Vertical Fragmentation and International Sourcing

Abstract

In a North-South model of international trade, we analyze the ways firms procure their inputs in the presence of relationship-specific investments and incomplete contracts. There are heterogenous final-good producers that are located in the North and compete in monopolistic competition. Production entails a well-defined sequence of highly complementary stages such that a failure in any one of them destroys the whole project. In this environment, we first characterize an equilibrium in which based on their productivity, firms decide where to buy their inputs in each production stage. While doing so, they also choose their ownership structure in order to alleviate the hold-up problem they face due to contract incompleteness. Next, we examine how within sectoral heterogeneity and variations in industry characteristics affect the relative prevalence of firms that choose to (i) procure inputs from different locations, and (ii) form different organizational structures.