Incomplete Contracts and the Welfare Impact of Globalization

We embed an incomplete contracts setting into a model of economic geography with heterogeneous firms whose process of production can be geographically separated. Because of the presence of international incomplete contracts, trade liberalization is not necessarily welfare-enhancing. We show that firms that use a large share of the low-tech input relocate first, using outsourcing. Then, more technological firms start to relocate also, but integrating their supplier. We argue that this change in the organizational structure of firms increases the speed of Southern industrialization, but, it might be detrimental to workers’ welfare in both countries.