Outsourcing

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Review of Economic Studies (2005) 72, 135–159 c 2005 The Review of Economic Studies Limited

0034-6527/05/00070135$02.00

Outsourcing in a Global Economy
GENE M. GROSSMAN
Princeton University and

ELHANAN HELPMAN
Harvard University, Tel Aviv University and CIAR
First version received August 2002; final version accepted November 2003 (Eds.) We study the determinants of the location of subcontracted activity in a general equilibrium model of outsourcing and trade. We model outsourcing as an activity that requires search for a partner and relationship-specific investments that are governed by incomplete contracts. The extent of international outsourcing depends inter alia on the thickness of the domestic and foreign market for input suppliers, the relative cost of searching in each market, the relative cost of customizing inputs and the nature of the contracting environment in each country.

“Subcontracting as many non-core activities as possible is a central element of the new economy”. Financial Times, 31 July 2001, p. 10.

1. INTRODUCTION We live in an age of outsourcing. Firms seem to be subcontracting an ever expanding set of activities, ranging from product design to assembly, from research and development to marketing, distribution and after-sales service. Some firms have gone so far as to become “virtual” manufacturers, owning designs for many products but making almost nothing themselves.1 Vertical disintegration is especially evident in international trade. A recent annual report of the World Trade Organization (1998) details, for example, the production of a particular “American” car: Thirty per cent of the car’s value goes to Korea for assembly, 17·5% to Japan for components and advanced technology, 7·5% to Germany for design, 4% to Taiwan and Singapore for minor parts, 2·5% to the United Kingdom for advertising and marketing services and 1·5% to Ireland and Barbados for data processing. This means that only 37% of the production value . . . is generated in the United States (p. 36).

Feenstra (1998), citing Tempest (1996), describes similarly the production of a Barbie doll. According to Feenstra, Mattel procures raw materials (plastic and hair) from Taiwan and Japan, conducts assembly in Indonesia and Malaysia, buys the moulds in the U.S., the doll clothing in China and the paints used in decorating the dolls in the U.S. Indeed, when many observers use the term “globalization”, they have in mind a manufacturing process similar to what Feenstra and the WTO have described. 1. See The Economist (1991) for an overview of trends toward greater outsourcing in manufacturing. Bardi and Tracey (1991), Gardner (1991), Helper (1991), Bamford (1994) and Abraham and Taylor (1996) document increased subcontracting in particular industries or for particular activities. 135

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To us, outsourcing means more than just the purchase of raw materials and standardized intermediate goods. It means finding a partner with which a firm can establish a bilateral relationship and having the partner undertake relationship-specific investments so that it becomes able to produce goods or services that fit the firm’s particular needs. Often, but not always, the bilateral relationship is governed by a contract, but even in those cases the legal document does not ensure that the partners will conduct the promised activities with the same care that the firm would use itself if it were to perform the tasks.2 Because outsourcing involves more than just the purchase of a particular type of good or service, it has been difficult to measure the growth in international outsourcing. Audet (1996), Campa and Goldberg (1997), Hummels, Rapoport and Yi (2001) and Yeats (2001) have used trade in intermediate inputs or in parts and components to proxy for what they have variously termed “vertical specialization”, “intra-product specialization” and “global production sharing”. While these are all imperfect measures of...
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