Vertical FDI versus Outsourcing: A Welfare Comparison from the Perspective of the Host Country

The theory on organization of offshore production is most often viewed through the lens of a source country. Moreover, internalization literature in a vertical production transfer context is divorced from its welfare consequences. That is, the decision to “make or buy” offshore input is usually not connected with the welfare effect of each alternative organizational mode. In this paper we recognize the importance of the mode of organization of fragmented production for the host country. Whether production sharing arrangement is internalized by the parent firm in the form of a vertical foreign direct investment (VFDI) relationship or transacted externally through outsourcing contracts, affects the welfare of the host country in a significant way. Using a Grossman-Helpman quality ladders model and Vernon’s product cycle set up, we compare the welfare derived by the host country in the two alternative regimes of production sharing arrangements in the host country. The ability to maximize welfare in the alternative regimes is found to be contingent on the absorptive capacity of the host country. If the host country's absorptive capacity is above a threshold level, outsourcing is more welfare enhancing vis-à-vis VFDI; while even with an absorptive capacity lower than this threshold, outsourcing being welfare improving over VFDI cannot be ruled out.