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Keywords:

  • middle-product trade;
  • vertical mergers;
  • global sourcing
  • F20;
  • F21;
  • F23

We construct a unified framework to study under what conditions one of the three frequently observed organizational structures of international middle-product production may arise in equilibrium: (i) separation of upstream and downstream firms with middle-product trade, (ii) vertical integration of upstream and downstream firms, and (iii) global sourcing with upstream firms internalizing design and marketing tasks while only outsourcing the final good production to subcontractors. We examine how conventional comparative advantage (search, communication, trade and diversification costs) and the concern of the product-defect risk arising from outsourcing jointly determine the organization of production and trade. We show that the potential availability of one organizational structure can change the trade-off of the other two structures, thereby making simple pairwise comparison invalid.