The Impact of Contract Enforcement Costs on Outsourcing and Aggregate Productivity

Contracting frictions affect the organization of firms, but how much does this matter on the aggregate level? This paper studies how costly supplier contract enforcement shapes the patterns of intermediate input use and quantifies the impact of these distortions on aggregate productivity and welfare. Using the frequency of litigation between US firms to measure the potential for hold-up problems, I find a robust relationship between countries' input-output structure and their quality of legal institutions: in countries with high enforcement costs, firms have lower expenditure shares on intermediate inputs in sector pairs where US firms litigate frequently for breach of contract. I adapt a Ricardian trade model to the study of intersectoral trade, and show that the variation in intermediate input shares that is explained by contracting frictions is large enough to generate sizeable welfare increases when enforcement institutions are improved.