Financial development and the product cycle

I develop a model to study how financial institution differences across countries affect the offshoring decision of Northern firms and whether a product cycle arises when the only comparative advantage of Northern suppliers is their access to better financial institutions. A Northern final-good producer needs to buy an intermediate input from a supplier to complete production. She can find this supplier either in the low-wage but financially underdeveloped South or in the high-wage and financially developed North. I show that financial institution differences affect the optimal contract offered to the supplier and are enough to generate a product cycle. The final-good producer faces a trade-off between low wages and contracting distortions. When the good is new, she finds it optimal to keep production in the North, at the cost of a higher wage but with the benefit of a less distorted contract. However, as the good becomes more standardized, the importance of the supplier increases and the cost of not shifting production to the South and take advantage of the lower wage offsets the contractual distortions that the underdeveloped Southern financial institutions create. The most salient empirical prediction is that the more R&D-intensive an industry is, the larger is the effect of financial development on offshoring. These results also hold when wages are endogenized. In the empirical section, the prediction is tested and confirmed using disaggregated trade data.