The Impact of Contract Enforcement Costs on Outsourcing and Aggregate Productivity

Contracting frictions affect the organization of firms, but how much does this matter on the aggregate level? This paper studies how costly supplier contract enforcement shapes the patterns of intermediate input use and quantifies the impact of these distortions on aggregate productivity and welfare. Using the frequency of litigation between US firms to measure the potential for hold-up problems, I find a robust relationship between countries’ input-output structure and their quality of legal institutions: in countries with high enforcement costs, firms have lower expenditure shares on intermediate inputs in sector pairs where US firms litigate frequently for breach of contract. I adapt a Ricardian trade model to the study of intersectoral trade, and show that the variation in intermediate input shares that is explained by contracting frictions is large enough to generate sizeable welfare increases when enforcement institutions are improved. Countries differ vastly in the speed and cost of formal contract enforcement: while Icelandic courts often resolve commercial disputes within a few months, cases in India that are decades old are commonplace. A large and prominent literature has argued that these institutional frictions constitute transaction costs between firms, which affect their organizational choice and intermediate input sourcing decision (Williamson, 1985), and potentially even the pattern of development (North, 1990). The logic goes as follows: if enforcement of supplier contracts is costly or impossible, firms will perform a larger part of the production process in-house, instead of outsourcing it, thereby avoiding having to contract with an external supplier. Compared to a world with good enforcement, firms will have a lower expenditure on externally sourced intermediate inputs, and a higher cost of production. Higher production costs then feed into ∗Boehm: Department of Economics, Sciences Po, and International Economics Section, Princeton University. Email: [email protected]. I thank Francesco Caselli, Lorenzo Caliendo, Thomas Chaney, Davin Chor, Swati Dhingra, Ben Faber, Luis Garicano, Jason Garred, Sergei Guriev, Beata Javorcik, Kalina Manova, Thierry Mayer, Michael Peters, Veronica Rappoport, Markus Riegler, John Sutton, Silvana Tenreyro, Catherine Thomas, John Van Reenen, and seminar participants at Alicante, Ecares Brussels, Edinburgh, Essex, Illinois, Insead, Johns Hopkins, LSE, Munich, Mannheim, Oxford, Paris Trade Seminar, Princeton, Rochester, Sciences Po, Stockholm School of Economics, Surrey, Tokyo, Warwick, and Yale, as well as audiences at many conferences for helpful comments. I am grateful to Andreas Moxnes for sharing data. Council of Europe (2005), Supreme Court of India (2009)