Incomplete Contracts and the Impact of Globalization on Consumer Welfare
Paper No' CEPDP1057:
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Keywords: Consumer Welfare; Incomplete Contracts, hold-up problem
JEL Classification: F23; L22; R3
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This Paper is published under the following series:
CEP Discussion Papers
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We embed a North-South trade model into an incomplete contracts setting where the production of heterogeneous firms can be geographically separated. When a Northern headquarter contracts with a Southern supplier instead of a Northern supplier, the presence of international incomplete contracts may lead to a higher price. As a result, trade liberalization, that induces offshoring, is not necessarily welfare-enhancing for consumers, despite the lower cost of labor in the South. In addition, firms which use the supplier's component intensively, offshore their supplier in the South using outsourcing. As trade costs fall, less componentintensive firms also offshore, but by vertically integrating their supplier. We argue that this organizational change increases production-shifting in the South, implying that a larger number of varieties will be produced in the South where contracts are incomplete. We show that, this may reduce consumer welfare in both countries.