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

essarily make FDI more likely. An opposite effect can only be found at medium
or low levels of trade costs.

6.2 Complete contracts

To understand the role of contractual incompleteness, it is useful to compare the
previous results with the equilibrium outcome under complete contracts. When
complete contracts are feasible, the Y -firm and its local supplier set I and x as
to maximize the joint surplus from the outsourcing agreement, S_O , and agree
ex-ante on the sharing rule β . The joint surplus is revenues net of variable and
fixed costs:

S = √ AxsI — x — 1²

which is maximized for intermediate supply:

A²

^XS = 32

and investment in assembly:

IS = 8

The corresponding price can be obtained by substituting (39) into the inverse
1

demand function p = (A/y)² implied by (2):

PS = 16                            (41)

A

Substituting (39) and (40) in (38) gives the maximized joint surplus SS =
A² /64. Thus, under complete contracts, the payoff from outsourcing accruing
to the Y -firm is not ΠO but rather:

∏S = (1 — β) (AA)                         (42)

Differently from (26), for given A, (42) is a decreasing function of β. The
larger the MNE’s share of surplus, the higher its profits from outsourcing. The
reason is that, in the absence of hold-up problems, the MNE’s investment, the
supplier’s output, and therefore the final revenues are independent from the
division between parties. Accordingly, the parameter β acts as a sort of frictional
cost on the MNE’s revenues.

As in the case of incomplete contracts, two cases arise depending on the
relative value of β and τ .Ifβ > (1 — τ² ) then ΠE > ΠS so that FDI plus

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