Trade Liberalization, Outsourcing, and the Hold-Up Problem
London School of Economics & Political Science (LSE) - Department of Management; London School of Economics & Political Science (LSE) - Centre for Economic Performance (CEP)
John L. Turner
University of Georgia - C. Herman and Mary Virginia Terry College of Business - Department of Economics
In a bilateral relationship where the supplier of an intermediate good has to make a relationship-specific investment but cannot write or enforce a complete contract, the standard hold-up problem of underinvestment arises. We show that this problem is aggravated when the buyer is located in a different country and that country has a tariff on imports of the intermediate good. In that context, trade liberalization enhances international trade through three distinct mechanisms: it directly reduces the cost of imported intermediate goods, it induces foreign suppliers to increase cost-reducing investments, and it may prompt the formation of vertical multinational firms. The extra investment increases the value of international bilateral relationships and amplifies the impact of lower tariffs on trade flows. The possible formation of vertical multilateral firms further increases investment and trade. These indirect effects of trade liberalization help explain why standard trade models fail to explain the observed large responses of trade volumes to small tariff reductions and rationalize current trends toward increased foreign outsourcing and intra-firm trade.
Number of Pages in PDF File: 24
Keywords: Trade Liberalization, Outsourcing, Hold-Up Problem
JEL Classification: F13, F23, L22, D23
Date posted: February 21, 2006
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