Quality of Institutions and Outsourcing

ABSTRACT

This paper explores the effects of international trade and contracting on intermediate and final-goods producers’ decisions regarding outsourcing of production in an environment of imperfect contract enforcement, measured by the quality of the respective legal system in each country. The efficiency versus profitability trade-off has a crucial impact on the location decisions of intermediate producers. Improving the quality of the legal system will increase the volume of outsourcing in the country with imperfect contract enforcement.

Keywords:

• Contract enforcement
• legal systems
• international trade bargaining
• outsourcing

JEL Classifications:

• F1
• C7
• D2
• L1

Acknowledgements

The author would like to thank Sunwoong Kim (editor), two anonymous referees, the participants at the Mid-West Economics Association conference and the Western Economics Association International conference for helpful comments and suggestions, which greatly improved the quality of the paper.

Notes

¹Antras (2003), Antras and Helpman (2004), Grossman and Helpman (2002, 2003, 2004, 2005), to name the most important.

²There is a vast literature on different aspects of incomplete contracts and their implications, which we will not discuss in detail since it is not always directly related to the topic of outsourcing. See Anderlini and Felli (1999), Bac (2001), Davis (1997), Dearden and Klotz (1997), Foss (1996), Hart and Moore (1999), Markusen (2001), Markusen and Maskus (2002), Maskin and Tirole (1999), Segal (1999).

³See Anderson and Marcouiller (2002).

⁴Anderson and Young (2002) make a similar assumption but do not consider outsourcing.

⁵Grossman and Helpman (2002) state that ‘ … such firms face relatively high fixed and variable production costs, due to their lack of complete specialization and to the extra governance costs, associated with their extensive organizations’.

⁶For more on the hold-up problem, see Schmitz (2001).

⁷Feenstra (1998), Grossman and Hart (1986), Hart and Moore (1990) also study aspects of ‘disintegration of production’, but do not consider contract enforcement.

⁸Alternatively, one can assume that each economy has a certain endowment of capital, costs are measured in terms of capital, and capital is producing z one-to-one. This second approach is equivalent to the (more compact) one taken in the model.

⁹We prove explicitly that using the parameters of this model in the Appendix.

¹⁰This follows immediately when one solves the maximization problem, equations (6)–(8). Intuitively, since the intermediate producer is presented with a take-it-or-leave-it offer only, he has no bargaining power. If he takes the offer, then he will be indifferent between reneging on and honoring the contract.

¹¹The first index in the subscript in all the variables that follow, will correspond to the location of the final producer, and the second index to the location of the intermediate one.

¹²Using equation (22) we are able to find explicitly the number of intermediate producers that enter initially, and prove that this number is indeed bigger than the number of final producers, using the parameters of the model. This proof is included in the Appendix.