Subcontracting bargaining power and the trade policy

ABSTRACT

In this paper, we consider that the split of surplus from a subcontracting deal depends on the relative bargaining powers of domestic and foreign firms. The finding shows that a domestic optimal export policy is a tax (subsidy) if the bargaining power of the domestic firm is sufficiently small (large). We also demonstrate that a domestic firm’s higher bargaining power increases (may decrease) domestic profit if the export policy is exogenous (endogenous). In the presence of an outsider option, the domestic optimal export policy will be threatened by the outsider option if the domestic firm’s bargaining power is sufficiently small, and thus a large bargaining power increases the optimal export tax. At the same time, the foreign firm may still subcontract to the domestic firm even if the domestic firm has a higher total marginal cost of the intermediate good than the outsider option.

KEYWORDS:

• Bargaining power
• subcontracting
• trade policy
• outsider option

JEL Classifications:

• D21
• D43
• F13
• L13
• L23

Acknowledgements

The authors are grateful to the participants at Hong Hwang's trade workshop for their valuable comments, leading to substantial improvements of this paper.

Disclosure statement

No potential conflict of interest was reported by the authors.

Notes

1. Chen, Ishikawa, and Yu (2004) find that when the intermediate good price is determined by vertically integrated firms, the price competition strength will be weaker in the final goods market, so that the intermediate and final good prices both increase. Moreover, the prices of the final goods increase (decrease) if the intermediate (final) goods market liberalizes the trade. Ornelas and Turner (2008) point out that tariff reduction raises the incentives to conduct R&D cost reduction by foreign subcontractors and promotes multinational vertical integration by the manufacturer. Maiti and Mukherjee (2013) discuss the trade cost reduction impact on domestic wages when the domestic firm determines its output decision among in-house production and outsourcing to the informal sector.

2. Ghosh and Saha (2008) use additional surplus, which comes from licensing, as a basis for mutual agreement. Yang and Maskus (2009) discuss the issue about license and trade and assume what rate the north country licenses its technology to the south country depends on the rate of the surplus of licensing he gains, which is also this firm's relative bargaining power. Therefore, there are many papers using this kind of surplus distribution as a type of bargaining power for illustration in different issues. This paper follows Spiegel (1993), Liang and Mai (2006), Ghosh and Saha (2008), Yang and Maskus (2009), and Ishikawa, Morita, and Mukunoki (2010) in that firms distribute the cooperative surplus according to their relative bargaining powers.

3. Note that the subcontracting takes place on the intermediate good in this paper. However, the subcontracting can also take place on the final good, making no difference in the results. The outsourcing model in this paper considers the case that firm F outsources to firm D and then ships the subcontract products back to country F. Firm F then labels its own brand and exports the labeled products to a third country. The labeling cost is simplified to be zero here, such that exporting the labeled products to a third country will not increase the production cost. This kind of outsourcing can be viewed as an outsourcing of the final product. Furthermore, the intermediate product's price is assumed to be exogenous here while one unit of the intermediate good is required to produce one unit of the final good. Therefore, taxations on final or intermediate products will both increase the production cost of final products, with the same net effects on price competition in final products. Consequently, the effect of an export tax on firm D's subcontract products is equivalent to taxing the export to the third country by firm F. The tax policy taken into account in this paper is only on the export of subcontract products, but not for the export to the third country by Firm D under its own brand.

4. The other one is the ex-ante contract. The ex-post contract means the quantity and price are determined before the subcontracting stage. Spiegel (1993) shows that ‘when there is considerable uncertainty about the demand for the final good or the cost of marketing, firms may prefer to postpone their decisions about subcontracts until they actually receive orders from downstream retailers.’ Furthermore, Kamien, Li, and Samet (1989) and Liang and Mai (2006) also use this ex-post contract setting. Thus, given the quantity, we just discuss whether to subcontract this quantity to the subcontractor. When the price and quantity are given, the cost saving surplus will equal the profit difference between before and after subcontracting.

5. Note that is exogenous in this paper. Therefore, the transfer payment is a function of , where the transfer payment increase with .

6. The current text does not cover the issue of capacity constraint. This paper assumes no capacity constraint for firm D. That is, firm D can produce as much as the market demands.

7. From (1) and (2), if we delete the surplus of the subcontract part, then these become the profit function under non-subcontracting. From (3) and (4), if we delete the subcontracting surplus effect, then these are the first-order conditions without a subcontract.

8. Equilibrium prices with the subcontract are: Equilibrium prices without the subcontract are: The price difference with and without the subcontract is:

if . Since , we have , and , if .

9. .

10. Although the marginal cost for firm K may be lower than firm D, we focus on the strategic effect when firm F subcontracts to firm D. We ignore firm D subcontracting to firm K in order to avoid complexity and a fuzzy focus.

11. If firm F subcontracts to firm D, then firm F's profit function is: . The first-order condition is: ; and the second-order condition is: . We define . When , , which is an unreasonable area. Therefore, is a condition for a reasonable area.

12. From , we have and . Since , is meaningful.

13. Firms' price strategies are strategic complements under price competition. That is, an increase in one firm's price induces the other firm's price to increase, which promotes both firms' profits. Therefore, under price competition, there is a collusion effect between firms D and F. Since the unit subcontract production cost of firm D is higher while that of firm K is lower, the market prices under firm D's subcontract are higher than those under firm K's subcontract, helping promote firm F's profit. Therefore, in presence of the collusion effect, firm F has an incentive to outsource to firm D which has a higher subcontract production cost.

Additional information

Funding

Financial support from the National Science Council [grant number NSC-102-2410-H-259-003-MY3] is gratefully acknowledged.