Firms are going global: they source an increasing share of their intermediate inputs from foreign countries. Richard Baldwin (2006) argues that the actual globalisation process occurs at the level of the firms, which can fragment their production stages and/or delocalise tasks because of lower communication and coordination costs. The empirical literature confirms that a growing share of international trade consists of intermediate inputs. Yeats (2001) reports that more than 30% of world trade in manufactured goods in 1995 were shipments of intermediate products and components.
Trade in intermediate inputs takes place both within firm (internalisation) and outside the boundaries of firm (outsourcing). The question whether firms internalise or outsource is crucial to the understanding of the pattern of trade and makes its impact on host and source countries unpredictable (Baldwin 2006). Internalisation is a growing phenomenon in France while the United States is experiencing the opposite trend. From 1990 to 1999, French intra-firm imports increased by 88.4% while they decreased by 9.8% in the U.S during the same period. Understanding these different trends requires a small theoretical detour.
This “make or buy” decision has a long tradition in economics especially in industrial organisation. However, it has been only recently introduced in trade models. Pol Antràs and Elhanan Helpman (2004, 2008) have developed elegant theoretical models that rely on contract incompleteness and firm-level heterogeneity. Contracts are typically incomplete either because they are difficult to write and/or because the court cannot enforce them. In their models, the firm’s sourcing mode depends on the interaction between its productivity, its factor intensity, and the contracting environment of the exporting country. Firms that rely largely on intermediate inputs might choose to internalise if outsourcing involves substantial organisational costs in countries with poor contracting environments. There is thus a mapping between firms’ characteristics and their mode of sourcing from particular markets. These facts are of course unobservable at the aggregate level, and more firm-level evidence is needed.
Our recent empirical analysis demonstrates the relative role of firm-level and country-level determinants of internalisation. We rely on a French business survey carried out by SESSI (Service des études et des statistiques industrielles) on all firms belonging to an international and industrial group. The sample covers about 80% of the manufacturing imports of industrial firms in 1999. In addition, the dataset provides information on the geographical breakdown of firms’ imports at product level and their mode of sourcing. Here are some of the most salient facts.
The most productive French firms outsource
Each sourcing mode has different costs that might not be appropriate for all firms, given their production process. For instance, firms that source their inputs internally might have lower organisational costs because they combine the coordination costs of two independent organisations. Among firms that have been surveyed by SESSI, 70% respond that internalising the production of intermediate inputs involves cheaper organisational costs than outsourcing. This explains why the most productive firms, i.e those that are likely to be able to afford these organisational costs, choose to outsource.
Figure 1 ranks the cumulative distribution of firms’ total factor productivity according to their sourcing modes. A lower cumulative distribution corresponds to a higher average productivity of the considered group.
Figure 1 Cumulative distribution of (log) total factor productivity by sourcing
As Figure 1 shows, firms that outsource are more productive than firms that internalise the production of intermediate inputs.
Factors intensities affect the sourcing mode
Firms that are highly productive are able to pay higher organisational costs and outsource. However, they also need to have a production process that is adapted to this mode of sourcing. The theory of incomplete contracts has long acknowledged the role of factor intensity in the sourcing mode decision. The production of a final good requires both the inputs of the firm and of its supplier. The relative input intensity governs the sourcing mode: a firm finds more profitable to outsource in order incentivise its foreign suppliers when its production process relies intensively on their specific factors.
We find two important results. First, in line with the theory, French firms outsource when they intensively use intermediate inputs in their production process. Second, empirical studies using U.S. data find that unskilled-labour intensive industries outsource more (See Nunn and Trefler, 2008 for a detailed analysis on the boundaries of U.S. multinational enterprises). However, we find that within the same industry, firm-level factor-intensities matter. French firms that are relatively more intensive in unskilled labour are more likely to outsource.
Host country characteristics matter
About 87% of French firms’ transactions are imported using outsourcing only from developed countries. When analysing the geography of French firms’ imports, the interaction between firm-level and country-level attributes reveals some interesting patterns.
We observe that relative factor-intensities simultaneously determine the sourcing modes of French firms and the location of their intermediate inputs’ suppliers. French firms that intensively use unskilled labour in their production process outsource the production of intermediate inputs from relatively unskilled-labour-abundant countries. Firms that have more complex production processes that involve the input of skilled labour choose to internalise and import from relatively skilled labour abundant countries.
Moreover, the contracting environment of the exporting country plays a major role. The theoretical literature finds different predictions on the impact of the contracting environment on the sourcing mode (Antràs and Helpman, 2004, 2008). We find that French firms internalise in countries with better contracting environment.
Antràs, P., and Helpman, E., (2004). Global Sourcing. Journal of Political Economy, 112(3): 552-580.
Antràs, P., and Helpman, E., (2008). Contractual Friction and Global Sourcing. In Helpman, E., Marin, D., and Verdier, T., (editors). The Organization of Firms in a Global Economy, Harvard University Press.
Baldwin, R., (2006). Globalisation: The Great Unbundling(s) in Challenges of globalisation for Europe and Finland, 26 September 2006.
Nunn, N., and Trefler, D., (2008). The Boundaries of the Multinational Firm: An Empirical Analysis. In Helpman, E., Marin, D., and Verdier, T., (editors). The Organization of Firms in a Global Economy, Harvard University Press.
Yeats, A., (2001). How big is global production sharing? In Arndt, S. and H. Kierzkowski, 2001, Fragmentation: New Production and Trade Patterns the World Economy. Oxford University Press, Oxford.
1 Defever, F., and F., Toubal (2007). Productivity and the Sourcing Modes of Multinational Firms: Evidence from French Firm-Level Data, CEP Discussion Paper No 842.