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Abstract

This article presents a model where firms may endogenously externalize part of their production process. We start from the premise that adaptation to uncertainty cannot be contracted upon in the worker/employer relationship. Vertical separation then balances flexibility gains against hold-up costs of opportunistic behavior by outside contractors. In equilibrium, the degree of separation is shown to depend on the degree of product market competition, contractor's bargaining power, and the volatility of demand shocks. Our main result is that an increase in the degree of vertical separation amplifies the elasticity to demand shocks of firms' sales and employment. It does not, however, amplify aggregate uncertainty. Evidence from firm-level data is shown to be largely consistent with the main implications of our theory. (JEL: L16, L23, L24)