OVERSEAS ASSEMBLY PRODUCTION CHOICES

I. INTRODUCTION Outsourcing can be viewed as a technological innovation that enables producers to geographically separate production processes. In this vein, theoretical work on the topic, including Jones and Kierkowski (1990), Arndt (2001), and Deardorff (2001), notes that international fragmentation of production processes enables producers to take advantage of factor price differences and may facilitate factor price equalization in cases where dramatic differences in factor endowments prevent trade in final goods from achieving factor price equalization. No doubt, these factors have given rise to the marked contribution of outsourcing to the growth of trade. (1) One of the more fundamental decisions in this process involves firm choices regarding production techniques. In particular, firms must decide whether to use inputs from home or to purchase inputs in foreign markets. This decision is of great interest to countries, as it influences demand for their labor and their levels of economic activity. However, as recent work by Grossman and Helpman (2005) emphasizes, country cost differences are not sufficient in themselves to generate overseas fragmentation. While cost differences may cause firms to consider outsourcing in a low-cost location, a successful outsourcing venture requires the firms to first identify potential partners overseas. Further, if the firm succeeds in finding potential partners, it must induce the potential partners to make relationship-specific investments as a means of tailoring their abilities to the particular needs of the outsourcing firm. Alternatively, if the firm decides to keep the activity in house, the firm may need to make sizeable investments in the foreign host before production begins. However, while there is an understanding that outsourcing plays a large and growing role in international trade, there is a less well-developed understanding of the empirical factors that govern firm production choices. The nature of production decisions is relevant for welfare, since the gains from trade generated by overseas outsourcing depend on the responsiveness of outsourcing decisions to cost changes. If the responsiveness of outsourcing trade to costs is large, Yi (2003) shows that the gains from trade are much larger than previously believed. However, very little is known about this fundamental element of trade. (2) As a result, quantifying how vertical specialization responds to country costs requires us to turn to empirical methods. This article makes three contributions to the literature. First, the article shows that cost responses occur with a lag. An increase in a foreign country's costs reduce the relative contribution of foreign inputs two years down the road. In contrast, more recent cost changes in a country that is providing outsourcing items elevates the relative contribution of foreign parts and assembly. These effects are similar to the J-curve phenomenon that has been observed for overall trade flows. Second, the article highlights that the production responses are different for developing and developed countries. In particular, cost changes seem to have a larger influence on developing countries than they do on developed countries, suggesting that developing countries are more likely to produce in segments that are characterized by perfect competition. Finally, consistent with recent theories of outsourcing which note that the effects of costs may be diminished by procedural difficulties that are present in outsourcing relationships, the results show that cost responses are in fact largest for outsourcing that involves low capital intensity production in non-OECD locations. The article is structured as follows. Section II reviews evidence from U.S. outsourcing in the Overseas Assembly Program. Details of the program and data characteristics are used to guide the empirical estimation that follows in Section III. Here, empirical tests examine how country costs have influenced production choices. …