Aspects of International Fragmentation

Abstract

This paper uses a specific-factors model incorporating two sectors, in order to explore the efficiency and distributional consequences of international disintegration of production. The economy faces a neighboring region where the wage rate is lower than obtaining in the domestic economy under integrated production, which gives rise to an incentive for outsourcing. Assuming that outsourcing is takes place in only one of the two sectors, we show that under perfect markets it gives rise to an "outsourcing surplus" which is analogous to the "immigration surplus". However, in contrast to the case of immigration, the gain from outsourcing is the larger, the smaller the associated redistribution to the disadvantage of labor. However, if the activity which is lost to outsourcing involves a fixed input, then outsourcing may cause a welfare loss and the domestic wage rate may fall below the foreign level. The paper identifies conditions that lead to this outcome. The case is analyzed as a two-stage game where firms decide on the outsourcing strategy in stage one, and then behave competitively in their respective labor markets in stage two.