Volume 19, Number 2 Article by Arti Goswami June, 2007
A Comparison of Captives and Third Party Vendors from the Host Country’s Perspective :
The mode of organisation of fragmented production has always been viewed through the lens of a sourcing firm. However, governance strategy is also important for the economic prospects of a host country. The preferred mode of governance of foreign sourcing – captive (or affiliated supplier) versus third party vendor (TPV) regime – by a host country should depend on its growth and welfare effects.
This study formally distinguishes between a captive and a TPV in the Grossman-Helpman quality ladders framework with respect to their marginal cost of production. A difference in the marginal cost of production between the two regimes implies that their production technologies are different and hence entails a difference in relative demand for skilled and unskilled labour and their wages. This mechanism ensures that the aggregate wage income of the host country or the GDP, which is the measure used here for welfare, is different in the two alternative regimes. The paper then analyses the welfare impact or the change in real GDP as a result of switching from a captive regime to a TPV regime. The ability to maximise welfare in the alternative regimes of offshoring is found to be dependent on host country factors. Specifically, if the host country’s absorptive capacity is above a threshold level, and skilled labour productivity is high, international production sharing through TPVs is more welfare enhancing for a host country.
There are two crucial policy conclusions that can be drawn from the model. Firstly, the host country needs to make higher investment in human capital in order to have sustainable welfare gains from international production sharing through the TPV regime. Secondly, a higher incentive may be offered by the host country to encourage organisation of fragmented production in the mode that maximises its welfare.
Reprint No 07206
