The Organization of Production and Trade

We construct a unified framework to study under what conditions one of the three frequently observed organizational structure of international middle-product production may arise in equilibrium: (i) separation of upstream and downstream firms with middle-product trade, (ii) vertical integration of upstream and downstream firms, (iii) global sourcing with upstream firms outsource the final good production to subcontractors. While skilled workers are required for designing and marketing both upstream and downstream products as well as for manufacturing high-tech middle products, unskilled workers are only used for the low-tech manufacturing components of the production of the middle product and the consumable. Under the outsourcing configuration, we assume that the local firm does not own the designing component of the production of the consumable. We solve final output supply, middle-product demand and pricing under each of the three organizational structures and the optimal contract under outsourcing. We show that when subcontractor's default rate and bargaining strength are sufficiently low, the labor diversification loss is moderate and the communication and search cost is significant, outsourcing is the most preferred whereas separation is the least. We also show that the potential availability of one organizational structure can change the trade-off of the other two structures, thereby granting simple pairwise comparison invalid. Moreover, we find that an equilibrium organizational structure may be suboptimal, as a result of conflicting effects on firm payoffs and consumer surplus. Furthermore, we calibrate various economies and illustrate why different organizational structures may be more frequently observed under different regimes.