Contracting with Enemies? Vertical FDI with Outsourcing Contracts

Abstract

An exploration of Korean MNCs' foreign affiliate-level data reveals that a significant portion of manufacturing foreign affiliates sell both to related and unrelated firms at the same time. We refer to this as hybrid vertical FDI. We rationalize the presence of hybrid vertical FDI by modifying the otherwise standard property-rights model of global sourcing with the subsidiary-level option of supplying inputs to unrelated customers in addition to related firms. Given the positive production externality from serving additional customers (that is proportional to the MNC's productivity) and the costs of getting such benefit (that are increasing in relationship-specificity of the outsourced inputs), the model generates following testable hypotheses: Both MNCs' likelihood of choosing hybrid over pure vertical FDI and their foreign affiliate firms' related-firm sales ratio over unrelated-firm go up when the productivity of foreign affiliates increases (but such tendencies weaken when contractual complexity goes up), which our subsequent empirical analysis robustly confirms.