Information, incentives and multinational firms

I present a model that explains a multinational firm's choice of organizational form. If a firm in the developed country outsources the production of its intermediate goods to a supplier in the developing country, it faces an adverse selection problem. If it chooses to produce the intermediate goods in its own subsidiary in the developing country, it faces an inefficient monitoring problem. My analysis of this tradeoff provides a new explanation for the observation that FDI is concentrated in capital intensive industries and yields two empirical hypotheses: more firms should adopt outsourcing instead of FDI after trade liberalization; the share of intra-firm trade in total trade should be increasing in the degree of productivity dispersion across intermediate goods suppliers in the developing country.