10

Offshoring, Product Scope, and Firm
Performance
Sasan Bakhtiari, Antonio Minniti and Alireza Naghavii1 Introduction
Observations on the multinationalization of firms’ activities and the impact of shifting
production abroad on their performance do not always converge to the same results. Obvious
reasons for the contradicting conclusions include ex-ante firm-level heterogeneity,characteristics of the industry, and country-specific features related to the destination. It israther well-established by now that more productive firms engage in and gain more frominternational activities (Helpman et al. 2004), and that a sound business environment, due to for
example better institutional quality, attracts and benefits multinational firms (Antràs andHelpman 2008). As for industry characteristics, existing studies have usually categorizedindustries with their level of complexity, technology intensity, or product differentiation.
Multinationals are usually associated with industries with a high level of product complexity,
more sophisticated technologies, and a substantial degree of product differentiation.
In this paper we provide a theory to shed light on the joint role of offshoring and productscope on the productivity of multinational multiproduct firms, a concept of first introduced in
Baldwin and Ottaviano (2001). Yeaple (2013) later expanded the argument by highlighting thesimultaneous decisions of firms on the number of products to manage and the mode of serving
the foreign market (exports versus multinational production). In particular, he investigated theproximity-concentration tradeoff faced by firms in an environment where managerial expertiseis in fixed supply within a firm and has to be allocated to particular products and production
locations. Our analysis continues on this path by exploring the innovation activity ofmultinational multiproduct firms and the role of spillovers in determining the effect of theinteraction between offshoring and product scope decisions on productivity growth and firm
performance.
We treat productivity as an endogenous variable determined by the extent of innovation
activities carried out by the firm. We look at product scope both in terms of the number of1varieties produced by firms as an outcome of product innovation, and the degree of productdifferentiation between the varieties it produces. More homogenous products translate into
innovation being more inclusive for a firm’s overall performance as R&D output can be spread
across different products within the firm. However, the model suggests that regardless of aseries of adverse effects associated with the geographical dispersion of production, a larger
degree of product differentiation enables a firm to better absorb benefits from the expanded
span of new information accessible in international markets. Learning spillovers that arise
while operating in a highly differentiated portfolio of products can therefore compensate losses
from limitations on knowledge transfer to offshore sites, resulting in more innovation andthereby enhancing the productivity of the firm.
The framework aims to provide a foundation to unify three important streams of related
literature on multinational production, multiproduct firms, and innovation.
The question on how firms alter their product mix according to changes in economic
conditions in the international market has been addressed by Eckel and Neary (2010), whoshow that globalization increases firm productivity but decreases the scope of multiproductfirms by shifting their focus towards their core competence. Other influential papers such as
Bernard et al. (2011) and Mayer et al. (2014) also provide evidence that tougher international
competition leads firms to concentrate on exporting their key products, which in turn increases
their productivity. Qiu and Zhou (2013) also contributes to this branch and shows that
globalization can result in scope expansion by the most productive firms if the fixed cost of
introducing new varieties is steeply rising in the product scope. Interestingly, they use thenotion that R&D efficiency declines in the number of products due to the inefficiency of largeorganizations known also in other fields as core rigidity (Leonard-Barton 1992), incumbent’s
curse (Chandy and Tellis 2000) and organizational inertia (Tripsas and Gavetti 2000). Using thesame concept, our analysis adds to the literature by exploring the endogenous process thatcauses such improvements in the performance of firms. Our idea adds to this literature by2

studying how being active in more differentiated product lines may influence the impact ofoffshoring on the innovation decision and the performance of firms.
In a small but recently growing literature on multiproduct firms and innovation, Dhingra(2013) looks at the interaction between process and product innovation by multiproduct firms.
She argues that access to a larger market through trade does not necessarily translate into
innovation oriented towards the introduction of new products, but shifts focus towards process
R&D to improve productivity on a limited range of products. Akcigit and Kerr (2012) likewise
distinguish between external (product) and internal (process) innovation. They show thatexternal innovation does not scale with the number of product lines, resulting in less majorinnovations by larger firms. Liu et al. (2015) instead explores the trade-off between a larger
scope of inputs within a product in terms of functionality and higher quality in a contractual
environment. Using this concept, they study the organization of firms in ideas-oriented andcost-oriented industries. In a more closely related context to ours, Eckel et al. (2015) introduces
firms’ endogenous choice to compete on the basis of either quality or cost by investing to
improve the quality of an individual variety or that of their overall brand respectively. They
highlight the role of product differentiation in a sector in determining the incentives to invest in
the quality of their core products. Our model falls within this literature and contributes bystudying the role of multinational production on innovation by multiproduct firms.
The question of the relationship between innovation, international trade and multinational
production have been elegantly modeled in Atkeson and Burstein (2010) and Arkolakis et al.
(2013) respectively. Although the latter does incorporate the geographical separation of
innovation and production in the light of Helpman (1984), they do not deal with the role ofmultiproduct firms or knowledge spillovers that arise from engagement in international
markets. Our value added to this branch of literature is the introduction of the role of knowledge
spillovers associated with offshoring on innovation by multiproduct firms with different
degrees of differentiation across their products. We do so by (i) adopting the mechanism from3

Naghavi and Ottaviano (2009) on how offshoring production reduces innovation due toimperfect international R&D spillovers between labs and production sites, (ii) modelling thenotion of Peri (2005) that learning externalities from research in other regions also affects R&D
productivity in generating innovation. Combining these arguments, we bring the diversity
hypothesis of Nelson (1959) into the context of multinational production by showing that firms
with more diverse operations are better fit to access, learn, and absorb new knowledge madeavailable by operating in foreign markets.
Our analysis first assesses the impact of offshoring on product and process innovation. On
this basis, it then reveals that the product scope of firms plays a decisive role in determining
how the geographical fragmentation of production through offshoring regulates firm incentives
to engage in productivity-enhancing innovation. Here we see that in the absence of offshoring
the more homogeneous are a firm’s products, the more it strives to engage in cost-reducing
innovation. Once a firm enters new markets, the results can reverse depending on the degree ofdifferentiation between its products. In the presence of a negative international knowledge
spillover effect of offshoring on innovation, external (inward) spillovers through learning fromnew production locations kicks in when a firm has a more differentiated product range. This
allows us to conclude that firms active in a wide product scope have larger learning possibilities
from international operations and can therefore improve the efficiency of their R&D activities.
To summarize, multinationals with highly differentiated products that offshore a larger
share of their production can better exploit external learning spillovers, resulting in moreinnovation and improved firm performance. On the contrary, firms involved in a limited scopeof products that are technically similar are best off as local firms since offshoring would reduce
their innovation activities. This occurs because the geographical separation of their production
from innovation activities only results in reduced efficacy of their technology abroad, which
would otherwise have been boosted from high internal spillovers within the firm.

4

Although our approach does not take into consideration cost heterogeneities among productsof a firm, the notion of innovation in our model parallels that in Eckel et al. (2015), where
investment are made on quality rather than process innovation. In their work, a more broad typeof innovation could enhance the attractiveness of the firm’s brand (i.e. all products), while amore specific innovation improves only the quality of an individual product. Interestingly, theyshow that a higher level of product differentiation induces firms to invest relatively more in thequality of individual varieties than in the quality of their overall brand. In the present paper wesuggest a solid dividing line between internal knowledge spillovers of a firm’s innovation
across its product range and external spillovers absorbed from international markets. Our line ofreasoning to distinguish between the two types of spillovers is that (i) internally a firm’sknowledge can be more easily spread across its different operations if it has a homogeneous
product scope and (ii) a more differentiated product scope allows a firm to concentrate on
learning possibilities that arise through external spillovers from outside markets. The latter
concept is also in line with Noteboom (2000), who points out that the heterogeneity ofknowledge is essential for learning and should be “sufficiently small to allow forunderstanding, but sufficiently large to yield non-redundant knowledge”. In a parallel sense, we
also claim the existence of a trade-off in the role product differentiation for innovation within afirm by showing how it can encourage innovation via external spillovers (relatively more
important in international markets) and at the same time deter innovation by blocking internal
spillovers (relatively more important in local markets).

2 A Simple Theory
We consider a simple model of multiproduct operation with L identical consumers, eachendowed with a unit of labor. There are two sectors. In the first sector, a homogeneous goodchosen as numéraire is produced under constant returns to scale at unit cost. This is supplied5

competitively, which implies a unit wage. In the second sector, firms are monopolisticallycompetitive. They pay an entry cost F and produce multiple differentiated products. We firstconsider a scenario in which firms produce all of their output domestically. Then, we
incorporate international operations into the model and assume that firms produce a fraction of
their output overseas.
2.1 Consumers
We follow Melitz and Ottaviano (2008) and assume that each consumer has a linear quadratic
preference for a continuum of differentiated goods indexed by j ∈ Ω , and a homogeneous
good: A typical agent consumes q0 of the homogeneous good and q j of variety j ∈ Ω jproduced by firm i ∈ J . Her utility function is defined as:

U ≡ q0 + α ∫j∈Ω

q j dj −d

2 ∫ j∈Ω

q 2j dj −η(

2 ∫ j∈Ω)

2

q j dj ,(1)

where the demand parameters α , δ and η are all positive. The parameters α and η
determine substitutability between the homogeneous and differentiated goods: increases in α
and decreases in η both shift out the demand for the differentiated varieties relative to the
numéraire. The parameter δ measures the degree of product differentiation across varieties.
As δ increases, products become more differentiated. Given a market price p j for product j,
individual consumption choice gives rise to the market demand for product j

Q j ≡ Lq j =
α−

η

L∫

j∈Ω

q j dj −

d
L

qj.

(2)

6

Let

the

aggregate

price

of

all

products

be

P≡∫

j∈Ω

p jd j

.

Then

η
d


P=
 α − ∫ j∈Ω q j d j  M − ∫ j∈Ω q j d j , where M ≡ ∫ j∈Ω d j is the total number of products. As
LLa result,αM − P ηq jd j = η and the demand for product j writes∫
L j∈Ω
 d + Mη 

p j= A −

δ
L

qj,

with

A≡

αδ + η P.
δ +η M(3)

2.2 Firms
In the differentiated goods sector, firms enter freely by paying a cost F. After paying entry
costs, firms decide how many products to supply, how much to invest in cost reduction andwhat quantity of each variety to produce. We denote by N i firm i’s product range. Firms face a
fee for introducing new varieties. We denote the fixed variety-introduction fee as h( j ) for thejth variety and assume that varieties are increasingly costly to introduce, namely h′( j ) > 0 . A
firm can either make product j at unit cost c or choose a lower unit cost by investing in process
innovation ζ j ∈ [0,1] at a rate rs . There are also internal knowledge spillovers between
varieties within a firm, which means that a firm can apply part of the process innovation of one
variety to all other varieties in its portfolio. As a result, the post-innovation unit cost of the jthvariety amounts to:ci (ζ j ) = c (1 − ζ 1/2
j − β (δ ) Z − j ) ,where Z − j ≡ ∫

Ω j

(4)

ζ 1/2
j dj . The extent to which knowledge is applicable to other firm’s products

depends on the spillover parameter β (δ ) ∈ (0,1) with β ′(δ ) < 0 . This parameter captures theidea that process innovation aimed at a specific product is better applicable to the entire
portfolio when products are more homogeneous and the production processes are more similar.
7Firm behavior
Firm i chooses its number of varieties, N i , its investment in process innovation, ζ j , and eachvariety’s output, q j , for all products j ∈ [0, N i ] to maximize its total profit:=Πi∫ ( p − c (ζ ) ) q − r ζ dj − ∫ h( j )dj − F .
Ni

0

Ni

j

i

j

j

s

j

0

(5)

Individual firms regard the inverse demand intercept A as given when making output
choices. However, they internalize spillovers between production lines when undertaking
process innovation. Eq. (4) can be rearranged as:ci (ζ j ) = c (1 − (1 − β (δ ))ζ 1/2
j − β (δ ) Z i ) ,Niwhere Z i = ∫ ζ i1/2 di denotes total investment in process innovation by firm i. Because a firm0

produces all its varieties with equal efficiency, it chooses the same investment in process
innovation and output for each variety produced. Therefore, in what follows, we can suppress
the firm-product subscripts.
The first order conditions (FOCs) for the firm problem writes as:

L [ A − c(ζ ) ]∂Π∂p,= p − c(ζ ) + q = 0 ⇒ q =
2δ
∂q
∂q

(6)

2

 cq 
∂Π2=−cζ′ (ζ )q − rs =⇒0 ζ = [1 − β (δ ) + β (δ ) N ] ,∂ζ 2rs (7)∂Π[ p − c(ζ )]q − rsζ − h( N ) =0 ⇒ [ p − c(ζ )]q − rsζ ==h( N ).
∂N(8)

Now, combining (6) and (7), we obtain the output choice and the investment in process
innovation for each variety, namely:

8

2

q=

L
( A − c)
2δ

2
 L 
1 − β (δ ) + β (δ ) N ][
2 ( A − c) c 2δ 
ζ = 2.
2
4rs  Lc 22[1 − β (δ ) + β (δ ) N ] 
1 − 4δ rs

2

Lc 2
2
1−
[1 − β (δ ) + β (δ ) N ]
4δ rs

,

As one can see, both q and ζ are increasing in N. Intuitively, when the number of varieties
increases, R&D becomes more effective at reducing the unit cost because of internal spillovers.
Firms react by increasing output and investment in process innovation for each variety.
Replacing for ζ into (4) and for q into (3), the unit cost c(ζ ) and the absolute markup

p − c(ζ ) write respectively as:L2( A − c) [1 − β (δ ) + β (δ ) N ] 

c


2δ
) c 1 −c(ζ=,2 2rs 1 − Lc [1 − β (δ ) + β (δ ) N ]2 


4δ rs

( A − c) / 2
p − c(ζ ) = 2
.
Lc
2
1−
[1 − β (δ ) + β (δ ) N ]4δ rs

Using these results, the variety’s profit (gross of its variety-introduction fee) becomes:L( A − c) 24δ

[ p − c(ζ )]q − rsζ = 2
.
Lc
2
1−
[1 − β (δ ) + β (δ ) N ]4δ rs

Finally, we replace this expression into (8). The optimal number of varieties (product scope)
is defined implicitly by the following equation:
L( A − c) 2
4δ
Lc 2
2
1−
[1 − β (δ ) + β (δ ) N ]4δ rs= h( N ).

(9)

A firm chooses its optimal scope by comparing the marginal benefit of scope (the left-handside of Eq. 9) with its marginal cost (the right-hand side). As one can see, the marginal benefit isincreasing in N. Intuitively, because of the intra-firm spillovers, a larger number of varieties
makes R&D more effective at reducing the unit cost. This, in turn, increases the impact ofprocess innovation on profits. The marginal cost is also increasing in N. Figure 1 depicts the9optimal choice of product scope. The point of intersection between the marginal cost curve andthe marginal benefit curve gives the equilibrium number of varieties for each firm. Thisequilibrium is stable when the marginal cost curve is steeper than the marginal benefit curve.
Thus, firms expand their product scope when the marginal benefit of scope exceeds themarginal cost and vice versa. As process R&D becomes more expensive ( rs rises), firms find it
less profitable to upgrade their production process and, consequently, each variety’s output
decreases. Because the marginal benefit of scope also decreases, firms decide to make fewer
products. The opposite occurs when market size gets larger (L rises): in bigger markets, firms
increase both the output of a single variety, q, and the number of products, N.

Figure 1: The optimal choice of product scope
2.3 Offshoring
We now incorporate international operations into the model and assume that firms produce afraction S of their output overseas. The problem of the firm remains as in the previous section
with two additional components: learning spillovers from operating in international markets
and limited international transferability of the firm’s process R&D. We refer to the former as
the positive and the latter as the negative externalities of offshoring.

10

On the one hand, operation in international markets is associated with external spillovers
through learning (Bernard and Jensen 1999, MacGarvie 2006, Brambilla 2009, Criscuolo et al.
2010). We therefore assume that firms engaging in offshoring can benefit from a larger scope ofoverseas knowledge. We model learning externalities as the functional relationship θ ≡ θ ( S ) ,where the following properties hold: (i) θ (0) = 1 , (ii) θ ′ ( S ) > 0 . These properties capture thenotion of the propagation of accessible knowledge in other regions developed in Peri (2005). In
what follows, we posit that firms engaging in offshoring can enhance the impact of process
innovation by a factor of θ ( S ) , so that direct savings from innovation are now given byθ ( S )ζ 1/2
j .
On the other hand, evidence points towards the localized nature of innovation (Jaffe et al.
1993, Audretsch and Feldman 1996, Branstetter 2001, Keller 2002, Bottazzi and Peri 2003).
Using this argument, we take from Naghavi and Ottaviano (2009) that a proportion φ ofprocess innovation is lost when applied in the international sites of a multinational.
Consequently, a firm can only realize a reduction in its cost equivalent to a fraction 1 − φ S of
the overall innovation it undertakes. Similar to the situation prior to innovation, production at
offshore sites only allows the use of a proportion ( 1 − φ S ) of the firm’s technology, which now
also includes external spillovers from learning. Note that the effect of internal spillovers withina firm also diminishes when production activities of the firm are scattered across different
countries. In the following analysis, we denote by φ S the total loss from limited international
spillovers.
With these added components, the unit cost of a firm’s variety can be rewritten as follows:c(ζ ) =c 1 − (θ ( S )ζ 1/2 + β (δ ) Z − j ) (1 − φ S )  .

(10)

11

Eq. (10) highlights that offshoring can on the one hand impede the applicability of process
R&D to a firm’s foreign production locations and on the other hand increase cost savings frominnovation through learning spillovers from foreign markets.
Firm behavior
As before, each firm chooses its number of varieties, its investment in process innovation andeach variety’s output for all products to maximize its total profits in (5). The FOCs for the firm
problem gives:

L [ a − c(ζ ) ]∂Π∂p= p − c(ζ ) + q = 0 ⇒ q =
,
∂q
∂q
2δ
2

 cq 
∂Π
2
2
0 ζ =
=
−cζ′ (ζ )q − rs =⇒ (1 − φ S ) [q ( S ) − β (δ ) + β (δ ) N ] ,∂ζ 2rs ∂Π[ p − c(ζ )]q − rsζ − h( N ) =0 ⇒ [ p − c(ζ )]q − rsζ =h( N ).
=∂N
Following the same procedure as above, we obtain the output choice and the amount ofinvestment in process innovation for each variety, namely:q=( A − c)

L
2δ

Lc 2
2
1−
(1 − φ S ) 2 [q ( S ) − β (δ ) + β (δ ) N ]
4δ rs

,

2

2
 L 
( A − c) 2 (1 − φ S ) 2 [θ ( S ) − β (δ ) + β (δ ) N ]

2 
c
2δ
ζ = 2 .
2
4rs  Lc 22
(1 − φ S ) 2 [θ ( S ) − β (δ ) + β (δ ) N ] 
1 − 4δ rs
Both q and ζ are functions of the share of output that is produced overseas by firms, S. As
we will see shortly, the sign of these relationships depends on the trade-off between the positive
and the negative externalities of offshoring.
12

In this new setting, the variety’s profit becomes:L( A − c) 24δ

[ p − c(ζ )]q − rsζ = 2
.
Lc
2
2
1−
(1 − φ S ) [q ( S ) − β (δ ) + β (δ ) N ]4δ rs

Using this result into the FOC for product range, the optimal number of varieties satisfies thefollowing condition:
L( A − c) 2
4δ
Lc 2
2
1−
(1 − φ S ) 2 [θ ( S ) − β (δ ) + β (δ ) N ]4δ rs= h( N ).

(12)

As above, when choosing its optimal scope, a firm compares the marginal benefit of scopewith its marginal cost. As one can see, the marginal benefit is now a function of the share of
output that is produced overseas by firms, S. This means that offshoring does not only affectinvestment in process innovation, but also has an impact on the firm’s optimal product scope.
2.4 The impact of offshoring on innovation
Changing the share of output that is produced overseas by firms, S, has two opposing effects onprocess innovation, ζ , and product scope, N. The first effect is positive and arises fromlearning spillovers: increasing the share of operation in international markets S makes the scopeof learning from other firms, θ ( S ) , larger. As a result, process R&D becomes more effective at
reducing the unit cost. Firms find it more profitable to upgrade their production process andincrease ζ . Because the variety’s profit increases, so does the marginal benefit of scope. Thismeans that the first effect leads to a larger N. The second effect is negative and is due to the
localized nature of firms’ process R&D: increasing S makes the loss from being multinational,

φ S , larger. Consequently, in this case, process R&D becomes less effective at reducing the unit

13

cost and firms reduce ζ . Because this affects negatively the marginal benefit of scope, thesecond effect also decreases N.
Let us first study the effect of offshoring on product innovation. Denoting by θ S =θ ′ (S )Sθ (S )

the elasticity of θ ( S ) with respect to S, we state the following proposition:
Proposition 1 When θ S >φ S  β (δ )( N − 1) 
1+, the positive effect of offshoring from(1 − φ S ) θ ( S ) 

learning dominates the negative effect of reduced international spillovers, increasing
investment in product innovation.
Proof. Taking the total differentiation of Eq. (12), the derivative of N with respect to S
amounts to:L2 c 2 ( A − c) 2
(1 − φ S ) [θ ( S ) + β (d )( N − 1) ]{[θ ( S ) + β (d )( N − 1) ] (−φ ) + (1 − φ S )θ ′( S )}8d 2 rsdN=.
dS
 Lc 2L2 c 2 ( A − c) 2222h′( N ) 1 −(1 − φ S ) [θ ( S ) + β (d )( N − 1) ]  −(1 − φ S ) [θ ( S ) + β (d )( N − 1) ]8d 2 rs
 4d rs

The denominator of this ratio is positive in a stable equilibrium. To ascertain this, using Eq.
(12), one can easily require that the marginal cost of scope is steeper than the marginal benefit.
As a result, the sign of the above derivative is determined by the expression in curly brackets atthe numerator, that is:(1 − φ S )θ ′ ( S ) − φ [θ ( S ) + β (δ )( N − 1) ]  0.
This expression is positive when the elasticity of learning spillovers with respect to S is large
enough, namely θ S >φ S  β (δ )( N − 1) 
1+
. Therefore, when this condition holds, the(1 − φ S ) θ ( S ) 

marginal benefit of scope increases and firms react by making more products.

14

Let us now turn to study the effect of offshoring on process innovation. The following
proposition studies the effect of an increase in S on ζ :Proposition 2 When θ S >φ S  β (δ )( N − 1) 
1+, the positive effect of offshoring(1 − φ S ) θ ( S ) from learning dominates the negative effect of reduced international spillovers, increasing
investment in process innovation.
Proof. The derivative of ζ with respect to S is:

dζ
=
dS

The

L2 c 2 ( A − c) 2
(1 − φ S ) [θ ( S ) + β (d )( N − 1) ]{[θ ( S ) + β (d )( N − 1) ] (−φ ) + (1 − φ S )θ ′( S )}8d 2 rs2
 Lc 22
(1 − φ S ) 2 [θ ( S ) + β (d )( N − 1) ] 
1 − 4d rs

sign

of

this

derivative(1 − φ S )θ ′ ( S ) − φ [θ ( S ) + β (δ )( N − 1) ]  0.
θ S >

isdetermined
This

is

2

by

.

the

expression

positivewhen

φ S  β (δ )( N − 1) 
1+
. Therefore, when this condition holds, the impact of a larger S(1 − φ S ) θ ( S ) 

on ζ is positive.

Proposition 1 and 2 show that the sign of relationship between offshoring and both productand process innovation depends on the following expression:

(+((1 − φ S )θ S

Beneφit φrom oφφshoring

Loss φrom oφφshoring
(((
+(((
 β (δ )( N − 1) 
− φ S 1 +
 0.
θ ( S ) 
(13)

The term (1 − φ S )θ S measures the marginal gains from learning brought about by apercentual increase in the proportion of offshore production. As discussed earlier, only aproportion (1 − φ S ) of the firm’s incremental knowledge can actually be used at production
sites abroad. As S increases, a firm engages more in international activities and learns more15

from other firms. However, a part of its technology is dispersed when applied in theβ (δ )( N − 1) international sites of a multinational. The expression φ S + φ S
represents theseθ ( S ) losses that emerge from offshoring. The first term in square brackets is simply the international
spillover losses associated with the additional part of production that has been moved tooffshore sites. The second term expresses the losses that occur from shifting production abroad
due to reduced intra-firm spillovers. As S increases, a fraction φ S of knowledge gained fromspillovers within the firm can no longer be used by the firm. As one can see, the parameter δaffects the extent of intra-firm spillovers and, in turn, the loss from offshoring. This means thatthe degree of product differentiation across varieties plays a role in the relationship between
offshoring and innovation. We can then state the following Proposition:
Proposition 3 When products are more differentiated, δ ↑ , it is more likely that firms
engaging in more offshoring improves firm performance by increasing their investment in bothproduct and process innovation.
Proof. Follows directly from Eq. (13).
When the parameter δ increases, a firm’s process innovation is less applicable to the rest of
its product lines ( β (δ ) ↓ ). The impact of internal spillovers on the process of cost reduction
gets smaller, and so does the loss from being a multinational. Consequently, firms benefit morefrom offshoring activities by increasing their investment in innovation. Looking at thedenominator of the same term shows however that losses from internal spillovers can becompensated by external spillovers. Learning from international markets can therefore mitigate
offshoring-related losses from reduced internal spillover within a firm, more so the moredifferentiated are a firm’s product portfolio.
Taking from Nelson (1959), one can assume that a firm can better absorb knowledge fromoutside markets if it has expertise across more diverse fields and therefore a more differentiated16

range of products. This makes θ ( S ) dependent also on δ , i.e. increasing in δ . This
reinforces the previously obtained results by also increasing the denominator of the second termin brackets. A firm with more differentiated products is therefore more likely to increase
innovation and its performance if it geographically fragments production through offshoring
activities.
These findings reflect the importance of the heterogeneity of knowledge within a firmemphasized by Noteboom (2000) for firm performance. Using a trade-off between internal andexternal spillovers, we show that product differentiation should be small enough to renderinnovation more practical within the firm across its products, but sufficiently large to increase
the span of learning through non-redundant knowledge. The results put this concept in thecontext of offshoring, which changes the balance between internal and external spillovers.
External spillovers have a larger weight in international markets, whereas internal spillovers arelimited within the boundary of the firm. A higher degree of product differentiation increases theformer and decreases the latter, making offshoring a productivity-enhancing activity bystimulating both product and process innovation.

3 Conclusion
This chapter explores how the extent of offshoring production affects innovation bymultinational multiproduct firms. Looking at both product and process innovation, we are able
to make conclusions about the endogenous performance of firms in terms of productivity andproduct scope. Our argument focuses on the nature of spillovers made possible throughmultinational production and multiproduct activities. We find that product differentiation
among a firm’s product line is a decisive factor in determining whether offshoring production
can be advantageous or detrimental for firm performance.

17

Our analysis shows that both product and process innovation tend to go the same direction asa consequence of offshoring. The key insight to our analysis derives from pinning down andweighting spillovers that exist within the firm and those that are absorbed from outside the firm.
We associate the latter with moving to, and engaging in, international markets. Such learning
spillovers increase the efficiency of process innovation by firms, thereby creating incentives toengage in more productivity-enhancing R&D. Alternatively, intra-firm spillovers gain
importance with product scope and may be diminished by the geographical dispersion of
production.
Our simple theory shows that the degree of differentiation of a firm’s product portfolio is a
key factor in determining the net effect of offshoring on innovation. By reducing theimportance of internal spillovers, product differentiation gives significance to the positiveeffect of learning from international markets. A firm active in a diverse range of product lines istherefore more likely to gain from offshoring in terms of innovation and performance. In
contrast, a firm focused on a homogenous range of products could benefit more fromconcentrating production in the domestic economy. What we can take home from this analysis
is the important nexus between product scope, product differentiation, and knowledge
spillovers in governing the effect of offshoring on productivity growth.
An interesting extension of the current framework would be to account for the distance of avariety from the core competence of a firm in order to distinguish between innovation aimed at
the quality of its core competence as opposed to more generic attempts to improve the overall
performance of firms. Doing so allows us to study yet another dimension of multinational
production by looking at how offshoring impacts the innovation decision of firms in their coreand non-core sectors. Other possible avenues of research are the extension of the current
framework to also account for incomplete contracts and the choice of outsourcing production
outside the firm boundaries. In the current context, an investment to stretch the degree to whicha new product differs from a firm’s existing varieties can also be a gap worth exploring. Finally,18

incorporating the model into a framework with heterogeneous firms can examine the decisionof firms that differ with respect to their productivity with respect to innovation once they
engage in offshoring.

19

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