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

maxβ ( √AXI - πE (I)) - x.
x

Note that, due to the timing of events, in problem (20) the term πE (I) is treated
as exogenous. The necessary condition for this maximization problem generates
the best-reply quantity of the input supplier:

XO (I ) = β² AI,

which, together with the associated final price

2

^pO^(I ) = βI

gives total revenues as a function of the investment I: RO (I)=pO (I)XO (I)I.

The Y -firm maximizes profits with respect to I taking into account the best
reply of the intermediate supplier and the effect that the investment has on its
own outside option, π_E(I). The problem for the Y -firm is therefore

maxΠO(I)=(1-β) RO(I)+βπE(I) -I²            (23)

The necessary condition for (23) yields

IO = ^βA h(1 - β) + 2i                      (24)

which implies a price level equal to

PO = —?---------------                    (25)

^O   β²A [(1 - β) + τ/2]                       ^{k J}

and the maximized profits

∏O = μ^βAУ h(1 - β) + 2]²                  (26)

Profits (26) are concave in β and reach a maximum at β = (2 + τ)/4. For
given A, this would be the allocation of bargaining powers between parties that
maximizes the MNE’s payoff by striking the right balance between its incentive
to invest and the supplier’s incentive to produce. Profits are always positive,
are equal to zero at β =0and equal to ΠE at β =1. In the former case,
the intermediate supplier has no incentive to produce. In the latter, the MNE
has no claim on the surplus from outsourcing and thus falls back on its outside
option.

Finally, given (17), for the outsourcing agreement to be considered at all by
the two parties, it must be that R(IO) > πE (IO), which yields:

(27)

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