will choose their quantities noncooperatively Each one will produce the quantity that maximises their individual profits Total operating profits are given by
(6)
where
(7)
bull As H has to attract an M agent whose outside option (ie if they fail to agree) is zero and the contract includes a participation fee (t) which can be positive or negative the final-good production (H) will be the one who decides the organizational form because he will have the incentive to increase t as much as he can (as long as the payoff of M is not negative) As a result
III EQUILIBRIUM
bull Thus upon observing its productivity level H will decide the ownership structure and the location of manufacturing that maximizes (6) The productivity threshold will determine whether H exits the industry or not This productivity threshold depends on the sectorrsquos aggregate consumption index X and implies that
(9)
bull In fact to solve this optimization program the final-good producer will have to choose the triplet that maximizes (6)
bull Equation (6) puts in evidence that profits are decreasing both with and Hence from a cost saving point of view H faces a trade-off as fixed costs are higher in the South and variable costs are lower there ( )
bull Next the final good producer cannot freely choose its fraction of revenue bull Although a higher gives H a larger fraction of revenue it also induces M to produce fewer
components Therefore H trades the choice of a larger fraction of the revenue for a smaller revenue level In fact this fraction of revenue will be determined as follows
(10)
III EQUILIBRIUM
bull Each partyrsquos severity of underinvestment is inversely related to the fraction of the surplus that it appropriates Therefore ex ante efficiency requires giving a larger share of revenue to the party undertaking the relatively more important investment
IV ORGANIZATIONAL FORMS
bull Firms face two types of tensions when choosing the organizational formbull Regarding the location decision variable costs are lower in the South but fixed costs are lower in
the Northbull For the ownership decision the firm has to take into account the fact that insourcing entails higher
fixed costs and gives H a larger fraction of the revenue However if the effect of Mrsquos incentives are strong enough Hrsquos profits may be lower under integration (because if H appropriates a large fraction of revenue M will have no incentive to produce the components)
bull In component-intensive sectors firms donrsquot integrate high-productivity firms outsource in the South low-productivity firms outsource in the North and least productive firms exit the industry
bull In headquarter-intensive sectors we can find the four different organizational forms The most productive firms integrate in the South and somewhat less productive firms outsource in the South Firms with even lower productivity acquire components in the North and among them the more productive integrate and the less productive outsource Finally the least productive firms exit
IV ORGANIZATIONAL FORMS
bull A low headquarter intensity is depicted when As indicated by the arrows profits decrease with increases in bull In this situation H prefers outsourcing to
insourcing regardless the manufacturing location because outsourcing has lower fixed costs and it gives H a lower fraction of revenue
bull Depending on whether the cross-county difference in the wage rate is small or large relative to the cross-country difference in the fixed organizational costs the resulting equilibrium can havebull outsourcing in both countriesbull outsourcing in the South only
Low headquarter intensity sector
IV ORGANIZATIONAL FORMS
bull When wage differential is small relative to to the fixed cost differential firms with a productivity higher than the productivity threshold will outsource in the North and firms with even higher productivity will outsource in the South
bull When wage differential is large relative to the fixed costs all firms with a productivity higher than the threshold will outsource in the South
bull With this threshold level being the intersection between the red line and the horizontal axis
(6)
Low headquarter intensity sector
IV ORGANIZATIONAL FORMS
High headquarter intensity sector bull A high headquarter intensity is depicted when As indicated by the arrows profits increase with increases in
bull The figure 4 shows us that is steeper than for
bull When wage differential is small relative to the fixed cost differential and when the sector is relatively more intensive in headquarter services the marginal return of headquarter services is high making underinvestment significantly costly for H Therefore in such a situation itrsquos always profitable for H to insource regardless the manufacturing location because
bull Integration gives H a larger share of revenue However variable costs are lower in the South For that reason can be steeper or flatter than This is to say that can be larger or smaller than
bull Depending on whether the cross-county difference in the wage rate is small or large relative to the difference between and the resulting equilibrium can have bull The four organizational formsbull Outsourcing in the North insourcing in the North and insourcing in the
Southbull Outsourcing in the North and insourcing in the North
(6)
IV ORGANIZATIONAL FORMS
High headquarter intensity sector
(6)
First case
bull It follows that
(14)
bull Given the orderings in (3) and (14) figure 4 shows us that all four organizational forms exist in equilibrium
IV ORGANIZATIONAL FORMS
High headquarter intensity sector
(6)
Second case
bull In this event (14) doesnrsquot hold anymore because and there are only two equilibrium possibilities
bull Either bull Integration in the North
dominates Consequently only 3 organizational forms can exist in equilibrium at best
bull Outsourcing in the North
bull Insourcing in the Northbull Insourcing in the South
IV ORGANIZATIONAL FORMS
High headquarter intensity sector Second case
bull In this event (14) doesnrsquot hold anymore because and there are only two equilibrium possibilities
bull Orbull Integration in the North
dominates outsourcing and insourcing in the South Consequently only two organizational forms can exist in equilibrium at most
bull Outsourcing in the North
bull Insourcing in the Northbull Hence there is no
international trade in inputs
(6)
V PREVALENCE OF ORGANIZATIONAL FORMS
Measure of prevalence the fraction of firms and market share
COMPONENT-INTENSIVE SECTOR
bull No firm integrates low η
The fraction of firms that outsource in the South
1 Lower wage in the south Raises the profit of outsourcing in the SouthRaises The minimal productivity to be active in the sector rises
SO
COMPONENT-INTENSIVE SECTOR
The fraction of firms that outsource in the South
2 Increase in the dispersion of productivity Raises
3 Higher headquarter intensity is less prevalent
4 Smaller fraction of the surplus from outsourcing in the south (β)Raises the profitability of outsourcing in the South is more prevalent
HEADQUARTER-INTENSIVE SECTOR
Organizational forms
HEADQUARTER-INTENSIVE SECTOR
1 Lower wage in the South
2 Increase of productivity dispersionDecline Increase and ambiguous effect in the others
3 Higher headquarter intensity (η) Domestic outsourcing is favored relative to foreign outsourcingIntegration is favored relative to outsourcingThe effects of η on the fraction of firms that insource in the south is ambiguous
HEADQUARTER-INTENSIVE SECTOR
4 Increase in the revenue shares4 Increase in (rises slope of the profit line)
SV
The fraction of outsourcing firms in the South declines and the fraction of insourcing firms in the South rises
HEADQUARTER-INTENSIVE SECTOR
4 Increase in the revenue shares5 Increase in (rises slope of the profit line)
NV The fraction of firms that
outsource in the north declines and these that insource in the north rises The fraction of firms that outsource in the south declines and these that insource in the south does not change
HEADQUARTER-INTENSIVE SECTOR
5 Increase in the primitive bargaining power parameter (β)
bull Shifts the bargaining power in favor of Hbull Outsourcing becomes more attractivebull ise bull The fraction of firms that import components
rises
VI CONCLUDING COMMENTS
1 The high-productivity firms -gt South2 In the same country high-productivity firms
insource 3 In sectors with very low intensity of headquarter
services no firm integrates 1 Low-productivity firms outsource at home 2 High-productivity firms outsource abroad
VI CONCLUDING COMMENTS
4 The prevalence of organizational forms depends on industry characteristics and on the degree of productivity dispersion across firms
1 Sectors with more productivity dispersion (lower z) more imported inputs
1 Within the headquarter-intensive sectors integration is more prevalent
2 Higher headquarter intensity less imported inputs 1 Within the headquarter-intensive sectors integration is more
prevalent
5 Lower wages in the south raises the fraction of firms that import intermediate inputs
1 It raises the fraction of firms that outsource in each country 2 Armrsquos length trade rises relative to intrafirm trade
II THE MODEL
bull Following the property rights approach to the theory of the firm we assume that ex post bargaining takes place both under outsourcing and under integration The distribution of surplus is sensitive however to the mode of organization
bull More specifically the outside option of H is assumed to be different when it owns the manufacturing plant than when it does not In the latter case a failure to reach an agreement on the distribution of the surplus leaves both parties with no income because the inputs are tailored specifically to the other party in the transaction
bull However by vertically integrating the production of components H is effectively buying the right to fire M and seize the inputs mj(i) If there were no costs associated with firing the operator of the manufacturing plant the final-good producer would always have an incentive to seize the inputs mj(i) ex post and M wouldhave an incentive to choose mj(i) = 0 ex ante (which of course would imply xj(i) = 0)
bull In this case integration would never be chosen We therefore assume that firing M results in a loss of a fraction 1 1113110- δ of final-good production because H cannot use the intermediate inputs without M as effectively as it can with the cooperation of M
bull We also assume that δN ge δS This captures the notion that a contractual breach is likely to be more costly to H when M is in the South More figuratively we think of this assumption as reflecting less corruption and better legal protection in the North As is clear from the weak inequality however our results still hold when δN = δS
bull The location of M and the mode of ownership are chosen ex ante by H to maximize its profits There is an infinitely elastic supply of M agents in each one of the countries Each final-good producer H offers a contract that seeks to attract a plant operator M The contract includes an up-front fee for participation in the relationship that has to be paid by M This fee can be positive or negative that is the operator can make a payment to the final-good producer or vice versa The purpose of the fee is to secure the participation of M in the relationship at minimum cost to H When the supply of M is infinitely elastic Mrsquos profits from the relationship net of the participation fee are equal in equilibrium to its ex ante outside option For simplicity we set Mrsquos ex ante outside option equal to zero in both countries It is however easy to extend the analysis to cases in which these outside options are positive and different in the North and in the South
III EQUILIBRIUM
bull The organizational structure equilibrium will be determined bybull Incentives created by different organizationsbull Differences in their fixed costsbull Wage differentials across countries
bull Being in an incomplete contract framework it means that the contract will be renegotiated at some point in time Therefore a bargaining game specification is needed
bull If the parties agree in the bargaining the potential revenue from the sale of the final good is given by
(4)
bull The resulting payoffs implies that the final-good producer (henceforth H) appropriate higher fraction of the revenue under integration than under outsourcing with this fraction being higher when integration takes place in the North The payoffs ordering are the following
(5)
III EQUILIBRIUM
bull As we are in an incomplete contract framework both H and M will choose their quantities noncooperatively Each one will produce the quantity that maximises their individual profits Total operating profits are given by
(6)
where
(7)
bull As H has to attract an M agent whose outside option (ie if they fail to agree) is zero and the contract includes a participation fee (t) which can be positive or negative the final-good production (H) will be the one who decides the organizational form because he will have the incentive to increase t as much as he can (as long as the payoff of M is not negative) As a result
III EQUILIBRIUM
bull Thus upon observing its productivity level H will decide the ownership structure and the location of manufacturing that maximizes (6) The productivity threshold will determine whether H exits the industry or not This productivity threshold depends on the sectorrsquos aggregate consumption index X and implies that
(9)
bull In fact to solve this optimization program the final-good producer will have to choose the triplet that maximizes (6)
bull Equation (6) puts in evidence that profits are decreasing both with and Hence from a cost saving point of view H faces a trade-off as fixed costs are higher in the South and variable costs are lower there ( )
bull Next the final good producer cannot freely choose its fraction of revenue bull Although a higher gives H a larger fraction of revenue it also induces M to produce fewer
components Therefore H trades the choice of a larger fraction of the revenue for a smaller revenue level In fact this fraction of revenue will be determined as follows
(10)
III EQUILIBRIUM
bull Each partyrsquos severity of underinvestment is inversely related to the fraction of the surplus that it appropriates Therefore ex ante efficiency requires giving a larger share of revenue to the party undertaking the relatively more important investment
IV ORGANIZATIONAL FORMS
bull Firms face two types of tensions when choosing the organizational formbull Regarding the location decision variable costs are lower in the South but fixed costs are lower in
the Northbull For the ownership decision the firm has to take into account the fact that insourcing entails higher
fixed costs and gives H a larger fraction of the revenue However if the effect of Mrsquos incentives are strong enough Hrsquos profits may be lower under integration (because if H appropriates a large fraction of revenue M will have no incentive to produce the components)
bull In component-intensive sectors firms donrsquot integrate high-productivity firms outsource in the South low-productivity firms outsource in the North and least productive firms exit the industry
bull In headquarter-intensive sectors we can find the four different organizational forms The most productive firms integrate in the South and somewhat less productive firms outsource in the South Firms with even lower productivity acquire components in the North and among them the more productive integrate and the less productive outsource Finally the least productive firms exit
IV ORGANIZATIONAL FORMS
bull A low headquarter intensity is depicted when As indicated by the arrows profits decrease with increases in bull In this situation H prefers outsourcing to
insourcing regardless the manufacturing location because outsourcing has lower fixed costs and it gives H a lower fraction of revenue
bull Depending on whether the cross-county difference in the wage rate is small or large relative to the cross-country difference in the fixed organizational costs the resulting equilibrium can havebull outsourcing in both countriesbull outsourcing in the South only
Low headquarter intensity sector
IV ORGANIZATIONAL FORMS
bull When wage differential is small relative to to the fixed cost differential firms with a productivity higher than the productivity threshold will outsource in the North and firms with even higher productivity will outsource in the South
bull When wage differential is large relative to the fixed costs all firms with a productivity higher than the threshold will outsource in the South
bull With this threshold level being the intersection between the red line and the horizontal axis
(6)
Low headquarter intensity sector
IV ORGANIZATIONAL FORMS
High headquarter intensity sector bull A high headquarter intensity is depicted when As indicated by the arrows profits increase with increases in
bull The figure 4 shows us that is steeper than for
bull When wage differential is small relative to the fixed cost differential and when the sector is relatively more intensive in headquarter services the marginal return of headquarter services is high making underinvestment significantly costly for H Therefore in such a situation itrsquos always profitable for H to insource regardless the manufacturing location because
bull Integration gives H a larger share of revenue However variable costs are lower in the South For that reason can be steeper or flatter than This is to say that can be larger or smaller than
bull Depending on whether the cross-county difference in the wage rate is small or large relative to the difference between and the resulting equilibrium can have bull The four organizational formsbull Outsourcing in the North insourcing in the North and insourcing in the
Southbull Outsourcing in the North and insourcing in the North
(6)
IV ORGANIZATIONAL FORMS
High headquarter intensity sector
(6)
First case
bull It follows that
(14)
bull Given the orderings in (3) and (14) figure 4 shows us that all four organizational forms exist in equilibrium
IV ORGANIZATIONAL FORMS
High headquarter intensity sector
(6)
Second case
bull In this event (14) doesnrsquot hold anymore because and there are only two equilibrium possibilities
bull Either bull Integration in the North
dominates Consequently only 3 organizational forms can exist in equilibrium at best
bull Outsourcing in the North
bull Insourcing in the Northbull Insourcing in the South
IV ORGANIZATIONAL FORMS
High headquarter intensity sector Second case
bull In this event (14) doesnrsquot hold anymore because and there are only two equilibrium possibilities
bull Orbull Integration in the North
dominates outsourcing and insourcing in the South Consequently only two organizational forms can exist in equilibrium at most
bull Outsourcing in the North
bull Insourcing in the Northbull Hence there is no
international trade in inputs
(6)
V PREVALENCE OF ORGANIZATIONAL FORMS
Measure of prevalence the fraction of firms and market share
COMPONENT-INTENSIVE SECTOR
bull No firm integrates low η
The fraction of firms that outsource in the South
1 Lower wage in the south Raises the profit of outsourcing in the SouthRaises The minimal productivity to be active in the sector rises
SO
COMPONENT-INTENSIVE SECTOR
The fraction of firms that outsource in the South
2 Increase in the dispersion of productivity Raises
3 Higher headquarter intensity is less prevalent
4 Smaller fraction of the surplus from outsourcing in the south (β)Raises the profitability of outsourcing in the South is more prevalent
HEADQUARTER-INTENSIVE SECTOR
Organizational forms
HEADQUARTER-INTENSIVE SECTOR
1 Lower wage in the South
2 Increase of productivity dispersionDecline Increase and ambiguous effect in the others
3 Higher headquarter intensity (η) Domestic outsourcing is favored relative to foreign outsourcingIntegration is favored relative to outsourcingThe effects of η on the fraction of firms that insource in the south is ambiguous
HEADQUARTER-INTENSIVE SECTOR
4 Increase in the revenue shares4 Increase in (rises slope of the profit line)
SV
The fraction of outsourcing firms in the South declines and the fraction of insourcing firms in the South rises
HEADQUARTER-INTENSIVE SECTOR
4 Increase in the revenue shares5 Increase in (rises slope of the profit line)
NV The fraction of firms that
outsource in the north declines and these that insource in the north rises The fraction of firms that outsource in the south declines and these that insource in the south does not change
HEADQUARTER-INTENSIVE SECTOR
5 Increase in the primitive bargaining power parameter (β)
bull Shifts the bargaining power in favor of Hbull Outsourcing becomes more attractivebull ise bull The fraction of firms that import components
rises
VI CONCLUDING COMMENTS
1 The high-productivity firms -gt South2 In the same country high-productivity firms
insource 3 In sectors with very low intensity of headquarter
services no firm integrates 1 Low-productivity firms outsource at home 2 High-productivity firms outsource abroad
VI CONCLUDING COMMENTS
4 The prevalence of organizational forms depends on industry characteristics and on the degree of productivity dispersion across firms
1 Sectors with more productivity dispersion (lower z) more imported inputs
1 Within the headquarter-intensive sectors integration is more prevalent
2 Higher headquarter intensity less imported inputs 1 Within the headquarter-intensive sectors integration is more
prevalent
5 Lower wages in the south raises the fraction of firms that import intermediate inputs
1 It raises the fraction of firms that outsource in each country 2 Armrsquos length trade rises relative to intrafirm trade
III EQUILIBRIUM
bull The organizational structure equilibrium will be determined bybull Incentives created by different organizationsbull Differences in their fixed costsbull Wage differentials across countries
bull Being in an incomplete contract framework it means that the contract will be renegotiated at some point in time Therefore a bargaining game specification is needed
bull If the parties agree in the bargaining the potential revenue from the sale of the final good is given by
(4)
bull The resulting payoffs implies that the final-good producer (henceforth H) appropriate higher fraction of the revenue under integration than under outsourcing with this fraction being higher when integration takes place in the North The payoffs ordering are the following
(5)
III EQUILIBRIUM
bull As we are in an incomplete contract framework both H and M will choose their quantities noncooperatively Each one will produce the quantity that maximises their individual profits Total operating profits are given by
(6)
where
(7)
bull As H has to attract an M agent whose outside option (ie if they fail to agree) is zero and the contract includes a participation fee (t) which can be positive or negative the final-good production (H) will be the one who decides the organizational form because he will have the incentive to increase t as much as he can (as long as the payoff of M is not negative) As a result
III EQUILIBRIUM
bull Thus upon observing its productivity level H will decide the ownership structure and the location of manufacturing that maximizes (6) The productivity threshold will determine whether H exits the industry or not This productivity threshold depends on the sectorrsquos aggregate consumption index X and implies that
(9)
bull In fact to solve this optimization program the final-good producer will have to choose the triplet that maximizes (6)
bull Equation (6) puts in evidence that profits are decreasing both with and Hence from a cost saving point of view H faces a trade-off as fixed costs are higher in the South and variable costs are lower there ( )
bull Next the final good producer cannot freely choose its fraction of revenue bull Although a higher gives H a larger fraction of revenue it also induces M to produce fewer
components Therefore H trades the choice of a larger fraction of the revenue for a smaller revenue level In fact this fraction of revenue will be determined as follows
(10)
III EQUILIBRIUM
bull Each partyrsquos severity of underinvestment is inversely related to the fraction of the surplus that it appropriates Therefore ex ante efficiency requires giving a larger share of revenue to the party undertaking the relatively more important investment
IV ORGANIZATIONAL FORMS
bull Firms face two types of tensions when choosing the organizational formbull Regarding the location decision variable costs are lower in the South but fixed costs are lower in
the Northbull For the ownership decision the firm has to take into account the fact that insourcing entails higher
fixed costs and gives H a larger fraction of the revenue However if the effect of Mrsquos incentives are strong enough Hrsquos profits may be lower under integration (because if H appropriates a large fraction of revenue M will have no incentive to produce the components)
bull In component-intensive sectors firms donrsquot integrate high-productivity firms outsource in the South low-productivity firms outsource in the North and least productive firms exit the industry
bull In headquarter-intensive sectors we can find the four different organizational forms The most productive firms integrate in the South and somewhat less productive firms outsource in the South Firms with even lower productivity acquire components in the North and among them the more productive integrate and the less productive outsource Finally the least productive firms exit
IV ORGANIZATIONAL FORMS
bull A low headquarter intensity is depicted when As indicated by the arrows profits decrease with increases in bull In this situation H prefers outsourcing to
insourcing regardless the manufacturing location because outsourcing has lower fixed costs and it gives H a lower fraction of revenue
bull Depending on whether the cross-county difference in the wage rate is small or large relative to the cross-country difference in the fixed organizational costs the resulting equilibrium can havebull outsourcing in both countriesbull outsourcing in the South only
Low headquarter intensity sector
IV ORGANIZATIONAL FORMS
bull When wage differential is small relative to to the fixed cost differential firms with a productivity higher than the productivity threshold will outsource in the North and firms with even higher productivity will outsource in the South
bull When wage differential is large relative to the fixed costs all firms with a productivity higher than the threshold will outsource in the South
bull With this threshold level being the intersection between the red line and the horizontal axis
(6)
Low headquarter intensity sector
IV ORGANIZATIONAL FORMS
High headquarter intensity sector bull A high headquarter intensity is depicted when As indicated by the arrows profits increase with increases in
bull The figure 4 shows us that is steeper than for
bull When wage differential is small relative to the fixed cost differential and when the sector is relatively more intensive in headquarter services the marginal return of headquarter services is high making underinvestment significantly costly for H Therefore in such a situation itrsquos always profitable for H to insource regardless the manufacturing location because
bull Integration gives H a larger share of revenue However variable costs are lower in the South For that reason can be steeper or flatter than This is to say that can be larger or smaller than
bull Depending on whether the cross-county difference in the wage rate is small or large relative to the difference between and the resulting equilibrium can have bull The four organizational formsbull Outsourcing in the North insourcing in the North and insourcing in the
Southbull Outsourcing in the North and insourcing in the North
(6)
IV ORGANIZATIONAL FORMS
High headquarter intensity sector
(6)
First case
bull It follows that
(14)
bull Given the orderings in (3) and (14) figure 4 shows us that all four organizational forms exist in equilibrium
IV ORGANIZATIONAL FORMS
High headquarter intensity sector
(6)
Second case
bull In this event (14) doesnrsquot hold anymore because and there are only two equilibrium possibilities
bull Either bull Integration in the North
dominates Consequently only 3 organizational forms can exist in equilibrium at best
bull Outsourcing in the North
bull Insourcing in the Northbull Insourcing in the South
IV ORGANIZATIONAL FORMS
High headquarter intensity sector Second case
bull In this event (14) doesnrsquot hold anymore because and there are only two equilibrium possibilities
bull Orbull Integration in the North
dominates outsourcing and insourcing in the South Consequently only two organizational forms can exist in equilibrium at most
bull Outsourcing in the North
bull Insourcing in the Northbull Hence there is no
international trade in inputs
(6)
V PREVALENCE OF ORGANIZATIONAL FORMS
Measure of prevalence the fraction of firms and market share
COMPONENT-INTENSIVE SECTOR
bull No firm integrates low η
The fraction of firms that outsource in the South
1 Lower wage in the south Raises the profit of outsourcing in the SouthRaises The minimal productivity to be active in the sector rises
SO
COMPONENT-INTENSIVE SECTOR
The fraction of firms that outsource in the South
2 Increase in the dispersion of productivity Raises
3 Higher headquarter intensity is less prevalent
4 Smaller fraction of the surplus from outsourcing in the south (β)Raises the profitability of outsourcing in the South is more prevalent
HEADQUARTER-INTENSIVE SECTOR
Organizational forms
HEADQUARTER-INTENSIVE SECTOR
1 Lower wage in the South
2 Increase of productivity dispersionDecline Increase and ambiguous effect in the others
3 Higher headquarter intensity (η) Domestic outsourcing is favored relative to foreign outsourcingIntegration is favored relative to outsourcingThe effects of η on the fraction of firms that insource in the south is ambiguous
HEADQUARTER-INTENSIVE SECTOR
4 Increase in the revenue shares4 Increase in (rises slope of the profit line)
SV
The fraction of outsourcing firms in the South declines and the fraction of insourcing firms in the South rises
HEADQUARTER-INTENSIVE SECTOR
4 Increase in the revenue shares5 Increase in (rises slope of the profit line)
NV The fraction of firms that
outsource in the north declines and these that insource in the north rises The fraction of firms that outsource in the south declines and these that insource in the south does not change
HEADQUARTER-INTENSIVE SECTOR
5 Increase in the primitive bargaining power parameter (β)
bull Shifts the bargaining power in favor of Hbull Outsourcing becomes more attractivebull ise bull The fraction of firms that import components
rises
VI CONCLUDING COMMENTS
1 The high-productivity firms -gt South2 In the same country high-productivity firms
insource 3 In sectors with very low intensity of headquarter
services no firm integrates 1 Low-productivity firms outsource at home 2 High-productivity firms outsource abroad
VI CONCLUDING COMMENTS
4 The prevalence of organizational forms depends on industry characteristics and on the degree of productivity dispersion across firms
1 Sectors with more productivity dispersion (lower z) more imported inputs
1 Within the headquarter-intensive sectors integration is more prevalent
2 Higher headquarter intensity less imported inputs 1 Within the headquarter-intensive sectors integration is more
prevalent
5 Lower wages in the south raises the fraction of firms that import intermediate inputs
1 It raises the fraction of firms that outsource in each country 2 Armrsquos length trade rises relative to intrafirm trade
III EQUILIBRIUM
bull As we are in an incomplete contract framework both H and M will choose their quantities noncooperatively Each one will produce the quantity that maximises their individual profits Total operating profits are given by
(6)
where
(7)
bull As H has to attract an M agent whose outside option (ie if they fail to agree) is zero and the contract includes a participation fee (t) which can be positive or negative the final-good production (H) will be the one who decides the organizational form because he will have the incentive to increase t as much as he can (as long as the payoff of M is not negative) As a result
III EQUILIBRIUM
bull Thus upon observing its productivity level H will decide the ownership structure and the location of manufacturing that maximizes (6) The productivity threshold will determine whether H exits the industry or not This productivity threshold depends on the sectorrsquos aggregate consumption index X and implies that
(9)
bull In fact to solve this optimization program the final-good producer will have to choose the triplet that maximizes (6)
bull Equation (6) puts in evidence that profits are decreasing both with and Hence from a cost saving point of view H faces a trade-off as fixed costs are higher in the South and variable costs are lower there ( )
bull Next the final good producer cannot freely choose its fraction of revenue bull Although a higher gives H a larger fraction of revenue it also induces M to produce fewer
components Therefore H trades the choice of a larger fraction of the revenue for a smaller revenue level In fact this fraction of revenue will be determined as follows
(10)
III EQUILIBRIUM
bull Each partyrsquos severity of underinvestment is inversely related to the fraction of the surplus that it appropriates Therefore ex ante efficiency requires giving a larger share of revenue to the party undertaking the relatively more important investment
IV ORGANIZATIONAL FORMS
bull Firms face two types of tensions when choosing the organizational formbull Regarding the location decision variable costs are lower in the South but fixed costs are lower in
the Northbull For the ownership decision the firm has to take into account the fact that insourcing entails higher
fixed costs and gives H a larger fraction of the revenue However if the effect of Mrsquos incentives are strong enough Hrsquos profits may be lower under integration (because if H appropriates a large fraction of revenue M will have no incentive to produce the components)
bull In component-intensive sectors firms donrsquot integrate high-productivity firms outsource in the South low-productivity firms outsource in the North and least productive firms exit the industry
bull In headquarter-intensive sectors we can find the four different organizational forms The most productive firms integrate in the South and somewhat less productive firms outsource in the South Firms with even lower productivity acquire components in the North and among them the more productive integrate and the less productive outsource Finally the least productive firms exit
IV ORGANIZATIONAL FORMS
bull A low headquarter intensity is depicted when As indicated by the arrows profits decrease with increases in bull In this situation H prefers outsourcing to
insourcing regardless the manufacturing location because outsourcing has lower fixed costs and it gives H a lower fraction of revenue
bull Depending on whether the cross-county difference in the wage rate is small or large relative to the cross-country difference in the fixed organizational costs the resulting equilibrium can havebull outsourcing in both countriesbull outsourcing in the South only
Low headquarter intensity sector
IV ORGANIZATIONAL FORMS
bull When wage differential is small relative to to the fixed cost differential firms with a productivity higher than the productivity threshold will outsource in the North and firms with even higher productivity will outsource in the South
bull When wage differential is large relative to the fixed costs all firms with a productivity higher than the threshold will outsource in the South
bull With this threshold level being the intersection between the red line and the horizontal axis
(6)
Low headquarter intensity sector
IV ORGANIZATIONAL FORMS
High headquarter intensity sector bull A high headquarter intensity is depicted when As indicated by the arrows profits increase with increases in
bull The figure 4 shows us that is steeper than for
bull When wage differential is small relative to the fixed cost differential and when the sector is relatively more intensive in headquarter services the marginal return of headquarter services is high making underinvestment significantly costly for H Therefore in such a situation itrsquos always profitable for H to insource regardless the manufacturing location because
bull Integration gives H a larger share of revenue However variable costs are lower in the South For that reason can be steeper or flatter than This is to say that can be larger or smaller than
bull Depending on whether the cross-county difference in the wage rate is small or large relative to the difference between and the resulting equilibrium can have bull The four organizational formsbull Outsourcing in the North insourcing in the North and insourcing in the
Southbull Outsourcing in the North and insourcing in the North
(6)
IV ORGANIZATIONAL FORMS
High headquarter intensity sector
(6)
First case
bull It follows that
(14)
bull Given the orderings in (3) and (14) figure 4 shows us that all four organizational forms exist in equilibrium
IV ORGANIZATIONAL FORMS
High headquarter intensity sector
(6)
Second case
bull In this event (14) doesnrsquot hold anymore because and there are only two equilibrium possibilities
bull Either bull Integration in the North
dominates Consequently only 3 organizational forms can exist in equilibrium at best
bull Outsourcing in the North
bull Insourcing in the Northbull Insourcing in the South
IV ORGANIZATIONAL FORMS
High headquarter intensity sector Second case
bull In this event (14) doesnrsquot hold anymore because and there are only two equilibrium possibilities
bull Orbull Integration in the North
dominates outsourcing and insourcing in the South Consequently only two organizational forms can exist in equilibrium at most
bull Outsourcing in the North
bull Insourcing in the Northbull Hence there is no
international trade in inputs
(6)
V PREVALENCE OF ORGANIZATIONAL FORMS
Measure of prevalence the fraction of firms and market share
COMPONENT-INTENSIVE SECTOR
bull No firm integrates low η
The fraction of firms that outsource in the South
1 Lower wage in the south Raises the profit of outsourcing in the SouthRaises The minimal productivity to be active in the sector rises
SO
COMPONENT-INTENSIVE SECTOR
The fraction of firms that outsource in the South
2 Increase in the dispersion of productivity Raises
3 Higher headquarter intensity is less prevalent
4 Smaller fraction of the surplus from outsourcing in the south (β)Raises the profitability of outsourcing in the South is more prevalent
HEADQUARTER-INTENSIVE SECTOR
Organizational forms
HEADQUARTER-INTENSIVE SECTOR
1 Lower wage in the South
2 Increase of productivity dispersionDecline Increase and ambiguous effect in the others
3 Higher headquarter intensity (η) Domestic outsourcing is favored relative to foreign outsourcingIntegration is favored relative to outsourcingThe effects of η on the fraction of firms that insource in the south is ambiguous
HEADQUARTER-INTENSIVE SECTOR
4 Increase in the revenue shares4 Increase in (rises slope of the profit line)
SV
The fraction of outsourcing firms in the South declines and the fraction of insourcing firms in the South rises
HEADQUARTER-INTENSIVE SECTOR
4 Increase in the revenue shares5 Increase in (rises slope of the profit line)
NV The fraction of firms that
outsource in the north declines and these that insource in the north rises The fraction of firms that outsource in the south declines and these that insource in the south does not change
HEADQUARTER-INTENSIVE SECTOR
5 Increase in the primitive bargaining power parameter (β)
bull Shifts the bargaining power in favor of Hbull Outsourcing becomes more attractivebull ise bull The fraction of firms that import components
rises
VI CONCLUDING COMMENTS
1 The high-productivity firms -gt South2 In the same country high-productivity firms
insource 3 In sectors with very low intensity of headquarter
services no firm integrates 1 Low-productivity firms outsource at home 2 High-productivity firms outsource abroad
VI CONCLUDING COMMENTS
4 The prevalence of organizational forms depends on industry characteristics and on the degree of productivity dispersion across firms
1 Sectors with more productivity dispersion (lower z) more imported inputs
1 Within the headquarter-intensive sectors integration is more prevalent
2 Higher headquarter intensity less imported inputs 1 Within the headquarter-intensive sectors integration is more
prevalent
5 Lower wages in the south raises the fraction of firms that import intermediate inputs
1 It raises the fraction of firms that outsource in each country 2 Armrsquos length trade rises relative to intrafirm trade
III EQUILIBRIUM
bull Thus upon observing its productivity level H will decide the ownership structure and the location of manufacturing that maximizes (6) The productivity threshold will determine whether H exits the industry or not This productivity threshold depends on the sectorrsquos aggregate consumption index X and implies that
(9)
bull In fact to solve this optimization program the final-good producer will have to choose the triplet that maximizes (6)
bull Equation (6) puts in evidence that profits are decreasing both with and Hence from a cost saving point of view H faces a trade-off as fixed costs are higher in the South and variable costs are lower there ( )
bull Next the final good producer cannot freely choose its fraction of revenue bull Although a higher gives H a larger fraction of revenue it also induces M to produce fewer
components Therefore H trades the choice of a larger fraction of the revenue for a smaller revenue level In fact this fraction of revenue will be determined as follows
(10)
III EQUILIBRIUM
bull Each partyrsquos severity of underinvestment is inversely related to the fraction of the surplus that it appropriates Therefore ex ante efficiency requires giving a larger share of revenue to the party undertaking the relatively more important investment
IV ORGANIZATIONAL FORMS
bull Firms face two types of tensions when choosing the organizational formbull Regarding the location decision variable costs are lower in the South but fixed costs are lower in
the Northbull For the ownership decision the firm has to take into account the fact that insourcing entails higher
fixed costs and gives H a larger fraction of the revenue However if the effect of Mrsquos incentives are strong enough Hrsquos profits may be lower under integration (because if H appropriates a large fraction of revenue M will have no incentive to produce the components)
bull In component-intensive sectors firms donrsquot integrate high-productivity firms outsource in the South low-productivity firms outsource in the North and least productive firms exit the industry
bull In headquarter-intensive sectors we can find the four different organizational forms The most productive firms integrate in the South and somewhat less productive firms outsource in the South Firms with even lower productivity acquire components in the North and among them the more productive integrate and the less productive outsource Finally the least productive firms exit
IV ORGANIZATIONAL FORMS
bull A low headquarter intensity is depicted when As indicated by the arrows profits decrease with increases in bull In this situation H prefers outsourcing to
insourcing regardless the manufacturing location because outsourcing has lower fixed costs and it gives H a lower fraction of revenue
bull Depending on whether the cross-county difference in the wage rate is small or large relative to the cross-country difference in the fixed organizational costs the resulting equilibrium can havebull outsourcing in both countriesbull outsourcing in the South only
Low headquarter intensity sector
IV ORGANIZATIONAL FORMS
bull When wage differential is small relative to to the fixed cost differential firms with a productivity higher than the productivity threshold will outsource in the North and firms with even higher productivity will outsource in the South
bull When wage differential is large relative to the fixed costs all firms with a productivity higher than the threshold will outsource in the South
bull With this threshold level being the intersection between the red line and the horizontal axis
(6)
Low headquarter intensity sector
IV ORGANIZATIONAL FORMS
High headquarter intensity sector bull A high headquarter intensity is depicted when As indicated by the arrows profits increase with increases in
bull The figure 4 shows us that is steeper than for
bull When wage differential is small relative to the fixed cost differential and when the sector is relatively more intensive in headquarter services the marginal return of headquarter services is high making underinvestment significantly costly for H Therefore in such a situation itrsquos always profitable for H to insource regardless the manufacturing location because
bull Integration gives H a larger share of revenue However variable costs are lower in the South For that reason can be steeper or flatter than This is to say that can be larger or smaller than
bull Depending on whether the cross-county difference in the wage rate is small or large relative to the difference between and the resulting equilibrium can have bull The four organizational formsbull Outsourcing in the North insourcing in the North and insourcing in the
Southbull Outsourcing in the North and insourcing in the North
(6)
IV ORGANIZATIONAL FORMS
High headquarter intensity sector
(6)
First case
bull It follows that
(14)
bull Given the orderings in (3) and (14) figure 4 shows us that all four organizational forms exist in equilibrium
IV ORGANIZATIONAL FORMS
High headquarter intensity sector
(6)
Second case
bull In this event (14) doesnrsquot hold anymore because and there are only two equilibrium possibilities
bull Either bull Integration in the North
dominates Consequently only 3 organizational forms can exist in equilibrium at best
bull Outsourcing in the North
bull Insourcing in the Northbull Insourcing in the South
IV ORGANIZATIONAL FORMS
High headquarter intensity sector Second case
bull In this event (14) doesnrsquot hold anymore because and there are only two equilibrium possibilities
bull Orbull Integration in the North
dominates outsourcing and insourcing in the South Consequently only two organizational forms can exist in equilibrium at most
bull Outsourcing in the North
bull Insourcing in the Northbull Hence there is no
international trade in inputs
(6)
V PREVALENCE OF ORGANIZATIONAL FORMS
Measure of prevalence the fraction of firms and market share
COMPONENT-INTENSIVE SECTOR
bull No firm integrates low η
The fraction of firms that outsource in the South
1 Lower wage in the south Raises the profit of outsourcing in the SouthRaises The minimal productivity to be active in the sector rises
SO
COMPONENT-INTENSIVE SECTOR
The fraction of firms that outsource in the South
2 Increase in the dispersion of productivity Raises
3 Higher headquarter intensity is less prevalent
4 Smaller fraction of the surplus from outsourcing in the south (β)Raises the profitability of outsourcing in the South is more prevalent
HEADQUARTER-INTENSIVE SECTOR
Organizational forms
HEADQUARTER-INTENSIVE SECTOR
1 Lower wage in the South
2 Increase of productivity dispersionDecline Increase and ambiguous effect in the others
3 Higher headquarter intensity (η) Domestic outsourcing is favored relative to foreign outsourcingIntegration is favored relative to outsourcingThe effects of η on the fraction of firms that insource in the south is ambiguous
HEADQUARTER-INTENSIVE SECTOR
4 Increase in the revenue shares4 Increase in (rises slope of the profit line)
SV
The fraction of outsourcing firms in the South declines and the fraction of insourcing firms in the South rises
HEADQUARTER-INTENSIVE SECTOR
4 Increase in the revenue shares5 Increase in (rises slope of the profit line)
NV The fraction of firms that
outsource in the north declines and these that insource in the north rises The fraction of firms that outsource in the south declines and these that insource in the south does not change
HEADQUARTER-INTENSIVE SECTOR
5 Increase in the primitive bargaining power parameter (β)
bull Shifts the bargaining power in favor of Hbull Outsourcing becomes more attractivebull ise bull The fraction of firms that import components
rises
VI CONCLUDING COMMENTS
1 The high-productivity firms -gt South2 In the same country high-productivity firms
insource 3 In sectors with very low intensity of headquarter
services no firm integrates 1 Low-productivity firms outsource at home 2 High-productivity firms outsource abroad
VI CONCLUDING COMMENTS
4 The prevalence of organizational forms depends on industry characteristics and on the degree of productivity dispersion across firms
1 Sectors with more productivity dispersion (lower z) more imported inputs
1 Within the headquarter-intensive sectors integration is more prevalent
2 Higher headquarter intensity less imported inputs 1 Within the headquarter-intensive sectors integration is more
prevalent
5 Lower wages in the south raises the fraction of firms that import intermediate inputs
1 It raises the fraction of firms that outsource in each country 2 Armrsquos length trade rises relative to intrafirm trade
III EQUILIBRIUM
bull Each partyrsquos severity of underinvestment is inversely related to the fraction of the surplus that it appropriates Therefore ex ante efficiency requires giving a larger share of revenue to the party undertaking the relatively more important investment
IV ORGANIZATIONAL FORMS
bull Firms face two types of tensions when choosing the organizational formbull Regarding the location decision variable costs are lower in the South but fixed costs are lower in
the Northbull For the ownership decision the firm has to take into account the fact that insourcing entails higher
fixed costs and gives H a larger fraction of the revenue However if the effect of Mrsquos incentives are strong enough Hrsquos profits may be lower under integration (because if H appropriates a large fraction of revenue M will have no incentive to produce the components)
bull In component-intensive sectors firms donrsquot integrate high-productivity firms outsource in the South low-productivity firms outsource in the North and least productive firms exit the industry
bull In headquarter-intensive sectors we can find the four different organizational forms The most productive firms integrate in the South and somewhat less productive firms outsource in the South Firms with even lower productivity acquire components in the North and among them the more productive integrate and the less productive outsource Finally the least productive firms exit
IV ORGANIZATIONAL FORMS
bull A low headquarter intensity is depicted when As indicated by the arrows profits decrease with increases in bull In this situation H prefers outsourcing to
insourcing regardless the manufacturing location because outsourcing has lower fixed costs and it gives H a lower fraction of revenue
bull Depending on whether the cross-county difference in the wage rate is small or large relative to the cross-country difference in the fixed organizational costs the resulting equilibrium can havebull outsourcing in both countriesbull outsourcing in the South only
Low headquarter intensity sector
IV ORGANIZATIONAL FORMS
bull When wage differential is small relative to to the fixed cost differential firms with a productivity higher than the productivity threshold will outsource in the North and firms with even higher productivity will outsource in the South
bull When wage differential is large relative to the fixed costs all firms with a productivity higher than the threshold will outsource in the South
bull With this threshold level being the intersection between the red line and the horizontal axis
(6)
Low headquarter intensity sector
IV ORGANIZATIONAL FORMS
High headquarter intensity sector bull A high headquarter intensity is depicted when As indicated by the arrows profits increase with increases in
bull The figure 4 shows us that is steeper than for
bull When wage differential is small relative to the fixed cost differential and when the sector is relatively more intensive in headquarter services the marginal return of headquarter services is high making underinvestment significantly costly for H Therefore in such a situation itrsquos always profitable for H to insource regardless the manufacturing location because
bull Integration gives H a larger share of revenue However variable costs are lower in the South For that reason can be steeper or flatter than This is to say that can be larger or smaller than
bull Depending on whether the cross-county difference in the wage rate is small or large relative to the difference between and the resulting equilibrium can have bull The four organizational formsbull Outsourcing in the North insourcing in the North and insourcing in the
Southbull Outsourcing in the North and insourcing in the North
(6)
IV ORGANIZATIONAL FORMS
High headquarter intensity sector
(6)
First case
bull It follows that
(14)
bull Given the orderings in (3) and (14) figure 4 shows us that all four organizational forms exist in equilibrium
IV ORGANIZATIONAL FORMS
High headquarter intensity sector
(6)
Second case
bull In this event (14) doesnrsquot hold anymore because and there are only two equilibrium possibilities
bull Either bull Integration in the North
dominates Consequently only 3 organizational forms can exist in equilibrium at best
bull Outsourcing in the North
bull Insourcing in the Northbull Insourcing in the South
IV ORGANIZATIONAL FORMS
High headquarter intensity sector Second case
bull In this event (14) doesnrsquot hold anymore because and there are only two equilibrium possibilities
bull Orbull Integration in the North
dominates outsourcing and insourcing in the South Consequently only two organizational forms can exist in equilibrium at most
bull Outsourcing in the North
bull Insourcing in the Northbull Hence there is no
international trade in inputs
(6)
V PREVALENCE OF ORGANIZATIONAL FORMS
Measure of prevalence the fraction of firms and market share
COMPONENT-INTENSIVE SECTOR
bull No firm integrates low η
The fraction of firms that outsource in the South
1 Lower wage in the south Raises the profit of outsourcing in the SouthRaises The minimal productivity to be active in the sector rises
SO
COMPONENT-INTENSIVE SECTOR
The fraction of firms that outsource in the South
2 Increase in the dispersion of productivity Raises
3 Higher headquarter intensity is less prevalent
4 Smaller fraction of the surplus from outsourcing in the south (β)Raises the profitability of outsourcing in the South is more prevalent
HEADQUARTER-INTENSIVE SECTOR
Organizational forms
HEADQUARTER-INTENSIVE SECTOR
1 Lower wage in the South
2 Increase of productivity dispersionDecline Increase and ambiguous effect in the others
3 Higher headquarter intensity (η) Domestic outsourcing is favored relative to foreign outsourcingIntegration is favored relative to outsourcingThe effects of η on the fraction of firms that insource in the south is ambiguous
HEADQUARTER-INTENSIVE SECTOR
4 Increase in the revenue shares4 Increase in (rises slope of the profit line)
SV
The fraction of outsourcing firms in the South declines and the fraction of insourcing firms in the South rises
HEADQUARTER-INTENSIVE SECTOR
4 Increase in the revenue shares5 Increase in (rises slope of the profit line)
NV The fraction of firms that
outsource in the north declines and these that insource in the north rises The fraction of firms that outsource in the south declines and these that insource in the south does not change
HEADQUARTER-INTENSIVE SECTOR
5 Increase in the primitive bargaining power parameter (β)
bull Shifts the bargaining power in favor of Hbull Outsourcing becomes more attractivebull ise bull The fraction of firms that import components
rises
VI CONCLUDING COMMENTS
1 The high-productivity firms -gt South2 In the same country high-productivity firms
insource 3 In sectors with very low intensity of headquarter
services no firm integrates 1 Low-productivity firms outsource at home 2 High-productivity firms outsource abroad
VI CONCLUDING COMMENTS
4 The prevalence of organizational forms depends on industry characteristics and on the degree of productivity dispersion across firms
1 Sectors with more productivity dispersion (lower z) more imported inputs
1 Within the headquarter-intensive sectors integration is more prevalent
2 Higher headquarter intensity less imported inputs 1 Within the headquarter-intensive sectors integration is more
prevalent
5 Lower wages in the south raises the fraction of firms that import intermediate inputs
1 It raises the fraction of firms that outsource in each country 2 Armrsquos length trade rises relative to intrafirm trade
IV ORGANIZATIONAL FORMS
bull Firms face two types of tensions when choosing the organizational formbull Regarding the location decision variable costs are lower in the South but fixed costs are lower in
the Northbull For the ownership decision the firm has to take into account the fact that insourcing entails higher
fixed costs and gives H a larger fraction of the revenue However if the effect of Mrsquos incentives are strong enough Hrsquos profits may be lower under integration (because if H appropriates a large fraction of revenue M will have no incentive to produce the components)
bull In component-intensive sectors firms donrsquot integrate high-productivity firms outsource in the South low-productivity firms outsource in the North and least productive firms exit the industry
bull In headquarter-intensive sectors we can find the four different organizational forms The most productive firms integrate in the South and somewhat less productive firms outsource in the South Firms with even lower productivity acquire components in the North and among them the more productive integrate and the less productive outsource Finally the least productive firms exit
IV ORGANIZATIONAL FORMS
bull A low headquarter intensity is depicted when As indicated by the arrows profits decrease with increases in bull In this situation H prefers outsourcing to
insourcing regardless the manufacturing location because outsourcing has lower fixed costs and it gives H a lower fraction of revenue
bull Depending on whether the cross-county difference in the wage rate is small or large relative to the cross-country difference in the fixed organizational costs the resulting equilibrium can havebull outsourcing in both countriesbull outsourcing in the South only
Low headquarter intensity sector
IV ORGANIZATIONAL FORMS
bull When wage differential is small relative to to the fixed cost differential firms with a productivity higher than the productivity threshold will outsource in the North and firms with even higher productivity will outsource in the South
bull When wage differential is large relative to the fixed costs all firms with a productivity higher than the threshold will outsource in the South
bull With this threshold level being the intersection between the red line and the horizontal axis
(6)
Low headquarter intensity sector
IV ORGANIZATIONAL FORMS
High headquarter intensity sector bull A high headquarter intensity is depicted when As indicated by the arrows profits increase with increases in
bull The figure 4 shows us that is steeper than for
bull When wage differential is small relative to the fixed cost differential and when the sector is relatively more intensive in headquarter services the marginal return of headquarter services is high making underinvestment significantly costly for H Therefore in such a situation itrsquos always profitable for H to insource regardless the manufacturing location because
bull Integration gives H a larger share of revenue However variable costs are lower in the South For that reason can be steeper or flatter than This is to say that can be larger or smaller than
bull Depending on whether the cross-county difference in the wage rate is small or large relative to the difference between and the resulting equilibrium can have bull The four organizational formsbull Outsourcing in the North insourcing in the North and insourcing in the
Southbull Outsourcing in the North and insourcing in the North
(6)
IV ORGANIZATIONAL FORMS
High headquarter intensity sector
(6)
First case
bull It follows that
(14)
bull Given the orderings in (3) and (14) figure 4 shows us that all four organizational forms exist in equilibrium
IV ORGANIZATIONAL FORMS
High headquarter intensity sector
(6)
Second case
bull In this event (14) doesnrsquot hold anymore because and there are only two equilibrium possibilities
bull Either bull Integration in the North
dominates Consequently only 3 organizational forms can exist in equilibrium at best
bull Outsourcing in the North
bull Insourcing in the Northbull Insourcing in the South
IV ORGANIZATIONAL FORMS
High headquarter intensity sector Second case
bull In this event (14) doesnrsquot hold anymore because and there are only two equilibrium possibilities
bull Orbull Integration in the North
dominates outsourcing and insourcing in the South Consequently only two organizational forms can exist in equilibrium at most
bull Outsourcing in the North
bull Insourcing in the Northbull Hence there is no
international trade in inputs
(6)
V PREVALENCE OF ORGANIZATIONAL FORMS
Measure of prevalence the fraction of firms and market share
COMPONENT-INTENSIVE SECTOR
bull No firm integrates low η
The fraction of firms that outsource in the South
1 Lower wage in the south Raises the profit of outsourcing in the SouthRaises The minimal productivity to be active in the sector rises
SO
COMPONENT-INTENSIVE SECTOR
The fraction of firms that outsource in the South
2 Increase in the dispersion of productivity Raises
3 Higher headquarter intensity is less prevalent
4 Smaller fraction of the surplus from outsourcing in the south (β)Raises the profitability of outsourcing in the South is more prevalent
HEADQUARTER-INTENSIVE SECTOR
Organizational forms
HEADQUARTER-INTENSIVE SECTOR
1 Lower wage in the South
2 Increase of productivity dispersionDecline Increase and ambiguous effect in the others
3 Higher headquarter intensity (η) Domestic outsourcing is favored relative to foreign outsourcingIntegration is favored relative to outsourcingThe effects of η on the fraction of firms that insource in the south is ambiguous
HEADQUARTER-INTENSIVE SECTOR
4 Increase in the revenue shares4 Increase in (rises slope of the profit line)
SV
The fraction of outsourcing firms in the South declines and the fraction of insourcing firms in the South rises
HEADQUARTER-INTENSIVE SECTOR
4 Increase in the revenue shares5 Increase in (rises slope of the profit line)
NV The fraction of firms that
outsource in the north declines and these that insource in the north rises The fraction of firms that outsource in the south declines and these that insource in the south does not change
HEADQUARTER-INTENSIVE SECTOR
5 Increase in the primitive bargaining power parameter (β)
bull Shifts the bargaining power in favor of Hbull Outsourcing becomes more attractivebull ise bull The fraction of firms that import components
rises
VI CONCLUDING COMMENTS
1 The high-productivity firms -gt South2 In the same country high-productivity firms
insource 3 In sectors with very low intensity of headquarter
services no firm integrates 1 Low-productivity firms outsource at home 2 High-productivity firms outsource abroad
VI CONCLUDING COMMENTS
4 The prevalence of organizational forms depends on industry characteristics and on the degree of productivity dispersion across firms
1 Sectors with more productivity dispersion (lower z) more imported inputs
1 Within the headquarter-intensive sectors integration is more prevalent
2 Higher headquarter intensity less imported inputs 1 Within the headquarter-intensive sectors integration is more
prevalent
5 Lower wages in the south raises the fraction of firms that import intermediate inputs
1 It raises the fraction of firms that outsource in each country 2 Armrsquos length trade rises relative to intrafirm trade
IV ORGANIZATIONAL FORMS
bull A low headquarter intensity is depicted when As indicated by the arrows profits decrease with increases in bull In this situation H prefers outsourcing to
insourcing regardless the manufacturing location because outsourcing has lower fixed costs and it gives H a lower fraction of revenue
bull Depending on whether the cross-county difference in the wage rate is small or large relative to the cross-country difference in the fixed organizational costs the resulting equilibrium can havebull outsourcing in both countriesbull outsourcing in the South only
Low headquarter intensity sector
IV ORGANIZATIONAL FORMS
bull When wage differential is small relative to to the fixed cost differential firms with a productivity higher than the productivity threshold will outsource in the North and firms with even higher productivity will outsource in the South
bull When wage differential is large relative to the fixed costs all firms with a productivity higher than the threshold will outsource in the South
bull With this threshold level being the intersection between the red line and the horizontal axis
(6)
Low headquarter intensity sector
IV ORGANIZATIONAL FORMS
High headquarter intensity sector bull A high headquarter intensity is depicted when As indicated by the arrows profits increase with increases in
bull The figure 4 shows us that is steeper than for
bull When wage differential is small relative to the fixed cost differential and when the sector is relatively more intensive in headquarter services the marginal return of headquarter services is high making underinvestment significantly costly for H Therefore in such a situation itrsquos always profitable for H to insource regardless the manufacturing location because
bull Integration gives H a larger share of revenue However variable costs are lower in the South For that reason can be steeper or flatter than This is to say that can be larger or smaller than
bull Depending on whether the cross-county difference in the wage rate is small or large relative to the difference between and the resulting equilibrium can have bull The four organizational formsbull Outsourcing in the North insourcing in the North and insourcing in the
Southbull Outsourcing in the North and insourcing in the North
(6)
IV ORGANIZATIONAL FORMS
High headquarter intensity sector
(6)
First case
bull It follows that
(14)
bull Given the orderings in (3) and (14) figure 4 shows us that all four organizational forms exist in equilibrium
IV ORGANIZATIONAL FORMS
High headquarter intensity sector
(6)
Second case
bull In this event (14) doesnrsquot hold anymore because and there are only two equilibrium possibilities
bull Either bull Integration in the North
dominates Consequently only 3 organizational forms can exist in equilibrium at best
bull Outsourcing in the North
bull Insourcing in the Northbull Insourcing in the South
IV ORGANIZATIONAL FORMS
High headquarter intensity sector Second case
bull In this event (14) doesnrsquot hold anymore because and there are only two equilibrium possibilities
bull Orbull Integration in the North
dominates outsourcing and insourcing in the South Consequently only two organizational forms can exist in equilibrium at most
bull Outsourcing in the North
bull Insourcing in the Northbull Hence there is no
international trade in inputs
(6)
V PREVALENCE OF ORGANIZATIONAL FORMS
Measure of prevalence the fraction of firms and market share
COMPONENT-INTENSIVE SECTOR
bull No firm integrates low η
The fraction of firms that outsource in the South
1 Lower wage in the south Raises the profit of outsourcing in the SouthRaises The minimal productivity to be active in the sector rises
SO
COMPONENT-INTENSIVE SECTOR
The fraction of firms that outsource in the South
2 Increase in the dispersion of productivity Raises
3 Higher headquarter intensity is less prevalent
4 Smaller fraction of the surplus from outsourcing in the south (β)Raises the profitability of outsourcing in the South is more prevalent
HEADQUARTER-INTENSIVE SECTOR
Organizational forms
HEADQUARTER-INTENSIVE SECTOR
1 Lower wage in the South
2 Increase of productivity dispersionDecline Increase and ambiguous effect in the others
3 Higher headquarter intensity (η) Domestic outsourcing is favored relative to foreign outsourcingIntegration is favored relative to outsourcingThe effects of η on the fraction of firms that insource in the south is ambiguous
HEADQUARTER-INTENSIVE SECTOR
4 Increase in the revenue shares4 Increase in (rises slope of the profit line)
SV
The fraction of outsourcing firms in the South declines and the fraction of insourcing firms in the South rises
HEADQUARTER-INTENSIVE SECTOR
4 Increase in the revenue shares5 Increase in (rises slope of the profit line)
NV The fraction of firms that
outsource in the north declines and these that insource in the north rises The fraction of firms that outsource in the south declines and these that insource in the south does not change
HEADQUARTER-INTENSIVE SECTOR
5 Increase in the primitive bargaining power parameter (β)
bull Shifts the bargaining power in favor of Hbull Outsourcing becomes more attractivebull ise bull The fraction of firms that import components
rises
VI CONCLUDING COMMENTS
1 The high-productivity firms -gt South2 In the same country high-productivity firms
insource 3 In sectors with very low intensity of headquarter
services no firm integrates 1 Low-productivity firms outsource at home 2 High-productivity firms outsource abroad
VI CONCLUDING COMMENTS
4 The prevalence of organizational forms depends on industry characteristics and on the degree of productivity dispersion across firms
1 Sectors with more productivity dispersion (lower z) more imported inputs
1 Within the headquarter-intensive sectors integration is more prevalent
2 Higher headquarter intensity less imported inputs 1 Within the headquarter-intensive sectors integration is more
prevalent
5 Lower wages in the south raises the fraction of firms that import intermediate inputs
1 It raises the fraction of firms that outsource in each country 2 Armrsquos length trade rises relative to intrafirm trade
IV ORGANIZATIONAL FORMS
bull When wage differential is small relative to to the fixed cost differential firms with a productivity higher than the productivity threshold will outsource in the North and firms with even higher productivity will outsource in the South
bull When wage differential is large relative to the fixed costs all firms with a productivity higher than the threshold will outsource in the South
bull With this threshold level being the intersection between the red line and the horizontal axis
(6)
Low headquarter intensity sector
IV ORGANIZATIONAL FORMS
High headquarter intensity sector bull A high headquarter intensity is depicted when As indicated by the arrows profits increase with increases in
bull The figure 4 shows us that is steeper than for
bull When wage differential is small relative to the fixed cost differential and when the sector is relatively more intensive in headquarter services the marginal return of headquarter services is high making underinvestment significantly costly for H Therefore in such a situation itrsquos always profitable for H to insource regardless the manufacturing location because
bull Integration gives H a larger share of revenue However variable costs are lower in the South For that reason can be steeper or flatter than This is to say that can be larger or smaller than
bull Depending on whether the cross-county difference in the wage rate is small or large relative to the difference between and the resulting equilibrium can have bull The four organizational formsbull Outsourcing in the North insourcing in the North and insourcing in the
Southbull Outsourcing in the North and insourcing in the North
(6)
IV ORGANIZATIONAL FORMS
High headquarter intensity sector
(6)
First case
bull It follows that
(14)
bull Given the orderings in (3) and (14) figure 4 shows us that all four organizational forms exist in equilibrium
IV ORGANIZATIONAL FORMS
High headquarter intensity sector
(6)
Second case
bull In this event (14) doesnrsquot hold anymore because and there are only two equilibrium possibilities
bull Either bull Integration in the North
dominates Consequently only 3 organizational forms can exist in equilibrium at best
bull Outsourcing in the North
bull Insourcing in the Northbull Insourcing in the South
IV ORGANIZATIONAL FORMS
High headquarter intensity sector Second case
bull In this event (14) doesnrsquot hold anymore because and there are only two equilibrium possibilities
bull Orbull Integration in the North
dominates outsourcing and insourcing in the South Consequently only two organizational forms can exist in equilibrium at most
bull Outsourcing in the North
bull Insourcing in the Northbull Hence there is no
international trade in inputs
(6)
V PREVALENCE OF ORGANIZATIONAL FORMS
Measure of prevalence the fraction of firms and market share
COMPONENT-INTENSIVE SECTOR
bull No firm integrates low η
The fraction of firms that outsource in the South
1 Lower wage in the south Raises the profit of outsourcing in the SouthRaises The minimal productivity to be active in the sector rises
SO
COMPONENT-INTENSIVE SECTOR
The fraction of firms that outsource in the South
2 Increase in the dispersion of productivity Raises
3 Higher headquarter intensity is less prevalent
4 Smaller fraction of the surplus from outsourcing in the south (β)Raises the profitability of outsourcing in the South is more prevalent
HEADQUARTER-INTENSIVE SECTOR
Organizational forms
HEADQUARTER-INTENSIVE SECTOR
1 Lower wage in the South
2 Increase of productivity dispersionDecline Increase and ambiguous effect in the others
3 Higher headquarter intensity (η) Domestic outsourcing is favored relative to foreign outsourcingIntegration is favored relative to outsourcingThe effects of η on the fraction of firms that insource in the south is ambiguous
HEADQUARTER-INTENSIVE SECTOR
4 Increase in the revenue shares4 Increase in (rises slope of the profit line)
SV
The fraction of outsourcing firms in the South declines and the fraction of insourcing firms in the South rises
HEADQUARTER-INTENSIVE SECTOR
4 Increase in the revenue shares5 Increase in (rises slope of the profit line)
NV The fraction of firms that
outsource in the north declines and these that insource in the north rises The fraction of firms that outsource in the south declines and these that insource in the south does not change
HEADQUARTER-INTENSIVE SECTOR
5 Increase in the primitive bargaining power parameter (β)
bull Shifts the bargaining power in favor of Hbull Outsourcing becomes more attractivebull ise bull The fraction of firms that import components
rises
VI CONCLUDING COMMENTS
1 The high-productivity firms -gt South2 In the same country high-productivity firms
insource 3 In sectors with very low intensity of headquarter
services no firm integrates 1 Low-productivity firms outsource at home 2 High-productivity firms outsource abroad
VI CONCLUDING COMMENTS
4 The prevalence of organizational forms depends on industry characteristics and on the degree of productivity dispersion across firms
1 Sectors with more productivity dispersion (lower z) more imported inputs
1 Within the headquarter-intensive sectors integration is more prevalent
2 Higher headquarter intensity less imported inputs 1 Within the headquarter-intensive sectors integration is more
prevalent
5 Lower wages in the south raises the fraction of firms that import intermediate inputs
1 It raises the fraction of firms that outsource in each country 2 Armrsquos length trade rises relative to intrafirm trade
IV ORGANIZATIONAL FORMS
High headquarter intensity sector bull A high headquarter intensity is depicted when As indicated by the arrows profits increase with increases in
bull The figure 4 shows us that is steeper than for
bull When wage differential is small relative to the fixed cost differential and when the sector is relatively more intensive in headquarter services the marginal return of headquarter services is high making underinvestment significantly costly for H Therefore in such a situation itrsquos always profitable for H to insource regardless the manufacturing location because
bull Integration gives H a larger share of revenue However variable costs are lower in the South For that reason can be steeper or flatter than This is to say that can be larger or smaller than
bull Depending on whether the cross-county difference in the wage rate is small or large relative to the difference between and the resulting equilibrium can have bull The four organizational formsbull Outsourcing in the North insourcing in the North and insourcing in the
Southbull Outsourcing in the North and insourcing in the North
(6)
IV ORGANIZATIONAL FORMS
High headquarter intensity sector
(6)
First case
bull It follows that
(14)
bull Given the orderings in (3) and (14) figure 4 shows us that all four organizational forms exist in equilibrium
IV ORGANIZATIONAL FORMS
High headquarter intensity sector
(6)
Second case
bull In this event (14) doesnrsquot hold anymore because and there are only two equilibrium possibilities
bull Either bull Integration in the North
dominates Consequently only 3 organizational forms can exist in equilibrium at best
bull Outsourcing in the North
bull Insourcing in the Northbull Insourcing in the South
IV ORGANIZATIONAL FORMS
High headquarter intensity sector Second case
bull In this event (14) doesnrsquot hold anymore because and there are only two equilibrium possibilities
bull Orbull Integration in the North
dominates outsourcing and insourcing in the South Consequently only two organizational forms can exist in equilibrium at most
bull Outsourcing in the North
bull Insourcing in the Northbull Hence there is no
international trade in inputs
(6)
V PREVALENCE OF ORGANIZATIONAL FORMS
Measure of prevalence the fraction of firms and market share
COMPONENT-INTENSIVE SECTOR
bull No firm integrates low η
The fraction of firms that outsource in the South
1 Lower wage in the south Raises the profit of outsourcing in the SouthRaises The minimal productivity to be active in the sector rises
SO
COMPONENT-INTENSIVE SECTOR
The fraction of firms that outsource in the South
2 Increase in the dispersion of productivity Raises
3 Higher headquarter intensity is less prevalent
4 Smaller fraction of the surplus from outsourcing in the south (β)Raises the profitability of outsourcing in the South is more prevalent
HEADQUARTER-INTENSIVE SECTOR
Organizational forms
HEADQUARTER-INTENSIVE SECTOR
1 Lower wage in the South
2 Increase of productivity dispersionDecline Increase and ambiguous effect in the others
3 Higher headquarter intensity (η) Domestic outsourcing is favored relative to foreign outsourcingIntegration is favored relative to outsourcingThe effects of η on the fraction of firms that insource in the south is ambiguous
HEADQUARTER-INTENSIVE SECTOR
4 Increase in the revenue shares4 Increase in (rises slope of the profit line)
SV
The fraction of outsourcing firms in the South declines and the fraction of insourcing firms in the South rises
HEADQUARTER-INTENSIVE SECTOR
4 Increase in the revenue shares5 Increase in (rises slope of the profit line)
NV The fraction of firms that
outsource in the north declines and these that insource in the north rises The fraction of firms that outsource in the south declines and these that insource in the south does not change
HEADQUARTER-INTENSIVE SECTOR
5 Increase in the primitive bargaining power parameter (β)
bull Shifts the bargaining power in favor of Hbull Outsourcing becomes more attractivebull ise bull The fraction of firms that import components
rises
VI CONCLUDING COMMENTS
1 The high-productivity firms -gt South2 In the same country high-productivity firms
insource 3 In sectors with very low intensity of headquarter
services no firm integrates 1 Low-productivity firms outsource at home 2 High-productivity firms outsource abroad
VI CONCLUDING COMMENTS
4 The prevalence of organizational forms depends on industry characteristics and on the degree of productivity dispersion across firms
1 Sectors with more productivity dispersion (lower z) more imported inputs
1 Within the headquarter-intensive sectors integration is more prevalent
2 Higher headquarter intensity less imported inputs 1 Within the headquarter-intensive sectors integration is more
prevalent
5 Lower wages in the south raises the fraction of firms that import intermediate inputs
1 It raises the fraction of firms that outsource in each country 2 Armrsquos length trade rises relative to intrafirm trade
IV ORGANIZATIONAL FORMS
High headquarter intensity sector
(6)
First case
bull It follows that
(14)
bull Given the orderings in (3) and (14) figure 4 shows us that all four organizational forms exist in equilibrium
IV ORGANIZATIONAL FORMS
High headquarter intensity sector
(6)
Second case
bull In this event (14) doesnrsquot hold anymore because and there are only two equilibrium possibilities
bull Either bull Integration in the North
dominates Consequently only 3 organizational forms can exist in equilibrium at best
bull Outsourcing in the North
bull Insourcing in the Northbull Insourcing in the South
IV ORGANIZATIONAL FORMS
High headquarter intensity sector Second case
bull In this event (14) doesnrsquot hold anymore because and there are only two equilibrium possibilities
bull Orbull Integration in the North
dominates outsourcing and insourcing in the South Consequently only two organizational forms can exist in equilibrium at most
bull Outsourcing in the North
bull Insourcing in the Northbull Hence there is no
international trade in inputs
(6)
V PREVALENCE OF ORGANIZATIONAL FORMS
Measure of prevalence the fraction of firms and market share
COMPONENT-INTENSIVE SECTOR
bull No firm integrates low η
The fraction of firms that outsource in the South
1 Lower wage in the south Raises the profit of outsourcing in the SouthRaises The minimal productivity to be active in the sector rises
SO
COMPONENT-INTENSIVE SECTOR
The fraction of firms that outsource in the South
2 Increase in the dispersion of productivity Raises
3 Higher headquarter intensity is less prevalent
4 Smaller fraction of the surplus from outsourcing in the south (β)Raises the profitability of outsourcing in the South is more prevalent
HEADQUARTER-INTENSIVE SECTOR
Organizational forms
HEADQUARTER-INTENSIVE SECTOR
1 Lower wage in the South
2 Increase of productivity dispersionDecline Increase and ambiguous effect in the others
3 Higher headquarter intensity (η) Domestic outsourcing is favored relative to foreign outsourcingIntegration is favored relative to outsourcingThe effects of η on the fraction of firms that insource in the south is ambiguous
HEADQUARTER-INTENSIVE SECTOR
4 Increase in the revenue shares4 Increase in (rises slope of the profit line)
SV
The fraction of outsourcing firms in the South declines and the fraction of insourcing firms in the South rises
HEADQUARTER-INTENSIVE SECTOR
4 Increase in the revenue shares5 Increase in (rises slope of the profit line)
NV The fraction of firms that
outsource in the north declines and these that insource in the north rises The fraction of firms that outsource in the south declines and these that insource in the south does not change
HEADQUARTER-INTENSIVE SECTOR
5 Increase in the primitive bargaining power parameter (β)
bull Shifts the bargaining power in favor of Hbull Outsourcing becomes more attractivebull ise bull The fraction of firms that import components
rises
VI CONCLUDING COMMENTS
1 The high-productivity firms -gt South2 In the same country high-productivity firms
insource 3 In sectors with very low intensity of headquarter
services no firm integrates 1 Low-productivity firms outsource at home 2 High-productivity firms outsource abroad
VI CONCLUDING COMMENTS
4 The prevalence of organizational forms depends on industry characteristics and on the degree of productivity dispersion across firms
1 Sectors with more productivity dispersion (lower z) more imported inputs
1 Within the headquarter-intensive sectors integration is more prevalent
2 Higher headquarter intensity less imported inputs 1 Within the headquarter-intensive sectors integration is more
prevalent
5 Lower wages in the south raises the fraction of firms that import intermediate inputs
1 It raises the fraction of firms that outsource in each country 2 Armrsquos length trade rises relative to intrafirm trade
IV ORGANIZATIONAL FORMS
High headquarter intensity sector
(6)
Second case
bull In this event (14) doesnrsquot hold anymore because and there are only two equilibrium possibilities
bull Either bull Integration in the North
dominates Consequently only 3 organizational forms can exist in equilibrium at best
bull Outsourcing in the North
bull Insourcing in the Northbull Insourcing in the South
IV ORGANIZATIONAL FORMS
High headquarter intensity sector Second case
bull In this event (14) doesnrsquot hold anymore because and there are only two equilibrium possibilities
bull Orbull Integration in the North
dominates outsourcing and insourcing in the South Consequently only two organizational forms can exist in equilibrium at most
bull Outsourcing in the North
bull Insourcing in the Northbull Hence there is no
international trade in inputs
(6)
V PREVALENCE OF ORGANIZATIONAL FORMS
Measure of prevalence the fraction of firms and market share
COMPONENT-INTENSIVE SECTOR
bull No firm integrates low η
The fraction of firms that outsource in the South
1 Lower wage in the south Raises the profit of outsourcing in the SouthRaises The minimal productivity to be active in the sector rises
SO
COMPONENT-INTENSIVE SECTOR
The fraction of firms that outsource in the South
2 Increase in the dispersion of productivity Raises
3 Higher headquarter intensity is less prevalent
4 Smaller fraction of the surplus from outsourcing in the south (β)Raises the profitability of outsourcing in the South is more prevalent
HEADQUARTER-INTENSIVE SECTOR
Organizational forms
HEADQUARTER-INTENSIVE SECTOR
1 Lower wage in the South
2 Increase of productivity dispersionDecline Increase and ambiguous effect in the others
3 Higher headquarter intensity (η) Domestic outsourcing is favored relative to foreign outsourcingIntegration is favored relative to outsourcingThe effects of η on the fraction of firms that insource in the south is ambiguous
HEADQUARTER-INTENSIVE SECTOR
4 Increase in the revenue shares4 Increase in (rises slope of the profit line)
SV
The fraction of outsourcing firms in the South declines and the fraction of insourcing firms in the South rises
HEADQUARTER-INTENSIVE SECTOR
4 Increase in the revenue shares5 Increase in (rises slope of the profit line)
NV The fraction of firms that
outsource in the north declines and these that insource in the north rises The fraction of firms that outsource in the south declines and these that insource in the south does not change
HEADQUARTER-INTENSIVE SECTOR
5 Increase in the primitive bargaining power parameter (β)
bull Shifts the bargaining power in favor of Hbull Outsourcing becomes more attractivebull ise bull The fraction of firms that import components
rises
VI CONCLUDING COMMENTS
1 The high-productivity firms -gt South2 In the same country high-productivity firms
insource 3 In sectors with very low intensity of headquarter
services no firm integrates 1 Low-productivity firms outsource at home 2 High-productivity firms outsource abroad
VI CONCLUDING COMMENTS
4 The prevalence of organizational forms depends on industry characteristics and on the degree of productivity dispersion across firms
1 Sectors with more productivity dispersion (lower z) more imported inputs
1 Within the headquarter-intensive sectors integration is more prevalent
2 Higher headquarter intensity less imported inputs 1 Within the headquarter-intensive sectors integration is more
prevalent
5 Lower wages in the south raises the fraction of firms that import intermediate inputs
1 It raises the fraction of firms that outsource in each country 2 Armrsquos length trade rises relative to intrafirm trade
IV ORGANIZATIONAL FORMS
High headquarter intensity sector Second case
bull In this event (14) doesnrsquot hold anymore because and there are only two equilibrium possibilities
bull Orbull Integration in the North
dominates outsourcing and insourcing in the South Consequently only two organizational forms can exist in equilibrium at most
bull Outsourcing in the North
bull Insourcing in the Northbull Hence there is no
international trade in inputs
(6)
V PREVALENCE OF ORGANIZATIONAL FORMS
Measure of prevalence the fraction of firms and market share
COMPONENT-INTENSIVE SECTOR
bull No firm integrates low η
The fraction of firms that outsource in the South
1 Lower wage in the south Raises the profit of outsourcing in the SouthRaises The minimal productivity to be active in the sector rises
SO
COMPONENT-INTENSIVE SECTOR
The fraction of firms that outsource in the South
2 Increase in the dispersion of productivity Raises
3 Higher headquarter intensity is less prevalent
4 Smaller fraction of the surplus from outsourcing in the south (β)Raises the profitability of outsourcing in the South is more prevalent
HEADQUARTER-INTENSIVE SECTOR
Organizational forms
HEADQUARTER-INTENSIVE SECTOR
1 Lower wage in the South
2 Increase of productivity dispersionDecline Increase and ambiguous effect in the others
3 Higher headquarter intensity (η) Domestic outsourcing is favored relative to foreign outsourcingIntegration is favored relative to outsourcingThe effects of η on the fraction of firms that insource in the south is ambiguous
HEADQUARTER-INTENSIVE SECTOR
4 Increase in the revenue shares4 Increase in (rises slope of the profit line)
SV
The fraction of outsourcing firms in the South declines and the fraction of insourcing firms in the South rises
HEADQUARTER-INTENSIVE SECTOR
4 Increase in the revenue shares5 Increase in (rises slope of the profit line)
NV The fraction of firms that
outsource in the north declines and these that insource in the north rises The fraction of firms that outsource in the south declines and these that insource in the south does not change
HEADQUARTER-INTENSIVE SECTOR
5 Increase in the primitive bargaining power parameter (β)
bull Shifts the bargaining power in favor of Hbull Outsourcing becomes more attractivebull ise bull The fraction of firms that import components
rises
VI CONCLUDING COMMENTS
1 The high-productivity firms -gt South2 In the same country high-productivity firms
insource 3 In sectors with very low intensity of headquarter
services no firm integrates 1 Low-productivity firms outsource at home 2 High-productivity firms outsource abroad
VI CONCLUDING COMMENTS
4 The prevalence of organizational forms depends on industry characteristics and on the degree of productivity dispersion across firms
1 Sectors with more productivity dispersion (lower z) more imported inputs
1 Within the headquarter-intensive sectors integration is more prevalent
2 Higher headquarter intensity less imported inputs 1 Within the headquarter-intensive sectors integration is more
prevalent
5 Lower wages in the south raises the fraction of firms that import intermediate inputs
1 It raises the fraction of firms that outsource in each country 2 Armrsquos length trade rises relative to intrafirm trade
V PREVALENCE OF ORGANIZATIONAL FORMS
Measure of prevalence the fraction of firms and market share
COMPONENT-INTENSIVE SECTOR
bull No firm integrates low η
The fraction of firms that outsource in the South
1 Lower wage in the south Raises the profit of outsourcing in the SouthRaises The minimal productivity to be active in the sector rises
SO
COMPONENT-INTENSIVE SECTOR
The fraction of firms that outsource in the South
2 Increase in the dispersion of productivity Raises
3 Higher headquarter intensity is less prevalent
4 Smaller fraction of the surplus from outsourcing in the south (β)Raises the profitability of outsourcing in the South is more prevalent
HEADQUARTER-INTENSIVE SECTOR
Organizational forms
HEADQUARTER-INTENSIVE SECTOR
1 Lower wage in the South
2 Increase of productivity dispersionDecline Increase and ambiguous effect in the others
3 Higher headquarter intensity (η) Domestic outsourcing is favored relative to foreign outsourcingIntegration is favored relative to outsourcingThe effects of η on the fraction of firms that insource in the south is ambiguous
HEADQUARTER-INTENSIVE SECTOR
4 Increase in the revenue shares4 Increase in (rises slope of the profit line)
SV
The fraction of outsourcing firms in the South declines and the fraction of insourcing firms in the South rises
HEADQUARTER-INTENSIVE SECTOR
4 Increase in the revenue shares5 Increase in (rises slope of the profit line)
NV The fraction of firms that
outsource in the north declines and these that insource in the north rises The fraction of firms that outsource in the south declines and these that insource in the south does not change
HEADQUARTER-INTENSIVE SECTOR
5 Increase in the primitive bargaining power parameter (β)
bull Shifts the bargaining power in favor of Hbull Outsourcing becomes more attractivebull ise bull The fraction of firms that import components
rises
VI CONCLUDING COMMENTS
1 The high-productivity firms -gt South2 In the same country high-productivity firms
insource 3 In sectors with very low intensity of headquarter
services no firm integrates 1 Low-productivity firms outsource at home 2 High-productivity firms outsource abroad
VI CONCLUDING COMMENTS
4 The prevalence of organizational forms depends on industry characteristics and on the degree of productivity dispersion across firms
1 Sectors with more productivity dispersion (lower z) more imported inputs
1 Within the headquarter-intensive sectors integration is more prevalent
2 Higher headquarter intensity less imported inputs 1 Within the headquarter-intensive sectors integration is more
prevalent
5 Lower wages in the south raises the fraction of firms that import intermediate inputs
1 It raises the fraction of firms that outsource in each country 2 Armrsquos length trade rises relative to intrafirm trade
COMPONENT-INTENSIVE SECTOR
bull No firm integrates low η
The fraction of firms that outsource in the South
1 Lower wage in the south Raises the profit of outsourcing in the SouthRaises The minimal productivity to be active in the sector rises
SO
COMPONENT-INTENSIVE SECTOR
The fraction of firms that outsource in the South
2 Increase in the dispersion of productivity Raises
3 Higher headquarter intensity is less prevalent
4 Smaller fraction of the surplus from outsourcing in the south (β)Raises the profitability of outsourcing in the South is more prevalent
HEADQUARTER-INTENSIVE SECTOR
Organizational forms
HEADQUARTER-INTENSIVE SECTOR
1 Lower wage in the South
2 Increase of productivity dispersionDecline Increase and ambiguous effect in the others
3 Higher headquarter intensity (η) Domestic outsourcing is favored relative to foreign outsourcingIntegration is favored relative to outsourcingThe effects of η on the fraction of firms that insource in the south is ambiguous
HEADQUARTER-INTENSIVE SECTOR
4 Increase in the revenue shares4 Increase in (rises slope of the profit line)
SV
The fraction of outsourcing firms in the South declines and the fraction of insourcing firms in the South rises
HEADQUARTER-INTENSIVE SECTOR
4 Increase in the revenue shares5 Increase in (rises slope of the profit line)
NV The fraction of firms that
outsource in the north declines and these that insource in the north rises The fraction of firms that outsource in the south declines and these that insource in the south does not change
HEADQUARTER-INTENSIVE SECTOR
5 Increase in the primitive bargaining power parameter (β)
bull Shifts the bargaining power in favor of Hbull Outsourcing becomes more attractivebull ise bull The fraction of firms that import components
rises
VI CONCLUDING COMMENTS
1 The high-productivity firms -gt South2 In the same country high-productivity firms
insource 3 In sectors with very low intensity of headquarter
services no firm integrates 1 Low-productivity firms outsource at home 2 High-productivity firms outsource abroad
VI CONCLUDING COMMENTS
4 The prevalence of organizational forms depends on industry characteristics and on the degree of productivity dispersion across firms
1 Sectors with more productivity dispersion (lower z) more imported inputs
1 Within the headquarter-intensive sectors integration is more prevalent
2 Higher headquarter intensity less imported inputs 1 Within the headquarter-intensive sectors integration is more
prevalent
5 Lower wages in the south raises the fraction of firms that import intermediate inputs
1 It raises the fraction of firms that outsource in each country 2 Armrsquos length trade rises relative to intrafirm trade
COMPONENT-INTENSIVE SECTOR
The fraction of firms that outsource in the South
2 Increase in the dispersion of productivity Raises
3 Higher headquarter intensity is less prevalent
4 Smaller fraction of the surplus from outsourcing in the south (β)Raises the profitability of outsourcing in the South is more prevalent
HEADQUARTER-INTENSIVE SECTOR
Organizational forms
HEADQUARTER-INTENSIVE SECTOR
1 Lower wage in the South
2 Increase of productivity dispersionDecline Increase and ambiguous effect in the others
3 Higher headquarter intensity (η) Domestic outsourcing is favored relative to foreign outsourcingIntegration is favored relative to outsourcingThe effects of η on the fraction of firms that insource in the south is ambiguous
HEADQUARTER-INTENSIVE SECTOR
4 Increase in the revenue shares4 Increase in (rises slope of the profit line)
SV
The fraction of outsourcing firms in the South declines and the fraction of insourcing firms in the South rises
HEADQUARTER-INTENSIVE SECTOR
4 Increase in the revenue shares5 Increase in (rises slope of the profit line)
NV The fraction of firms that
outsource in the north declines and these that insource in the north rises The fraction of firms that outsource in the south declines and these that insource in the south does not change
HEADQUARTER-INTENSIVE SECTOR
5 Increase in the primitive bargaining power parameter (β)
bull Shifts the bargaining power in favor of Hbull Outsourcing becomes more attractivebull ise bull The fraction of firms that import components
rises
VI CONCLUDING COMMENTS
1 The high-productivity firms -gt South2 In the same country high-productivity firms
insource 3 In sectors with very low intensity of headquarter
services no firm integrates 1 Low-productivity firms outsource at home 2 High-productivity firms outsource abroad
VI CONCLUDING COMMENTS
4 The prevalence of organizational forms depends on industry characteristics and on the degree of productivity dispersion across firms
1 Sectors with more productivity dispersion (lower z) more imported inputs
1 Within the headquarter-intensive sectors integration is more prevalent
2 Higher headquarter intensity less imported inputs 1 Within the headquarter-intensive sectors integration is more
prevalent
5 Lower wages in the south raises the fraction of firms that import intermediate inputs
1 It raises the fraction of firms that outsource in each country 2 Armrsquos length trade rises relative to intrafirm trade
HEADQUARTER-INTENSIVE SECTOR
Organizational forms
HEADQUARTER-INTENSIVE SECTOR
1 Lower wage in the South
2 Increase of productivity dispersionDecline Increase and ambiguous effect in the others
3 Higher headquarter intensity (η) Domestic outsourcing is favored relative to foreign outsourcingIntegration is favored relative to outsourcingThe effects of η on the fraction of firms that insource in the south is ambiguous
HEADQUARTER-INTENSIVE SECTOR
4 Increase in the revenue shares4 Increase in (rises slope of the profit line)
SV
The fraction of outsourcing firms in the South declines and the fraction of insourcing firms in the South rises
HEADQUARTER-INTENSIVE SECTOR
4 Increase in the revenue shares5 Increase in (rises slope of the profit line)
NV The fraction of firms that
outsource in the north declines and these that insource in the north rises The fraction of firms that outsource in the south declines and these that insource in the south does not change
HEADQUARTER-INTENSIVE SECTOR
5 Increase in the primitive bargaining power parameter (β)
bull Shifts the bargaining power in favor of Hbull Outsourcing becomes more attractivebull ise bull The fraction of firms that import components
rises
VI CONCLUDING COMMENTS
1 The high-productivity firms -gt South2 In the same country high-productivity firms
insource 3 In sectors with very low intensity of headquarter
services no firm integrates 1 Low-productivity firms outsource at home 2 High-productivity firms outsource abroad
VI CONCLUDING COMMENTS
4 The prevalence of organizational forms depends on industry characteristics and on the degree of productivity dispersion across firms
1 Sectors with more productivity dispersion (lower z) more imported inputs
1 Within the headquarter-intensive sectors integration is more prevalent
2 Higher headquarter intensity less imported inputs 1 Within the headquarter-intensive sectors integration is more
prevalent
5 Lower wages in the south raises the fraction of firms that import intermediate inputs
1 It raises the fraction of firms that outsource in each country 2 Armrsquos length trade rises relative to intrafirm trade
HEADQUARTER-INTENSIVE SECTOR
1 Lower wage in the South
2 Increase of productivity dispersionDecline Increase and ambiguous effect in the others
3 Higher headquarter intensity (η) Domestic outsourcing is favored relative to foreign outsourcingIntegration is favored relative to outsourcingThe effects of η on the fraction of firms that insource in the south is ambiguous
HEADQUARTER-INTENSIVE SECTOR
4 Increase in the revenue shares4 Increase in (rises slope of the profit line)
SV
The fraction of outsourcing firms in the South declines and the fraction of insourcing firms in the South rises
HEADQUARTER-INTENSIVE SECTOR
4 Increase in the revenue shares5 Increase in (rises slope of the profit line)
NV The fraction of firms that
outsource in the north declines and these that insource in the north rises The fraction of firms that outsource in the south declines and these that insource in the south does not change
HEADQUARTER-INTENSIVE SECTOR
5 Increase in the primitive bargaining power parameter (β)
bull Shifts the bargaining power in favor of Hbull Outsourcing becomes more attractivebull ise bull The fraction of firms that import components
rises
VI CONCLUDING COMMENTS
1 The high-productivity firms -gt South2 In the same country high-productivity firms
insource 3 In sectors with very low intensity of headquarter
services no firm integrates 1 Low-productivity firms outsource at home 2 High-productivity firms outsource abroad
VI CONCLUDING COMMENTS
4 The prevalence of organizational forms depends on industry characteristics and on the degree of productivity dispersion across firms
1 Sectors with more productivity dispersion (lower z) more imported inputs
1 Within the headquarter-intensive sectors integration is more prevalent
2 Higher headquarter intensity less imported inputs 1 Within the headquarter-intensive sectors integration is more
prevalent
5 Lower wages in the south raises the fraction of firms that import intermediate inputs
1 It raises the fraction of firms that outsource in each country 2 Armrsquos length trade rises relative to intrafirm trade
HEADQUARTER-INTENSIVE SECTOR
4 Increase in the revenue shares4 Increase in (rises slope of the profit line)
SV
The fraction of outsourcing firms in the South declines and the fraction of insourcing firms in the South rises
HEADQUARTER-INTENSIVE SECTOR
4 Increase in the revenue shares5 Increase in (rises slope of the profit line)
NV The fraction of firms that
outsource in the north declines and these that insource in the north rises The fraction of firms that outsource in the south declines and these that insource in the south does not change
HEADQUARTER-INTENSIVE SECTOR
5 Increase in the primitive bargaining power parameter (β)
bull Shifts the bargaining power in favor of Hbull Outsourcing becomes more attractivebull ise bull The fraction of firms that import components
rises
VI CONCLUDING COMMENTS
1 The high-productivity firms -gt South2 In the same country high-productivity firms
insource 3 In sectors with very low intensity of headquarter
services no firm integrates 1 Low-productivity firms outsource at home 2 High-productivity firms outsource abroad
VI CONCLUDING COMMENTS
4 The prevalence of organizational forms depends on industry characteristics and on the degree of productivity dispersion across firms
1 Sectors with more productivity dispersion (lower z) more imported inputs
1 Within the headquarter-intensive sectors integration is more prevalent
2 Higher headquarter intensity less imported inputs 1 Within the headquarter-intensive sectors integration is more
prevalent
5 Lower wages in the south raises the fraction of firms that import intermediate inputs
1 It raises the fraction of firms that outsource in each country 2 Armrsquos length trade rises relative to intrafirm trade
HEADQUARTER-INTENSIVE SECTOR
4 Increase in the revenue shares5 Increase in (rises slope of the profit line)
NV The fraction of firms that
outsource in the north declines and these that insource in the north rises The fraction of firms that outsource in the south declines and these that insource in the south does not change
HEADQUARTER-INTENSIVE SECTOR
5 Increase in the primitive bargaining power parameter (β)
bull Shifts the bargaining power in favor of Hbull Outsourcing becomes more attractivebull ise bull The fraction of firms that import components
rises
VI CONCLUDING COMMENTS
1 The high-productivity firms -gt South2 In the same country high-productivity firms
insource 3 In sectors with very low intensity of headquarter
services no firm integrates 1 Low-productivity firms outsource at home 2 High-productivity firms outsource abroad
VI CONCLUDING COMMENTS
4 The prevalence of organizational forms depends on industry characteristics and on the degree of productivity dispersion across firms
1 Sectors with more productivity dispersion (lower z) more imported inputs
1 Within the headquarter-intensive sectors integration is more prevalent
2 Higher headquarter intensity less imported inputs 1 Within the headquarter-intensive sectors integration is more
prevalent
5 Lower wages in the south raises the fraction of firms that import intermediate inputs
1 It raises the fraction of firms that outsource in each country 2 Armrsquos length trade rises relative to intrafirm trade
HEADQUARTER-INTENSIVE SECTOR
5 Increase in the primitive bargaining power parameter (β)
bull Shifts the bargaining power in favor of Hbull Outsourcing becomes more attractivebull ise bull The fraction of firms that import components
rises
VI CONCLUDING COMMENTS
1 The high-productivity firms -gt South2 In the same country high-productivity firms
insource 3 In sectors with very low intensity of headquarter
services no firm integrates 1 Low-productivity firms outsource at home 2 High-productivity firms outsource abroad
VI CONCLUDING COMMENTS
4 The prevalence of organizational forms depends on industry characteristics and on the degree of productivity dispersion across firms
1 Sectors with more productivity dispersion (lower z) more imported inputs
1 Within the headquarter-intensive sectors integration is more prevalent
2 Higher headquarter intensity less imported inputs 1 Within the headquarter-intensive sectors integration is more
prevalent
5 Lower wages in the south raises the fraction of firms that import intermediate inputs
1 It raises the fraction of firms that outsource in each country 2 Armrsquos length trade rises relative to intrafirm trade
VI CONCLUDING COMMENTS
1 The high-productivity firms -gt South2 In the same country high-productivity firms
insource 3 In sectors with very low intensity of headquarter
services no firm integrates 1 Low-productivity firms outsource at home 2 High-productivity firms outsource abroad
VI CONCLUDING COMMENTS
4 The prevalence of organizational forms depends on industry characteristics and on the degree of productivity dispersion across firms
1 Sectors with more productivity dispersion (lower z) more imported inputs
1 Within the headquarter-intensive sectors integration is more prevalent
2 Higher headquarter intensity less imported inputs 1 Within the headquarter-intensive sectors integration is more
prevalent
5 Lower wages in the south raises the fraction of firms that import intermediate inputs
1 It raises the fraction of firms that outsource in each country 2 Armrsquos length trade rises relative to intrafirm trade
VI CONCLUDING COMMENTS
4 The prevalence of organizational forms depends on industry characteristics and on the degree of productivity dispersion across firms
1 Sectors with more productivity dispersion (lower z) more imported inputs
1 Within the headquarter-intensive sectors integration is more prevalent
2 Higher headquarter intensity less imported inputs 1 Within the headquarter-intensive sectors integration is more
prevalent
5 Lower wages in the south raises the fraction of firms that import intermediate inputs
1 It raises the fraction of firms that outsource in each country 2 Armrsquos length trade rises relative to intrafirm trade
