International organization of production and distribution.

• Author: Helpman, Elhanan
• Position: Research Summaries

International trade has grown rapidly since World War II, and in the last two decades the acquisition of subsidiaries in foreign countries (that is, foreign direct investment, or FDI) has grown even faster. Not only have foreign trade and FDI expanded rapidly, but their nature also has changed as production has become more fragmented and its individual stages have been dispersed across many countries. These trends have been accompanied by growing domestic and international outsourcing. (1) As a result, we now have a more complex web of international trade and FDI than ever before, which cannot be explained by traditional trade theory. In response, theorists have developed new analytical tools for thinking about these issues. I will describe some of this research in which I was involved.

In order to understand the new organizational forms, it is useful to think about a simple two-dimensional choice that a business firm has to make concerning an intermediate input: it has to decide whether to produce it in-house or to outsource its production to another firm, and in either case it has to decide whether to make it offshore or not. This yields four possibilities. First, an input can be produced in-house in the home country of the firm, in which case there is neither foreign trade nor FDI. Second, an input can be outsourced in the home country, in which case there is also neither foreign trade nor FDI. Third, an input can be produced in-house in a foreign subsidiary, in which case there is foreign direct investment. If the input is imported back to the home country for further processing or assembly, there is also intra-firm trade. Finally, an input can be outsourced to a foreign supplier, in which case there is no FDI, but if the input is imported to the home country for further processing or assembly there is arm's-length trade. An understanding of what drives these choices is essential for an understanding of the recent trends in the world economy.

Incomplete Contracts

Grossman and I started to study these issues in the late 1990s, focusing first on the internalization decision (that is, a firm's decision to produce in-house or to outsource). We took an incomplete contracts approach to the theory of the firm. Having in mind dealing with trade and FDI, we first developed an analytical framework suitable for general equilibrium applications. (2) In this framework, final goods producers need specialized intermediate inputs, and they enter an industry as either integrated or outsourcing enterprises, while suppliers of intermediate inputs enter as independent entities. An outsourcing final goods producer has to find an input supplier, and a supplier has to find a buyer. An outsourcing firm pairs up with only one supplier, and vice versa. The probability of each side finding a match depends on the number of producers and suppliers seeking partners. Once a match has formed, the supplier decides on how much to invest in the buyer's specialized input. This is the point at which the incompleteness of contracts kicks in. This model implies that trade has no effect on the organization of industries when matching is subject to constant...