and assume that the local input suppliers may find themselves held-up with the
agreement due to contractual incompleteness and ex-post bargaining. The idea
is that, if contracts cannot be written ex-ante due to unforeseeable contingen-
cies and if the intermediate inputs requested are specific (i.e., of scarce alterna-
tive uses outside the MNE-supplier relationship), then the local subcontractor
may end up underproducing the input, anticipating less than full reward for its
services. Moreover, since also MNEs have to undertake relation-specific invest-
ments in an incomplete-contract environment, a double-sided hold-up problem
arises. However, as opposed to input suppliers, MNEs have an outside option
when engaging in outsourcing arrangements: they can fall back on intermediate
self-production and exportation.
The role of the outside option in the ex-post bargaining process is at the
source of the non-linearity between FDI and trade costs. It makes the payoff
from FDI plus outsourcing depend on trade costs even though no trade takes
place under that supply mode. To understand why this happens, consider again
the trade-offs a firm faces when choosing its supply mode. First, it faces the
traditional proximity-vs-concentration trade-off. Second, in the case of FDI, it
faces the trade-off between outsourcing and intermediate exports. This second
trade-off is entirely due to the contractual incompleteness and arises only if the
ex-post bargaining power of the firm is small enough with respect to the cost of
shipping intermediates.
Crucially, the level of trade costs affects both trade-offs. When trade costs
are large, the first trade-off dominates and makes FDI more appealing than ex-
ports due to traditional proximity considerations. When trade costs are small,
the second trade-off dominates. It is still true that small trade costs make
exports more appealing than FDI due to proximity-vs-concentration considera-
tions. However, they also strengthen the outside option of FDI plus intermediate
exports. This ‘outside option effect’ increases the MNE’s payoff from ex-post
bargaining and therefore, it makes outsourcing more attractive. If market size
is large enough such an outside option effect may prevail. This explains the
non-monotonic relation between FDI and distance only in countries with large
markets as reported in Table 1. Since the outside-option effect is entirely due to
the hold-up problem, non-monotonicity disappears under contract completeness.
The remainder of the paper is structured as follows. In the next section
we put our contribution into context by surveying some related literature. In
Section 3 we present the structure of the model. In section 4 firms’ equilibrium
profits are computed under the alternative modes of serving the foreign mar-
ket: final export, FDI plus intermediate export, and FDI plus outsourcing. In
section 5 we characterize the equilibrium of the model. In Section 6 we pro-
vide comparative statics results and solve the model under complete contracts.
Section 7 concludes.