Global COE Hi-Stat Discussion Paper Series 067

Research Unit for Statisticaland Empirical Analysis in Social Sciences (Hi-Stat)

Asymmetric Information and Global Sourcing

Hi-Stat Discussion Paper

Shin Chen Huang
Chia Hui Lu

April 2009

Hi-Stat
Institute of Economic Research
Hitotsubashi University
2-1 Naka, Kunitatchi Tokyo, 186-8601 Japan
http://gcoe.ier.hit-u.ac.jp

Asymmetric Information and Global Sourcing
Shin-Chen Huang

Chia-Hui Lu∗

National Cheng-Chi University

City University of Hong Kong

TaiwanHong Kong
February 2009

Abstract: This paper aims to study the choice of offshoring modes made by multinationals in thepresence of asymmetric information. We focus on two types of asymmetric information, namely
hidden characteristics and hidden action. The former creates adverse selection problem, and thelater leads to moral hazard problem, both of which incur non-trivial costs to multinationals. We
show that different offshoring modes, including greenfield foreign direct investment, joint venture,and outsourcing, can serve as a means to overcome or mitigate the problem of information asymmetry. We study the conditions under which one particular type of offshore modes dominates theothers. The model generates implications consistent with the patterns of the prevalence of various
offshoring models over time, and across industries and countries.

JEL Classification: F21; F23.
Keywords: Asymmetric Information, Global Sourcing, Foreign Direct Investment, Joint Venture,
Outsourcing∗

Corresponding Author: Chia-Hui Lu, Department of Economics, City University of Hong Kong, Tat Chee Avenue,

Kowloon, Hong Kong; Tel : +852-2194-2164; Fax : +852-2788-8806. E-mail address: chiahlu@cityu.edu.hk.

1Introduction

One of the most publicized potential disadvantages to offshore production is poor quality control. Cases in point are fire-hazard batteries, lead-paint toys, melamine-laced pet food crisis andmelamine-tainted milk incidence uncovered in recent years. In addition to the threat to consumers’safety, the costs of recalling all the the defective products from the market followed by the incidences and the damage caused to the business reputation and image have eroded a huge chunk of
the benefits by locating production activity in low-wage countries.
The reason for why it is so difficult to ensure product quality in the face of global operation may
attribute to problem of information asymmetry.
This paper aims to study firm’s optimal choice of global production modes in the presence ofasymmetric information. In particular, we focus on two types of asymmetric information, namely
hidden characteristics and hidden actions. The former creates adverse selection problem and thelater leads to moral hazard problem, which potentially incur non-trivial costs to multinationals. We
argue that multinationals’s choice of different global production modes, including greenfield foreign
direct investment, joint venture, and offshore outsourcing, can serve as a means to overcome or
mitigate the costs arising from certain or both types of asymmetric information.
In particular, greenfield FDI keeps the production within firm’s boundary and thus avoids adverse selection problem. However, the moral hazard problem still prevails. In contrast, throughoffshore joint venture, a foreign firm teams up with a local firm to produce the product and sharesthe profits with local joint venture partner. The business mode helps to enhance the interest alignment between two entities such that the moral hazard problem can be mitigated. On the other
hand, with the mode of offshore outsourcing, the foreign firm subcontracts the production process
to a third party, whose type and effort level is unobservable and non-verifiable. Even though theforeign firm can design a contract to induce truthful-telling and to deter shirking behavior, the costs
may be very expensive as when the problem of adverse selection is serious.
We study the conditions under which one particular type of offshore production modes is likely
to emerge. The implications generated by the model also help explain the trend and variation of
the prevalence of different global business models across industries and countries, and over time.
In particular, we show that in a particular industry, the mode of free-field FDI prevails in
the host county with low developmental levels while outsourcing mode prevails in the countries
which are relatively more developed. Joint venture modes prevails in the countries with moderate
developmental level. As the industry become more competitive, outsourcing eventually become the1most profitable way of offshoring. The implications are consistent with the findings by Hummels,
Rapoport and Yi (1998), Hummels, Ishii and Yi (2001), Feenstra and Hanson (2003), Borga andZeile (2002), Yeats (2001), Hanson et al. (2001, 2003), among others.

Empirical Motivation
In Figure (1), we utilize use the data from United Nations Conference on Trade and Development(UNCTAD) FDI/TNC Database and show the trend and variation of cross-border merger andacquisition (CMA) investments as a percentage of FDI inflows to the host countries over timeand across countries. According to the definition given in the World Investment Report issued by
UNCTAD, FDI inflow equals the sum of greenfield FDI and cross-border merger acquisition, andCMA refers to that a foreign firm acquires or merges with an existing local firm, which entails achange in the control of the merged or acquired firm and involves share-holding in a business entity.
As show in Figure (1), the importance of CMA is higher in the developed countries than that indeveloping countries. Moreover, there exhibits a increasing trend over the past two decades between
1987 and 2006.1
With regard to the question as which operation model to adopt when offshoring, the responsesof the CEO’s or top managers from the world’s largest 1000 companies vary across industries basedon the 2005 FDI Confidence Index, an annual survey conducted by the A.T.Kearney, Inc. since1998. As shown in Figure (2), the business models for moving corporate functions offshore include
captive (greenfield FDI) and joint venture, as well as third-party outsourcing and other non-FDI
options.
Offshoring is not a simple site-provider selection process, particularly when it comes to sophisticated and sensitive functions. The concerns over quality control in some business processes,
including R&D, knowledge management and analytic functions, result in the choice of offshoring
operation primarily through greenfield or joint ventures. Nearly 70 percent of future R&D offshoring will be through FDI, while less than 20 percent of offshore R&D activity will occur throughoutsourcing. When sending information technology, call centers, distribution and logistics offshore,CEOs prefer to rely on third-party outsourcing contacts. For example, about 55 percent of global
investors plan to work with an outside provider when offshoring their IT functions. Despite therapidly growing business process outsourcing (BPO) market, only 28 percent of global investors ex1

Source: UNCTAD. The simple OLS estimations of the coefficients of the time trends for the groups of developed

and developing countries are positive and significant. The numbers shown in the parentheses are the t-statistics.

2

Figure 1: Mergers and Acquisitions as a Percentage of FDI Inflow to Host Countries

1.000

0.900

0.800

Slop= 0.0077 (1.7624)
0.700

0.600

0.500

0.400

Slop= 0.0092 (2.5647)
0.300

0.200

0.100

0.000
1987

1988

1989

1990

Developed Economies

1991

1992

1993

1994

Developing Economies

1995

1996

1997

1998

1999

Time Trend for Developed Economies

2000

2001

2002

2003

2004

2005

2006

year

Time Trend for Developing Economics

pect to turn to outside service providers to handle functions such as human resources, and financeand accounting. Nearly 60 percent of investors favor using a captive or joint-venture business modelto handle BPO functions.

2

The Model

We consider a two-country model, in which the North(foreign country) is assumed to have higher
labor cost than the South(domestic country). In an attempt to exploit lower production cost in
the South, a foreign firm with an exclusive blueprint chooses one of the three potential production
modes to produce a given number of final good in the South, which is normalized to be one.
Three possible offshore production modes are: greenfield foreign direct investment, denoted by (F ),offshore outsourcing, denoted by (O), and joint venture, denoted by (J). In the case of F , theforeign firm will start up a subsidiary in the domestic country and keeps the production activity inhouse. In the case of O, the foreign firm will subcontract the production process to a local firm.

3Figure 2: CEO’s Choice of Operation Models when Offshoring

In the case of J, the foreign firm will form a joint venture with a local firm. Production will be
carried out by the new entity, and then two parties will share the profit based on the pre-agreed
profit-sharing rule.
Different offshore production modes encounter different types of asymmetric information as
summarized in the table shown below and to be elaborated shortly:

2.1

Green Field FDI (F )Outsourcing (O)Joint Venture (J)Hidden Characteristic

No

Yes

Yes

Hidden Action

Yes

Yes

Yes

Hidden Characteristics

Domestic firm can be either efficient or inefficient. Suppose that the efficient type has low marginal
production cost, denoted by c0 , and inefficient type has high marginal production cost, denoted by
c1 , where 0 ≤ c0 < c1 , and ∆c ≡ c1 − c0 > 0. Moreover, the likelihood of randomly meeting anefficient type equals τ , where 0 ≤ τ ≤ 1, and an inefficient type is 1 − τ , i.e. P r(c = c0 ) = τ , andP r(c = c1 ) = (1 − τ ). Domestic firm’s true type is private information and is not observable by theforeign firm. Foreign firm only knows the distribution of the efficiency level of the domestic firm
regardless of either O or J. In the case of F , foreign firm will transplant its own technology to the4subsidiary located in the South. The marginal production cost of local subsidiary is denoted cF ,and by assumption, c0 ≤ cF < c1 .

2.2

Hidden Actions

All type of production modes encounter the problem of hidden information as the foreign firm can
not correctly verify the effort level, denoted by e, exerted by the manager. The manager can choose
the two effort levels, say being diligent, denoted by d or shirking, denoted by s, which consequently
affect the likelihood of producing/delivering high-quality output. Specifically, let q ∈ {H, L} denotethe quality of the output, where H and l denote high-and low-quality, respectively. Further more,
let γe denote the probability of producing high-quality good given the manager’s effort level e,where P r(q = H | e = d) = γd , P r(q = L | e = d) = (1 − γd ), P r(q = H | e = s) = γs ,P r(q = L | e = s) = (1 − γs ), 0 < γs < γd < 1, ∆γ ≡ γd − γs > 0. Exerting effort incurs cost; inparticular, ψ i (e = s) = 0, ψ i (e = d) = ψ i , where i ∈ {F, O, J}. We assume that ψ F ≤ ψ O = ψ J ≡ ψ.
Consumer’s willingness to pay to high- and low-quality good is different. For a high quality
good, the value to a consumer is aH , and a low-quality good is aL , aL < aH , where aH > aL , i.e.
∆a ≡ aH − aL > 0. Finally, we assume that both foreign and domestic firms are risk neutral.

Assumption 1 c0 < c1 < As < Ad , and ψ < A, where Ad ≡ γd aH + (1 − γd )aL , As ≡ γs aH + (1 −γs )aL , and A ≡ Ad − As .
Assumption 1 implies that the expected value of the final output is sufficient high such that withcomplete information (or in the case of first best), the foreign firm(principle) prefers production to
shutdown, and prefers diligence to shirking.

3

Greenfield Foreign Direct Investment

We first explain the time line of case when the foreign firm chooses F . As shown shown in Figure(3), at t = 0, the foreign firm learns its marginal production cost cF , and offers a take-it-or-leave-it
contract denoted by ΩF to a local manager manager. The manager then decides whether to accept
or reject the offer. The project is abandoned if manager rejects the offer; otherwise, manager decides
effort level and produces the agreed amount of output. At the time t = 4, the output is delivered
and the quality of the output is realized. Finally, the pre-agreed contract is honored. As discussed
earlier, foreign firm encounters only the problem of hidden action. To overcome the problem, the5foreign firm designs and offers a contract contingent on the quality outcome of the product. In
particular, we use ΩF = {f (q), q ∈ {H, L}} to denote the contract. If the delivered output is of ofhigh-quality, the manager receives f (H); otherwise f (L).
Figure 3: The Timeline of Greenfield FDI

t=0
is realized

t=1
Foreign firm offers atake‐it‐or‐leave‐it
contract to local
manager

t=2

t=3

t=4

Manager
decides to
accept or
reject theofferManager decides
effort level andproduces output if
accepting the offer

Quality is realized
and contract ishonoredThe project isabandoned if
manager rejects
the offer

Quality-contingent Contract: ΩF = {f (q), q = {H, L}, }For simplicity, we assume that greenfield FDI does not incur fixed costs. We proceed to solve theoptimal contract. Under Assumption 1, we know that the foreign firm aims to induce manager tobe diligent. The profit optimization problem is presented below:

max ΠF = γd (aH − f (H)) + (1 − γd )(aL − f (L)){f (q)}s.t.
IC M : γd f (H) + (1 − γd )f (L) − cF − ψ F ≥IR :γs f (H) + (1 − γs )f (L) − cF

(1)

γd f (H) + (1 − γd )f (L) − cF − ψ F ≥ 0(2)where, ΠF denotes the foreign firm’s expected profit under the mode of F , IC M denotes the incentive
compatibility constraint, which ensures that the manager weakly prefers diligence to shirking, andIR denotes the individual rationality constraint, which ensures the participation of the manager

6

(manager has no incentive to reject the offer). We solve the optimal contract as shown as follows:(1 − γs )ψ F
(1 − γs )ψ F
= cF +,
γd − γs∆γ
γs ψ Fγs ψ F= cF −
f (L) = cF −,γd − γs∆γ
optimal ΠF = [γd aH + (1 − γd )aL ] − [cF + ψ F ] = Ad − [cF + ψ F ],f (H) = cF +(3)

where Ad = γd aH + (1 − γd )aL and ∆γ = γd − γs . The detailed proof is provided in the Appendices.

4

Outsourcing

In the case of O, the foreign firms faces both hidden characteristics problem as well we hidden action
problem. The timeline of the case of O is summarized in Figure (4). At time t = 0, Domestic firms’
type is realized based on the deterministic distribution function. The information of each domestic
firm’s type c is private information. Foreign firm offers a take-it-or-leave-it contract denoted by ΩO
to a randomly met subcontractor. The subcontractor decides whether or not to accept the offer madeby the foreign firm, and chooses a preferred contract in the case when not rejecting. The project isabandoned if subcontractor rejects the offer; otherwise, the subcontractor decides effort level andproduces output. The output is delivered and the quality of the product is realized, upon which the
pre-agreed contract is honored. The foreign firm can offer a manu of contract to induce the local
subcontract to reveal his true type by choosing a particular contract. This manu of contract is called
the “separating contract,” which is denoted by ΩO = {(ω0 (q), q = {H, L}), (ω1 (q), q = {H, L})} .
In particular, the efficient-type with c = c0 will choose (ω0 (q), q = {H, L}), while the inefficienttype with c = c1 will prefer (ω1 (q), q = {H, L}). In the case of offering a separating contract,
we also discuss two possible outcomes–one is separating without shutdown, and the other is withshutdown. In the case of shutdown, the individual rationality constraint for the inefficient type is
not satisfied such that only the efficient type accept the offer. It is possible that the foreign prefers
offering a pooling contract if it is too costly to differentiate efficient type from inefficient type. We
use the ΩOp to denote pooling contract. In particular, ΩOp = {ω(q), q = {H, L}}.

7

Figure 4: The Timeline of Outsourcing

4.1

t=0

t=1

t=2

t=3

t=4

c is realized andit’s a private
information of
local
subcontractor

Foreign firm offers atake‐it‐or‐leave‐it contract
to subcontractor

Subcontractor
chooses thepreferred
contract orrejects

Subcontractor decides
effort level andproduces output if
accepting the offer

Quality is realized
and contract ishonoredor

The project isabandoned if
subcontractor
rejects the offer

Separating Contract without Shutdown: ΩO = {(ω0 (q), q = {H, L}), (ω1 (q), q = {H, L})}max{(ω0 (q)),(ω1 (q))}ΠO = τ [γd (aH − ω0 (H)) + (1 − γd )(aL − ω0 (L))]+ (1 − τ )[γd (aH − ω1 (H)) + (1 − γd )(aL − ω1 (L))]
s.t.
IC0A :

max γi ω0 (H) + (1 − γi )ω0 (L) − c0 − ψi ≥i∈{d,s}max γi ω1 (H) + (1 − γi )ω1 (L) − c0 − ψi(4)i∈{d,s}IC1A :

max γi ω1 (H) + (1 − γi )ω1 (L) − c1 − ψi ≥i∈{d,s}max γi ω0 (H) + (1 − γi )ω0 (L) − c1 − ψi(5)max γi ω0 (H) + (1 − γi )ω0 (L) − c0 − ψi ≥ 0(6)max γi ω1 (H) + (1 − γi )ω1 (L) − c1 − ψi ≥ 0(7)i∈{d,s}

IR0 :
IR1 :

i∈{d,s}i∈{d,s}

IC0M : γd ω0 (H) + (1 − γd )ω0 (L) − c0 − ψ ≥γs ω0 (H) + (1 − γs )ω0 (L) − c0

(8)

IC1M : γd ω1 (H) + (1 − γd )ω1 (L) − c1 − ψ ≥γs ω1 (H) + (1 − γs )ω1 (L) − c1(9)where, ΠO denotes the foreign firm’s expected profit under the mode of O, ICiA , i ∈ {0, 1} denotethe incentive compatibility constraints for both efficient type and inefficient type to reveal his true
type, IC M denotes the incentive compatibility constraint, which ensures that the manager weakly
prefers diligence to shirking, and IR denotes the individual rationality constraint, which ensures8the participation of the manager (manager has no incentive to reject the offer) of both types. We
solve the optimal contract as shown as follows:(1 − γs )ψ
∆γγs ψ
ω0 (L) = ω1 (L) = c1 −∆γOoptimal Π = [γd aH + (1 − γd )aL ] − [c1 + ψ] = Ad − [c1 + ψ]
ω0 (H) = ω1 (H) = c1 +(10)

The results suggest that separating contract without shutdown does not exist and degenerates
to the pooling contract. The detailed proof is provided in the Appendices.

4.2

Separating Contract with Shutdown: ΩO = {(ω0 (q), q = {H, L}), (ω1 (q), q = {H, L})}max{(ω0 (q)),(ω1 (q))}ΠO = τ [γd (aH − ω0 (H)) + (1 − γd )(aL − ω0 (L))] + (1 − τ )[0]s.t.
IC0A :

max γi ω0 (H) + (1 − γi )ω0 (L) − c0 − ψi ≥i∈{d,s}max γi ω1 (H) + (1 − γi )ω1 (L) − c0 − ψi(11)i∈{d,s}IC1A :

max γi ω1 (H) + (1 − γi )ω1 (L) − c1 − ψi ≥i∈{d,s}max γi ω0 (H) + (1 − γi )ω0 (L) − c1 − ψi(12)max γi ω0 (H) + (1 − γi )ω0 (L) − c0 − ψi ≥ 0(13)

max γi ω1 (H) + (1 − γi )ω1 (L) − c1 − ψi ≤ 0(14)

i∈{d,s}

IR0 :
IR1 :

i∈{d,s}i∈{d,s}

IC0M : γd ω0 (H) + (1 − γd )ω0 (L) − c0 − ψ ≥γs ω0 (H) + (1 − γs )ω0 (L) − c0(15)The optimization problem is identical to the case of separating contract without shutdown, except,(1) IR1 does not hold, and (2) IC1M is irrelevant. We then solve the optimal contract and the
optimized expected profit as follows:(1 − γs )ψ
∆γγs ψ
ω0 (L) = c0 −∆γω1 (H) = ω1 (L) = 0
ω0 (H) = c0 +optimal ΠO = τ {[γd aH + (1 − γd )aL ] − [c0 + ψ]} = τ [Ad − (c0 + ψ)](16)

The solution implies that only the efficient subcontractor will accept the offer and choose the contract(ω0 (H), ω0 (L)), and exerts good effort. The detailed proof is provided in the Appendices.
94.3

Pooling Contract: ΩOp = {ω(q), q = {H, L}}

Here, we show that the pooling contract is identical to the separating contract without shutdown:
max ΠO = γd (aH − ω(H)) + (1 − γd )(aL − ω(L)){ω(q)}s.t.
IC0M : γd ω(H) + (1 − γd )ω(L) − c0 − ψ ≥γs ω(H) + (1 − γs )ω(L) − c0

(17)

IC1M : γd ω(H) + (1 − γd )ω(L) − c1 − ψ ≥γs ω(H) + (1 − γs )ω(L) − c1(18)

IR0 : γd ω(H) + (1 − γd )ω(L) − c0 − ψ ≥ 0(19)

IR1 : γd ω(H) + (1 − γd )ω(L) − c1 − ψ ≥ 0(20)

where we need only check ICiM and IRi , where i ∈ {0, 1}.
(1 − γs )ψ
∆γγs ψ
ω(L) = c1 −∆γ
Opoptimal Π = [γd aH + (1 − γd )aL ] − [c1 + ψ] = Ad − [c1 + ψ] = ΠO
ω(H) = c1 +(21)

The detailed proof is provided in the Appendices.

5

Joint Venture

In the case of joint venture (J), the foreign firm also encounters the problem of hidden characteristics
and hidden action. The difference between J and O is the formate of contracts available for andadopted by the foreign firm to overcome the problem. In the case of J, a profit-sharing rule isoffered which make the interest of the manager more align with that of the foreign firm, but can not
be contingent on the quality of the output. The timeline of the joint venture case is summarized
in Figure (5). at time t = 0, local firm’s type c is realized, and again it’s a private information
and unobservable by the foreign firm. Foreign firm offers a take-it-or-leave-it joint venture contract,
denoted by ΩJ to domestic firm. Domestic firm decides to accept or reject the offer. The projectis abandoned if domestic firm rejects the offer; otherwise domestic firm decides effort level andproduces output. The output is delivered, quality is realized, and profits are realized, upon which

10Figure 5: The Timeline of Joint Venture

t=0

t=1

t=2

c is realized andit’s a private
information ofdomestic firm

Foreign firm offersa take‐it‐or‐leave‐it
joint venturecontract todomestic firm

Domestic firm
decides to
acceptor reject the
offer

t=3
Foreign firm learns cand domestic firm
The project isdecides effort level
abandoned if
and produces output
domestic firm rejects if offer is accepted
the offer

t=4
Quality is realized
and contract ishonoredand contract is honored and profits are slitted between the foreign firm and local joint venture
partner according to the sharing rule.
In the case of J, there does not exits separating equilibrium since both type of local firms will
choose the contract granting them greater share of profit. In other words, joint venture can not solve
adverse-selection problem. Moreover, to design a optimal profit-sharing rule, the foreign firm facesa trade-off between inducing diligent-behavior, which leads to greater profits, and smaller share of
the profits. Depending on the distribution of the domestic firms’ type and the disutility of being
diligent, the optimal profit sharing rule may not always aim to induce high effort as shown below:

5.1

Profit-sharing Rule (diligence-inducing contract): ΩJd = {θ}We first solve the optimal profit sharing rule such that both type of domestic firms exert high effort.
max ΠJd = τ θ[γd aH + (1 − γd )aL − c0 ] + (1 − τ )θ[γd aH + (1 − γd )aL − c1 ]
{θ}

s.t.
IC0M : (1 − θ)[γd aH + (1 − γd )aL − c0 ] − ψ ≥(1 − θ)[γs aH + (1 − γs )aL − c0 ](22)

IC1M : (1 − θ)[γd aH + (1 − γd )aL − c1 ] − ψ ≥(1 − θ)[γs aH + (1 − γs )aL − c1 ](23)

IR0 : (1 − θ)[γd aH + (1 − γd )aL − c0 ] − ψ ≥ 0(24)

IR1 : (1 − θ)[γd aH + (1 − γd )aL − c1 ] − ψ ≥ 0

(25)

11

where ΠJd denotes the expected profit if the foreign firm offers a contract ΩJd , ICiM , i ∈ {0, 1}
enure both type exert high effort, and IRi , i ∈ {0, 1} ensure both types of firm accept the offer.
The optimal profit sharing rule is solved as:
ψφ=1−[γd aH + (1 − γd )aL ] − [γs aH + (1 − γs )aL ]Aψ
optimal ΠJd = 1 −×[γd aH + (1 − γd )aL ] − [γs aH + (1 − γs )aL ]{[γd aH + (1 − γd )aL ] − [τ c0 + (1 − τ )c1 ]}ψ{Ad − [τ c0 + (1 − τ )c1 ]}= 1−Aθ0d = θ1d = 1 −(26)

The detailed proof is provided in the Appendices. It is clear from the solution that when high effort
incurs great disutility to the manager, i.e. φ is approaching A, it is very costly to offer sufficientincentive. So the foreign firm may consider an alternative, say shirking-inducing, profit-sharing rule:

5.2

Profit-sharing Rule (shirking-inducing contract): ΩJs = {θ}max ΠJs = τ θ[γs aH + (1 − γs )aL − c0 ] + (1 − τ )θ[γs aH + (1 − γs )aL − c1 ]
{θ}

s.t.
IC0M : (1 − θ)[γs aH + (1 − γs )aL − c0 ] ≥(1 − θ)[γd aH + (1 − γd )aL − c0 ] − ψ(27)

IC1M : (1 − θ)[γs aH + (1 − γs )aL − c1 ] ≥(1 − θ)[γd aH + (1 − γd )aL − c1 ] − ψ(28)

IR0 : (1 − θ)[γs aH + (1 − γs )aL − c0 ] ≥ 0(29)

IR1 : (1 − θ)[γs aH + (1 − γs )aL − c1 ] ≥ 0(30)where ΠJs denotes the expected profit when offering a contract ΩJs , ICiM , i ∈ {0, 1} enure bothtype exert low effort, and IRi , i ∈ {0, 1} ensure both types of firm accept the offer. The optimal
profit sharing rule is solved as:
θ0s = θ1s = 1
optimal ΠJs = [γs aH + (1 − γs )aL ] − [τ c0 + (1 − τ )c1 ] = As − [τ c0 + (1 − τ )c1 ](31)

The detailed proof is provided in the Appendices. The solution suggests that the foreign firm willkeep the full share of the profit, and the local joint venture partner regardless of efficient type orinefficient type will earn zero profit.
12

6

The Choices of Global Production Mode

Comparing the optimized expected profits functions facing the foreign firm given optimal contract
under different offshore production modes, say equations (3), (16), (21), (26), and (31), we are readyto study the optimal choice of global production mode. In particular, we write the optimized profits
as functions of τ , which is the likelihood of encountering a high-type domestic firm.
ΠF (τ ) = Ad − cF − ψ F(32)ΠOp (τ ) = Ad − c1 − ψ(33)ΠO (τ ) = τ [Ad − c0 − ψ]ψ
ΠJd (τ ) = (1 − )[Ad − τ c0 − (1 − τ )c1 ]AJsΠ (τ ) = As − τ c0 − (1 − τ )c1

(34)
(35)
(36)

Notice that in the case of greenfield FDI, these exists no adverse-selection problem, therefore, ΠF (τ )is a horizontal line. In the case of Op , outsourcing with pooling contract, the foreign firm offers
the same deal to both efficient and inefficient types, and thus the expected payment is independent
with τ , and thus a horizontal line.

Lemma 1 Under Assumption 1, we know ΠOp (τ ) ≤ ΠF (τ ) ∀τ ∈ [0, 1].

We thus only need to compare (32), (34), (35), and (36).

Lemma 2 Under Assumption 1,
F

Jd

Js

O

(i) ∂Π∂τ(τ ) < ∂Π∂τ (τ ) < ∂Π∂τ (τ ) < ∂Π∂τ(τ ) , ∀τ ∈ [0, 1].
(ii) ΠO (0) < min{ΠJd (0), ΠJs (0)} < max{ΠJd (0), ΠJs (0)} < ΠF (0).
(iii) max{ΠJd (1), ΠJs (1)} < ΠO (1). (See Appendices for the Proof)
Definition Define τJFs , τJFd , τOF , τOJs , τOJd , and τJJsd , such that ΠF (τJFs ) = ΠJs (τJFs ), ΠF (τJFd ) = ΠJd (τJFd ),ΠF (τOF ) = ΠO (τOF ), ΠO (τOJs ) = ΠJs (τOJs ), ΠO (τOJd ) = ΠJd (τOJd ), ΠJd (τJJsd ) = ΠJs (τJJsd ). We can solve

13them as:
τJFs

=

τJFd

=

τOF

=

τOJs

=

τOJd

=

τJJsd

=

(A − ψ F ) + (c1 − cF )c1 − c0
A(c1 − cF − ψ F ) + (Ad − c1 )ψ
(c1 − c0 )(A − ψ)F
Ad − c − ψ F
Ad − c0 − ψ(As − c1 )(Ad − c1 − ψ)(A − ψ)(Ad − c1 )A(Ad − c1 − ψ) + (c1 − c0 )ψ
A2 − (Ad − c1 )ψ
(c1 − c0 )ψ

Lemma 3 Under Assumption 1, if c0 + ψ < cF + ψ F , we know τJFs < τOF .
Proposition 1 Define ψ̂ and ψ̄, such that:
τOJd (ψ̂) = τJJsd (ψ̂), and τJFd (ψ̄) = τJFs (ψ̄).

(37)

Given c0 + ψ < cF + ψ F ,(i) if ψ < ψ̂, for τ ∈ [0, τJFd ), F is the dominant strategy; for τ ∈ [τJFd , τOJd ), Jd is dominant
strategy; and for τ ∈ (τOJd , 1], O is the dominate strategy, as shown as Case A in Figure (6)(ii) if ψ̂ < ψ < ψ̄, for τ ∈ [0, τJFd ), F is the dominant strategy; for τ ∈ [τJFd , τJJsd ), Jd is dominant
strategy; for τ ∈ [τJJsd , τOJs ), Js is dominant strategy; and for τ ∈ (τOJs , 1], O is the dominate
strategy as shown as Case B in Figure (6).
(iii) if ψ̄ < ψ, for τ ∈ [0, τJFs ), F is the dominant strategy; for τ ∈ [τJFs , τOJs ), Js is dominant
strategy; and for τ ∈ (τOJs , 1], O is the dominate strategy as shown as Case C in Figure (6).
Proposition 2(Case D) If cF + ψ F < c0 + ψ, max{ΠJd (τ ), ΠJs (τ ), ΠO (τ )} < ΠF (τ ) ∀τ ∈ [0, 1].
Greenfield FDI is the dominate global production mode for any τ ∈ [0, 1]. (See Appendices for
Proof.)
c0 + ψ < cF + ψF

cF + ψF < c0 + ψ

ψ < ψ̂

Case A: F and Jd and O

Case D: Fψ̂ < ψ < ψ̄Case B: F , Jd , Js , and O

Case D: Fψ̄ < ψ

Case C: F , Js , and O

Case D: F
14

7

Conclusions

The importance of asymmetric information in the decision making of multinational firms deserves
more careful study as suggested by recent high profile incidences related to bad quality control
arising from offshoring. This paper untangles two distinct aspects of information asymmetry, namely
hidden characteristics and hidden actions, and analyzes how different offshoring modes can serve asmeans to overcome or mitigate the information asymmetry problem. The implications generated
by the model are reich enough to reconcile the patterns of the prevalence of offshoring modes acrosscountries, industries, and over time.

15

Appendices
Optimal Contract under the FDI Arrangement
There exists an optimal contract ΩF = {f (q)} , q = H, L, which maximizes the foreign firm’s
expected profit and makes the manager’s IR and IC M constraints binding as explained below:• (2) must be binding. If not, γd f (H) + (1 − γd )f (L) − cF − ψ F > 0 , the foreign firm (principal)
then can reduce f (L) to make it binding without affecting the inequality of (1) since γd > γs .
• Since (2) is binding, ΠF = Ad − cF − φF which makes the binding condition of (1) irrelevant.
For simplicity, we assume (1) binding to solve the optimal contract.
Solving (1) and (2) with equalities, we can obtain ΩF = {f (q)} , q = H, L as
(1 − γs )ψ F
∆γ
F
γ
ψ
s
f (L) = cF −∆γ
optimal ΠF = Ad − [cF + ψ F ]f (H) = cF +Optimal Separating Contract without Shutdown under the Outsourcing Arrangement
There exists an optimal contract ΩO = {(ω0 (q)), (ω1 (q))} , q ∈ {H, L} which maximizes theforeign firm’s expected profit and makes the manager’s IC0A , IC0M , IC1M and IR1 constraints
binding as explained below:• Given (8) and (9), we can simplify (4), (5), (6) and (7) as
γd ω0 (H) + (1 − γd )ω0 (L) − c0 − ψ ≥γd ω1 (H) + (1 − γd )ω1 (L) − c0 − ψ(38)γd ω1 (H) + (1 − γd )ω1 (L) − c1 − ψ ≥γd ω0 (H) + (1 − γd )ω0 (L) − c1 − ψ(39)

γd ω0 (H) + (1 − γd )ω0 (L) − c0 − ψ ≥ 0(40)

γd ω1 (H) + (1 − γd )ω1 (L) − c1 − ψ ≥ 0(41)• (38) and (39) implies that the two conditions should be binding simultaneously and one ofwhich is redundant, say (39).
16• (38) and (41) imply (40), hence (40) is redundant.
• we than prove that (41) must be binding. If not, γd ω1 (H) + (1 − γd )ω1 (L) − c1 − ψ > 0,
the principal/foreign firm can reduce ω0 (L) and ω1 (L) with ∆ω0 (L) = ∆ω1 (L) to lower
rewards/payments to the subcontractor until it is binding but still ensure (38) and (39) hold.
• (38) must be binding since (41) is binding (). If not, γd ω0 (H) + (1 − γd )ω0 (L) > (c1 + ψ) ,then the foreign firm can reduce ω0 (L) until it is binding without violating the conditions of(41).
• If (12) is binding, no matter whether (6) is binding or not,

ΠO would not be affected.

Therefore, we can make (6) binding to find out one of the contracts.
• If (38) and (41) are binding, no matter whether (8) and (9) are binding or not,

ΠO isdetermined. For simplicity, we assume them to be binding to solve the optimal contract.
Solving (8), (9), (38), and (41) with equalities, we can obtain ΩO = {(ω0 (q)), (ω1 (q))} , q = H, L.
as:(1 − γs )ψ
∆γγs ψ
ω0 (L) = ω1 (L) = c1 −∆γOoptimal Π = Ad − [c1 + ψ]
ω0 (H) = ω1 (H) = c1 +Optimal Separating Contract with Shutdown under the Outsourcing Arrangement
There exists an optimal contract ΩO = {(ω0 (q)), (ω1 (q) = 0)} , q ∈ {H, L}, which maximizes
the principal’s expected profit and makes the subcontractor’s IC0A and IC0M constraints binding as
explained below:• We can let ω1 (q) = 0 to shutdown the inefficient subcontractor.
• Given ω1 (q) = 0, and (15), (14) is redundant and we can simplify (11), (12), and (13) as:
γd ω0 (H) + (1 − γd )ω0 (L) − c0 − ψ ≥ 0(42)

0 ≥ γd ω0 (H) + (1 − γd )ω0 (L) − c1 − ψ(43)γd ω0 (H) + (1 − γd )ω0 (L) − c0 − ψ ≥ 0(44)• (44) is redundant since (42) and (44) are identical.
17• (42) must be binding. If not, γd ω0 (H) + (1 − γd )ω0 (L) − c0 − ψ > 0 , the foreign firm canreduce ω0 (L) to make it binding without violating (15) and (43).
• (43) must be satisfied since (42) is binding and 0 ≥ (c0 − c1 ). Therefore, (43) is redundant.
• Given (42) is binding, no matter whether (15) is binding or not, ΠO would not be affected.
Therefore, for simplicity, we let (15) binding to solve the contracts
Solving (15) and (42) with equalities, we can obtain ΩO = {(ω0 (q)), (ω1 (q) = 0)} , q ∈ {H, L}
as:(1 − γs )ψ
∆γγs ψ
ω0 (L) = c0 −∆γω1 (H) = ω1 (L) = 0
ω0 (H) = c0 +optimal ΠO = τ {Ad − [c0 + ψ]}
Optimal Pooling Contract under the Outsourcing Arrangement
There exists an optimal contact ΩOp = {ω(q)} , q ∈ {= H, L}, which maximizes the foreign
firm’s expected profit and makes the subcontractor’s IC0M and IR1 constraints binding as explained
below:• (17) is redundant since (17) and (18) are identical.
• Since c1 > c0 , (20) implies (19), hence (19) is redundant.
• (20) must be binding. If not, γd ω(H) + (1 − γd )ω(L) − c1 − ψ > 0 , foreign firm can reduce ω(H) and ω(L) with ∆ω(H) = ∆ω(L) to make it binding without affecting the inequalityof (17).
• Since (20) is binding, no matter whether (17) is binding or not, ΠO would not be affected.
Therefore, for simplicity, we let it be binding to solve the contract.
Solving (20) and (17)(24) with equalities, we can obtain ΩOp = {ω(q)} , q ∈ {H, L} as(1 − γs )ψ
∆γγψsω p (L) = c1 −∆γ
optimal ΠOp = Ad − [c1 + ψ]
ω p (H) = c1 +18

Optimal Diligence-inducing, Profit-sharing Contract under the Joint Venture Arrangement
There exists an optimal contract ΩJd = {(θ)}, which maximizes the principal’s expected profit
and makes the joint venture partner’s IC0M constraint binding as explained below:• (22) and (23) are identical. We let (23) be redundant.
• (25) implies (24), hence (24) is redundant.
• (22) and Assumption 1 imply (25), hence (25) is redundant.
• (22) must be binding. If not, (1−θ)[γd aH +(1−γd )aL −c0 ]−ψ > (1−θ)[γs aH +(1−γs )aL −c0 ].
The foreign firm can increase θ to make it binding.
Solving (22) with equality, we can obtain ΩJd = {(θ)} as:ψψ=1−[γd aH + (1 − γd )aL ] − [γs aH + (1 − γs )aL ]Aψ
optimal ΠJd = 1 −{Ad − [τ c0 + (1 − τ )c1 ]}Aθd = 1 −(45)

Optimal Shirking-inducing Profit-sharing Contract under the Joint Venture Arrangement
There exists an optimal contract ΩJs = {(θ)}, which maximizes the principal’s expected profitsand makes domestic firm’s IR1 constraint binding as explained below:• (27) and (28) are identical. We let (28) be redundant.
• Since c1 > c0 , (30) implies (29), and (29) is redundant.
• (30) must be binding. If not (1 − θ)[γs aH + (1 − γs )aL − c1 ] > 0. The foreign firm canincrease θ to make it binding without violating (27).
• Since (30) is binding, θ = 1 and 0 ≥ −ψ under Assumption 1. Therefore (27) must be
satisfied, and is redundant
We can solve optimal ΠJs as:θs = 1
optimal ΠJs = [γs aH + (1 − γs )aL ] − [τ c0 + (1 − τ )c1 ]θs = 1
optimal ΠJs = As − [τ c0 + (1 − τ )c1 ]19

Proof of Lemma 2 (i)∂ΠF (τ )∂τ∂ΠJd (τ )∂τ∂ΠJs (τ )∂τ∂ΠO (τ )
∂τ

= 0


φ
(c1 − c0 )=1−A= (c1 − c0 )= (Ad − c0 − φ)Proof of Lemma 2 (ii)ΠF (0) = Ad − cF − ψ > 0ψΠJd (0) = (1 − )(Ad − c1 ) > 0AΠJs (0) = As − c1 > 0
ΠO (0) = 0
As − c1)ψ ≥ 0AΠF (0) − ΠJs (0) = (c1 − cF ) + (A − ψ) ≥ 0
ψ A2<
ΠJd (0) − ΠJs (0) = (− Ad + c1 ) 0.
A ψ>

ΠF (0) − ΠJd (0) = (c1 − cF ) + (Proof of Lemma 2 (iii)ΠO (1) = Ad − c0 − ψ > 0ψΠJd (1) = (1 − )(Ad − c0 ) > 0
AJsΠ (1) = As − c0 > 0ψΠO (1) − ΠJd (1) = (As − c0 ) ≥ 0
AΠO (1) − ΠJs (1) = A − ψ ≥ 0

Proof of Proposition 2
ΠF (1) = Ad − cF − ψΠO (1) = Ad − c0 − ψ
Since cF + ψ F < c0 + ψ, we know ΠO (1) < ΠF (1). According to Lemma 2, max{ΠJd (1), ΠJs (1)} <ΠO (1) < ΠF (1), and max{ΠJd (0), ΠJs (0), ΠO (0)} < ΠF (0). Since ΠJd (1), ΠJs (τ ), ΠO (τ ), and20ΠF (τ ) are continues and weakly increasing function, we prove that max{ΠJd (τ ), ΠJs (τ ), ΠO (τ )} <
ΠF (τ ) ∀τ ∈ [0, 1].

21

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22

Figure 6: Optimal Global Production Modes
Case A

Case B

Π

τ JF

τ OJ

d

d

ΠO

Π Js

O

Π Js
Π Jd

Π Jd

ΠF

ΠF

τ

1

τ JF

d

Case C

τ JJ

d

s

τ OJ

s

τ

1

Case D

ΠO

Π Js
Π Jd

ΠF
ΠO

ΠF

τ JF

s

τ JO

S

1

Π Jd
Π Js

τ

1

τ