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Effects of Adverse Selection on a Multinational Firm’s Decision on where to Subcontract

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  • Rosa Forte

  • António Brandão

Abstract

The present paper analyses the multinational firm's decision on where to subcontract in a context of asymmetric information. When a multinational firm (MNF) intends to subcontract the production of a good to a foreign firm, it faces an adverse selection problem. In fact, at the outset, foreign firms (agents) have an information advantage relative to the MNF with respect to their true production costs, which is not available to the MNF (principal). Methodologically, we adapt the general model of adverse selection to the particular case of the choice of the country on where to subcontract. We then compare the equilibrium obtained with the one which would occur in a context absent of adverse selection. Furthermore, we analyze the sensibility of the equilibrium and of a MNF's profits to changes in the parameters of the model. Since the subcontracting relationship is, generally, materialised through the accomplishment of a contract between the MNF and the foreign firm, the decision of the country on where to subcontract relates to the choice of the best contract, from the MNF's point of view, to offer to the foreign firm. Adverse selection modelling outcomes justify and are coherent with empirical evidence such as, the diversity of countries that MNFs subcontract and the fast production relocation between countries.
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Suggested Citation

  • Rosa Forte & António Brandão, 2008. "Effects of Adverse Selection on a Multinational Firm’s Decision on where to Subcontract," Journal of Industry, Competition and Trade, Springer, vol. 8(2), pages 133-146, June.
    • Handle: RePEc:kap:jincot:v:8:y:2008:i:2:p:133-146
    DOI: 10.1007/s10842-007-0014-x
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    References listed on IDEAS

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    1. Swenson, Deborah L., 2005. "Overseas assembly and country sourcing choices," Journal of International Economics, Elsevier, vol. 66(1), pages 107-130, May.
    2. Robert C. Feenstra, 1998. "Integration of Trade and Disintegration of Production in the Global Economy," Journal of Economic Perspectives, American Economic Association, vol. 12(4), pages 31-50, Fall.
    3. Gene M. Grossman & Elhanan Helpman, 2005. "Outsourcing in a Global Economy," The Review of Economic Studies, Review of Economic Studies Ltd, vol. 72(1), pages 135-159.
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    5. Robert C. Feenstra, 1998. "Integration of Trade and Disintegration of Production in the Global Economy," Journal of Economic Perspectives, American Economic Association, vol. 12(4), pages 31-50, Fall.
    6. Abraham, Katharine G & Taylor, Susan K, 1996. "Firms' Use of Outside Contractors: Theory and Evidence," Journal of Labor Economics, University of Chicago Press, vol. 14(3), pages 394-424, July.
    7. Satya P. Das, 1999. "Direct Foreign Investment Versus Licensing," Review of Development Economics, Wiley Blackwell, vol. 3(1), pages 86-97, February.
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    More about this item

    Keywords

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    JEL classification:

    • D82 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Asymmetric and Private Information; Mechanism Design
    • F23 - International Economics - - International Factor Movements and International Business - - - Multinational Firms; International Business
    • L24 - Industrial Organization - - Firm Objectives, Organization, and Behavior - - - Contracting Out; Joint Ventures

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