Outsourcing, Complementary Innovations and Growth

There are, however, gains from specialization in that, controlling for learning effects, the creation of
blueprints for vertically integrated production is more costly than the creation of an upstream and
a downstream blueprints reflecting the higher complexity of the corresponding innovation process.
Benefits from specialization are also present in terms of production as fragmentation is more efficient
than integration.

While integrated processes are more costly to design and less efficient, they are, nonetheless, ready
to run without additional burdens for the firms acquiring their blueprints. Fragmented processes
face, instead, searching and matching frictions between intermediate suppliers and final assemblers.
They also face contractual frictions as they require relation specific investments in order to make
matched upstream and downstream blueprints perfectly compatible with each other. As in Grossman
and Helpman (2002), we make the realistic assumption that contracts are incomplete due to the lack
of ex-post verifiability of the quality of deliverables by third parties, which implies that relation
specific investments give rise to hold-up problems. Thus, our model incorporates what Grossman
and Helpman (2005, p.136) “consider to be the three essential features of a modern outsourcing
strategy. First, firms must search for partners with the expertise that allows them to perform
the particular activities that are required. Second, they must convince the potential suppliers to
customize products for their own specific needs. Finally, they must induce the necessary relationship-
specific investments in an environment with incomplete contracting”.

There are a few existing contributions that are strictly related to this paper. The way we
model the choice on whether to fragment production or not follows recent research that investigates
outsourcing in an industry equilibrium when contracts are incomplete. The main contributions of
this literature are surveyed by Helpman (2006).³ In particular, the decision on whether production
should be kept in-house or outsourced has been explored by McLaren (2000) as well as Grossman
and Helpman (2002) for a closed economy, and by Antras (2003), Grossman and Helpman (2003)
as well as Feenstra and Hanson (2004) for an open economy. Our focus on the dynamic effects
of outsourcing is reminiscent of Glass and Saggi (2001) who develop a North-South quality ladder
³See Markusen (2002) as well as Barba Navaretti and Venables (2004) for a broader view of the theory of multi-
nationals.

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