Protection and International Sourcing

In an incomplete contracts model where there are otherwise no social motives for protection, we show that protection is socially beneficial when a buyer outsources customized inputs from a specialized domestic supplier while also purchasing generic inputs from the world market. The reason is that a tariff worsens the outside option of the buyer, thereby increasing the supplier's incentives to invest. Since under free trade the supplier would underinvest due to hold-up problems, welfare rises with protection for relatively low tariff levels. But protection always distorts sourcing decisions, and is ineffective at altering investment incentives whenever the specialized supplier is foreign, as in that case tariffs have no effect on the parties' negotiation surplus. Tariffs can be particularly harmful when the firms have curbed opportunism through vertical integration, as in that case they distort sourcing and induce excessive investment. Furthermore, protection promotes inefficient organizational choices. The reason is that tariff revenue, which is external to firms, drives a wedge between the private and the social gains of both offshoring and vertical integration, leading to excessive domestic integration