The Veblen-Gerschenkron Effect of FDI in Mezzogiorno and East Germany

4.3 FDI plus outsourcing

Under the outsourcing mode O, each Y -firm performs final production in coun-
try M (hence it is an MNE) relying on a specific local intermediate supplier
under incomplete contracts. The timing of events is such that first the Y -firm
chooses its level of investment I , then the supplier chooses its output and finally
the surplus from the outsourcing agreement is split between the two parties.

Solving backwards, we start with the bargaining stage. Contractual incom-
pleteness implies that the surplus of the match is distributed between the Y -firm
and its supplier through ex-post bargaining. Specifically, the MNE and the in-
put supplier share the revenues from final sales R = py solving the following
problem

max (R - RMNE)^β (RMNE - πE)^(1-β) ,              (16)

RMNE

where β denotes the barganing power of the input supplier, and RMNE the
amount of revenues captured by the MNE. Moreover, πE is the value of the
MNE’s outside option, i.e., the operating profit it would earn by importing
rather than outsourcing the intermediate input. Due to the specificity of its in-
put, the outside option of the supplier is instead zero. Thus, for the outsourcing
agreement to be considered at all by the two parties, the associated revenues
R cannot be lower than their outside options. Since the outside options are
zero for the supplier and πE for the MNE, for the outsourcing agreement to
be considered at all the associated revenues must be higher than the operating
profits under intermediate exports:

R>πE                         (17)

Denoting by RS the amount of revenues accruing to the input supplier, the
solution of (16) yields

RSupp = β(R-πE),                           (18)

R_MNE =(1- β)(R - π_E) + π_E.             (19)

The parties share the surplus from the agreement (i.e., revenues net of the
sum of parties’ outside options where the supplier has no outside option) ac-
cording to their bargaining powers. For each party the share of surplus is added
to the outside option. The expressions for R_Supp and R_MNE in (18) and (19)
represent the payoffs of the input supplier and the MNE respectively from in-
vesting in the outsourcing relationship. In the case of the input supplier the
investment consists of the production of an amount x of specific input. In the
case of the Y -firm the investment is an amount I of numeraire in assembly.
Of course, the stronger the bargaining power of the supplier β , the larger the
weight of the outside option in the revenues accruing to the MNE.

Solving backwards, recalling that y = xI and using the inverse demand
function, the problem of the input supplier can be written as:

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