exports. This outside-option effect increases the Y -firm’s payoff from ex-post
bargaining and therefore makes outsourcing more attractive. The more so the
larger the market size.
6Overviewofresults
In this section we discuss our findings. We start with a graphical presentation
of comparative statics results. Then, we characterize the complete contract
environment to highlight the impact of contractual incompleteness on the choice
of supply mode.
6.1 Comparative statics
Three scenarios can be distinguished depending on the values of β. Figure 2.a
characterizes the equilibrium configurations in the (L, τ) space for 0 < β < 1/2
so that all supply modes can arise depending on market size and trade costs. For
τ > 2β the figure portrays Case 1, in which mode O is always dominated for any
L and the choice between X and E is determined by market size considerations
only. For τ < 2β the figure depicts Case 2, in which mode O may dominate.
In this case, outsourcing is more likely to emerge as the equilibrium mode the
larger the market size and the higher the trade costs.
Figure 2.b characterizes the equilibrium configurations for 1/2 < β < 3/4
so that only Case 2 arises. In this case mode E is always dominated and, since
condition (35) is violated, the attractiveness of mode O with respect to mode
X increases not only with market size but also with trade costs.
Figure 2.c illustrates the situation for 3/4 < β < 1. Case 2 is still the
relevant one but now condition (35) can be satisfied. For τ < 4(1 - β) the figure
is qualitatively the same as Figure 2.b: mode O is more appealing the larger
the market size and the trade costs. However, forτ > 4(1 - β) the appeal of
outsourcing may exhibit a non-monotonic behaviour with respect to trade costs.
In particular, when market size is large enough (but smaller than LO), as τ rises
from 4(1 - β) towards 1, the share of firms choosing mode O first falls and then
rises.
This non-monotonic behavior is due to the outside-option effect, which can
prevail only when market size and the bargaining power of the local input sup-
pliers are sufficiently large. A large market size is required because Y -firm
investments are proportional to the size of the market, so that the outside op-
tion effect is also stronger the larger is the M market. A strong bargaining
power for suppliers is required because the surplus from the outsourcing agree-
ment is lower the greater the hold-up problem for the input supplier. Moreover,
the outside option effect dominates only when trade costs are relatively small.
This can be understood by noting that the payoffs of the Y -firm in both the
alternatives of export and outsourcing are continuous in the level of trade costs
and that prohibitive trade costs will leave the Y -firm with the only alternative
of outsourcing. So, increasing trade costs when they are already high will nec-
15