Outsourcing versus vertical integration: Ethier–Markusen meets the property‐rights approach

• Date: 01 March 2014
• Author: Yiqing Xie,James R. Markusen
• Published date: 01 March 2014
• DOI: http://doi.org/10.1111/ijet.12028

doi: 10.1111/ijet.12028

Outsourcing versus vertical integration: Ethier–Markusen

meets the property-rights approach

James R. Markusen∗and Yiqing Xie†

Early analyses of direct investment versus outsourcing focused on the existence of knowledge-

based assets, knowledge being non-rivaled and non-excludable. Ethier was the first to formally

model the consequences of non-excludability for the vertical integration versus outsourcing

decision. Later authors took a different approach, modeling physical capital as fully excludable

but relationship-specific. This paper further develops a model with both non-excludable

knowledge capital and fully excludable physical capital. Results show that vertical integration

tends to be chosen when (a) the technology is relatively knowledge intensive and/or when (b)

knowledge and physical capital are strong complements.

Key wor ds vertical integration, outsourcing, knowledge capital, excludability, property rights,

knowledge intensive.

JEL classification F12, F23

Accepted 1 September 2013

1 Introduction

International business scholars have long been interestedin the decisions of fir ms toproduce abroad

and their decisions on the “mode” of foreign production. Primary among these modes are foreign

direct investment (FDI), in which the foreign producer is vertically integrated into the parent firm,

and a contract or licensing arrangement with an independent foreign producer, now commonly

referred to as outsourcing (OS). The foreign production and mode choice problems are really quite

separate: the decision to produce abroad is a location decision, while the decision to keep production

in-house is an ownership decision. The international business literature is very rich indeed, but it

generally lacks formal models and often has to rely on corporate anecdotes, given the absence of

detailed firm-level data (the absence of OS data persists today).1

∗Department of Economics, University of Colorado at Boulder,USA. Email: james.markusen@colorado.edu

†Department of World Economy and Institute of World Economy, School of Economics, Fudan University, Shanghai,

China.

This paper has been prepared for a special issue of the International Journal of Economic Theory in honor of Professor

Wilfred Ethier. Markusen and Ethier further developed Ethier’s earlier work when they both visited the Institute for

Advanced Studies at the Hebrew Universityfor 6 months in 1989, under a g roupg rant obtained byElhanan Helpman.

Weare/were grateful for this opportunity.

1Dunning (1977) is an early treatment that examines the location and outsourcing issues, though he referred to “in-

ternalization” to mean in-house production, the opposite of outsourcing. Caves (2007) providesa good summar y and

evaluation of international business research.

International Journal of Economic Theory 10 (2014) 75–90 © IAET 75

International Journal of Economic Theory

Outsourcing vs vertical integration James R. Markusen and Yiqing Xie

One thing that comes up repeatedly in the international business literature is that multinational

firms (with owned foreign subsidiaries) are intensive in what we now broadly refer to as knowledge-

based assets or capital. This is inferred from looking at information such as R&D to sales ratios,

the white-collar share of the workforce, product newness and complexity, reputations, product

differentiation measures, and so forth. Physical capital does not tend to be strongly correlated with

multinationality.

Knowledge tends to have two characteristics associated with public goods: it is at least partially

non-rivaled and non-excludable, though we have not seen these terms used in the international

business literature we have read.The first of these proper ties createsan opportunit y for a knowledge-

intensive firm whereas the second creates a difficulty. The non-rivaled property means that, once

created, knowledge can be applied in many production facilities without reducing its value in any

single facility. This in turn gives firms a strong incentive to expand to multiple plants abroad, using

the same knowledge at zero additional cost. But the non-excludability property means that a foreign

firm, whether an owned subsidiary or an arm’s-lengthcontractor, cannot be prevented from learning

the knowledge and either demanding a high return or going it alone.

Twoearly papers (Helpman 1984; Markusen 1984) noted the role of non-rivaled knowledge assets

in determining the location decision, connecting the theory of the multinational with international

trade theory. That is, the non-rivaled property is connected to the location decision. But the question

of the mode of foreign production in these papers is simply assumed to be an owned subsidiary

(vertical integration).

Tothe best of our knowledge, the first formal model that attacked the non-excludability problem

was Ethier (1986). His general idea was that there is a difficulty trying to contract with a foreign

agent: the firm needs to reveal what knowledge it has in the negotiation, but once it does so the

(potential) agent absorbs some of that knowledge costlessly.

The basic consideration working against the arm’s-length [outsourcing] alternative is the fact

that in order to sell its information for its full value, the firm must convincingly indicate what

it has to sell, thereby losing, at least in part, its monopoly advantage (Ethier 1986, p. 808).

The potential agent or contractor needs to see the blueprints, but once he does, the firm’s

advantage is partially lost: the agent can walk away but retaining the knowledge. Non-excludability is

connected to the ownership decision. At least in the field of international economics, there seemed

to be little interest in this topic in the next decade, with the exception of a paper by Horstmannand

Markusen (1987) which focused on the existence and dissipation of reputation capital.

Ethier returned to this topic in a paper with Markusen (Ethier and Markusen 1996). Theirs is

a multi-period model with a new good every two periods. A foreign agent or firm can learn the

knowledge in the first period, and then defect to start a rival firm in the second period, so the

multinational must share rents with the foreign agent in the second period if the contract is to be

preserved. This approach was further developed in Markusen (2001), with closely related papers by

Fosfuri et al. (2001) and Glass and Saggi (2002) appearing at the same time. All of these papers focus

on the non-excludability properties of knowledge-based assets.

A couple of years later, a number of papers appeared which took a quite different and comple-

mentary approach to the FDI versus OS decision. These included Antr`

as (2003, 2005), Antr`

as and

Helpman (2004), and Grossman and Helpman(2002, 2004). These papers beg in with an extreme po-

lar assumption: capital assets are fully excludable physical capital. This assumption is combinedw ith

Williamson’s (1975) notion of relation-specific investments, developed more formally by Grossman

and Hart (1986) and Hart and Moore (1990). The two parties to an investment project, firm and

foreign agent, must make up front investment in capital goods, for example, that have little or no

76 International Journal of Economic Theory 10 (2014) 75–90 © IAET