Vertical FDI versus Outsourcing: The Role of Host Country Human Capital

The decision to make or buy” an input is usually studied with reference to the home country. However, since the offshored input is produced in a host country, there is a strong reason to believe that the host country factors would also influence the organization decision of offshore production. In this paper, we modify the Antràs (2005) model to explore the affect of the host country human capital on the organization of offshore production. We propose that the offshored input cannot be produced in a host country without incurring training cost on the host country labor. This training cost would in turn depend on the human capital gap between the home and the host country. We find that: 1. For low-tech goods, where the likelihood of outsourcing is higher in the Antràs model, vertical FDI is a possibility when the human capital gap between the home and the host country is low, 2. For high-tech goods, where the likelihood of vertical FDI is higher in the Antràs model, international outsourcing is also possible, especially when the human capital gap between the home and the host country is large. Our model also has policy suggestions for host countries which aspire to maximize their benefits from the exploding global production sharing phenomenon. As the wage gap between the source and the host country falls, offshoring for simply cost considerations falls. To keep this cost pressure from dampening offshoring activity, a host country must necessarily make investment in education to lower the human gap between the home and the host.