Outsourcing, Complementary Innovations and Growth



model of innovation in which production follows a value chain consisting of an upstream basic stage
and a downstream advanced stage. They show that, by lowering production costs, outsourcing the
basic stage from high-cost North to low-cost South boosts profits and therefore innovation. They
do not deal, however, with matching and contractual frictions, which in our framework generate an
ambiguous relation between outsourcing and innovation. Similarly, complementary innovation and
matching frictions appear neither in the North-South quality ladder model with incomplete contracts
by Ottaviano (2008) nor in the offshoring model with expanding product variety by Naghavi and
Ottaviano (2008b). They do appear in Naghavi and Ottaviano (2008a) who nonetheless disregard the
impact of outsourcing on innovation and growth in the long run, which is the main focus of the present
paper. Finally, Lai, Riezman and Wang (2005) endogenize the decision to outsource R&D rather
than perform it in-house by emphasizing the trade-off between the costs of information leakage and
the benefits of specialization. In Acemoglu, Aghion and Zilibotti (2005) R&D is always performed
in-house and firms closer to the technology frontier have a stronger incentive to outsource production
in order to concentrate on more valuable R&D. By highlighting the effects of fragmented production
on innovation when R&D is always outsourced, our model complements both contributions.

The core result of the present paper is that, albeit demonstrating a channel through which the
outsourcing of production may breed innovation, our model reveals a tension between the static and
dynamic implications of outsourcing that prevents this from always being the case. The reason is that
the production decision is made weighting the higher searching and contracting costs of outsourcing
against the missed specialization gains of vertical integration. In so doing, it does not take into
full account its effects on the incentives to innovate. As a result, the static gains from specialized
production may sometimes be associated with a slow down of innovation and growth. In particular,
firms and labs favor outsourcing when there are substantial gains from specialization and the ex-
post bargaining weights of intermediate suppliers and final producers reflect the relative incentives of
labs to create the corresponding blueprints. When this is the case, search and hold-up frictions are
minimized. Thus, when the R&D costs of intermediate blueprints are large (resp. small) with respect
to the R&D cost of final blueprints, outsourcing is likely accelerate innovation if the bargaining



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