Outsourcing with Heterogeneous Firms

A general framework for the study of outsourcing is introduced that incorporates dynamics and heterogeneity among both upstream and downstream producers to mimic an exit approach (Hirschman, 1970) to building vertical relations. The environment is one of search friction and incomplete contracts, where final-good producers require a specialized input and, upon matching with a supplier, can only contract the quantity of input. The results imply an assorted matching between producers and suppliers, so that more productive producers pair with more productive suppliers in the long run. It is shown that most efficient producers have some propensity to outsource, but only when there is a thick enough density of highly productive suppliers. Average employment in this model might increase or decrease with outsourcing, which is an observed pattern in the data. Some other diversities in plant-level behavior are also present in the results.