Skip to main content

Vertical Fragmentation and International Sourcing

With the second wave of globalisation after 1970s, the anatomy of international trade has changed dramatically.

The world economy has become much more integrated than before. The rise of global value chains played a prominent role in this change. Given its rising importance, an extensive amount of research has been done on vertical fragmentation of production. According to this literature, the main trade-off in undertaking production in various countries is between lower input costs and higher trade costs.

A key benefit of geographical dispersion is to save on factor costs (Navaretti and Venables, 2004). Another finding is that when operating internationally through supply chains, different organizational forms are chosen even within the same firm. In particular, firms may keep some operations internal, i.e., within the firm boundary, and some others external, i.e., under arm’s length contracts with independent input suppliers. In this project, based on these findings, a North-South model of international trade in intermediate inputs is developed in the presence of relationship-specific investments and incomplete contracts.

There are heterogeneous final-good producers that are located in the North and compete in monopolistic competition. Production entails a well-defined sequence of highly complementary stages such that a failure in any one of them destroys the whole project. In this environment, an equilibrium is characterized in which based on their productivity, firms decide where to buy their inputs in each production stage.

While doing so, they also choose their ownership structure in order to alleviate the hold-up problem they face due to contract incompleteness. Next, an analysis of how within sectoral heterogeneity and variations in industry characteristics affect the relative prevalence of firms that choose to (i) procure inputs from different locations, and (ii) form different organizational structures is performed.

This project is led by Bilgehan Karabay.