Complementarities between Outsourcing and Foreign Sourcing

Abstract

Outsourcing has been growing both domestically and internationally. So has foreign direct investment (FDI). New models of international trade address these phenomena using recent advances in the economic theory of organizations. The models help us to identify circumstances under which firms choose to make their inputs themselves or buy them from third parties, and when they choose to produce their inputs locally or abroad (see Grossman and Helpman, 2002, 2004, 2005; Dalia Marin and Thierry Verdier, 2002, 2003; Diego Puga and Daniel Trefler, 2002; Pol Antras, 2003; Antras and Helpman, 2004). Some authors investigate the organizational choices of homogeneous firms in an industry with some particular characteristics while others examine the relative prevalence of different organizational structures in industries with heterogeneous firms. In this paper, we combine elements from Antras and Helpman (2004) and Grossman et al. (2004a) to study the relationship between outsourcing and foreign sourcing (or “offshoring”). Our analysis focuses on industries with heterogeneous firms that make intensive use of intermediate inputs. Contracting problems limit the types of contracts that can be written between final producers and input suppliers. Intermediate inputs can be produced domestically or in a low-wage country and can be produced inhouse or outsourced. By assumption, assembly of final goods takes place within the boundaries of the firm that has developed the product, but we sometimes allow this activity to be performed abroad. First, we assume that assembly takes place at home and that intermediate goods can be transported at no cost. We identify conditions under which cross-industry variation in the fixed cost of outsourcing generates a positive correlation between outsourcing and foreign sourcing. We then introduce transport costs for intermediate inputs and allow firms to choose where to assemble their final output. In this case, crossindustry variation in the fixed cost of doing business abroad produces a second complementarity between outsourcing and foreign sourcing. The latter finding is in keeping with conditions described in a recent article in the Financial Times about problems facing firms producing in China (see Peter Marsh, 2004). Companies that cannot find efficient local sources for components in China are burdened with the extra costs of shipping inputs from home. Apparently, FDI often goes hand-in-hand with the ability to find suitable Chinese suppliers. The trade-offs between in-house production and outsourcing and between shipping intermediate goods and producing them in proximity to assembly operations are the subject of our investigation below.