Outsourcing and Optimal Trade Policy

Outsourcing under incomplete contracts tends to generate too little investment that is specific to the bilateral relationship. In a model where there are otherwise no social motives for protection, we show that protection is helpful when the buyer trades customized inputs with a specialized domestic supplier while also buying standardized inputs from the world market. In that case, a tariff worsens the outside option of the buyer, thereby increasing the seller’s incentives to invest. The optimal tariff never "solves" the hold-up problem, however, as positive tariffs create costs as well as benefits. In contrast, protection is not helpful when the specialized supplier is abroad, as tariffs have no effect on investment in that case. This provides a ‘wedge’ to domestic suppliers over foreign ones: even if there are no transportation costs and the foreign supplier has a better technology, domestic outsourcing can still be socially optimal, given the appropriate tariff. As transportation costs fall or contracts become more enforceable, however, the advantage of domestic outsourcing (and protection) over offshoring (and free trade) diminishes. Once a critical level is reached, optimal trade policy “jumps” to free trade. VERY PRELIMINARY AND INCOMPLETE COMMENTS AND SUGGESTIONS VERY WELCOME