Aspects of International Fragmentation

Abstract

The paper uses a specific-factors framework to address efficiency and distributional implications of international fragmentation which is driven by a low foreign wage rate. Focusing on the cost-savings linkage between fragmentation and labor demand in the remaining domestic activities, the author establishes a fragmentation surplus. If capital is an indivisible asset specific to the fragment produced abroad, then fragmentation may cause a domestic welfare loss, because outsourcing takes place in discrete steps where it affords firms "quasi-market-power" on the domestic labor market. The regime shift from domestic production to fragmentation is modeled as a two-stage game. In stage one, firms locate indivisible assets at home or abroad; in stage two they choose optimal employment. The share of fragmented firms is endogenously determined. The paper explores conditions under which outsourcing is beneficial for the domestic economy.