The Organization of Production and Trade

We construct a uni ed framework to study under what conditions one of the three frequently observed organizational structures of international middle-product production may arise in equilibrium: (i) separation of upstream and downstream firms with middle-product trade, (ii) vertical integration of upstream and downstream firms, and (iii) global sourcing with upstream fi rms internalizing design and marketing tasks while only outsourcing the final good production to subcontractors. We examine how conventional comparative advantage (search, communication, trade and labor diversi cation costs) and the concern of the product-defect risk arising from outsourcing jointly determine the organization of production and trade. We show that the potential availability of one organizational structure can change the trade-off of the other two structures, thereby making simple pairwise comparison invalid. Moreover, we fi nd that an equilibrium organizational structure may be suboptimal, as a result of conflicting effects on firm's payoffs and the consumer's surplus. Furthermore, we calibrate various economies and illustrate why different organizational structures may be more frequently observed in different economic environments.