Utopia, you are standing in it!

Forecasts of the offshoring of service jobs, as an example, can be constituted into a theory of North-South product cycles. The North-South theory of the life cycle of products starts with their research and development and refinement by entrepreneurs in the advanced countries (the North) with some exporting (Grossman and Helpmann 1991a, 1991b). These innovations require resources to be invested with uncertain prospects of success. Entrepreneurs in the North compete to discover new technology-intensive products using the ample supply of R&D workers and human capital-rich workers in the industrialised countries (Grossman and Helpmann 1991a, 1991b).

As a new product matures and its production becomes more standardised, the bulk of its production can migrate to the less developed countries (the South) to take advantage of lower production costs, and these countries will become net exporters. In the South, entrepreneurs focus more on imitation. They invest resources in importing and learning the production processes developed and proven to be a success in the North (Grossman and Helpmann 1991a, 1991b).

The shifting of production of standardised products to lower-wage foreign locations will frequently be within the originating company via a foreign affiliate, because of uncertainties about property rights and contract enforcement institutions in the host countries, and only later to independent foreign firms (Antràs 2005). Within corporate hierarchies, the high-skilled managers in the developed countries will specialise in problem-solving and non-routine tasks. They will interact with middle managers and production workers in developing countries who perform the routine tasks (Antràs et al. 2006, 2008).

Contracts are typically incomplete either because they are difficult to write and/or because the court cannot enforce them. The World Trade Organization (2005, 2008) concluded that, for example, the location of offshored services depends on:

• labour costs,
• trade costs,
• the quality of institutions, particularly the legal framework,
• the tax and investment regime,
• the quality of infrastructure, particularly telecommunications, and
• skills, particularly language and computer skills.

Risks in contract negotiation and enforcement will influence which types of production is outsourced. Roughly one-third of world trade is infra-firm, and this intra-firm trade is concentrated in the capital-intensive industries because of the costs and risks of investing in contracting with arm’s-length suppliers (Antràs 2003). Considerations about R&D incentives, the availability of human capital and the quality of contract enforcement institutions weigh heavily on the development of new products and their initial and later locations of different stages of production.

Products are initially developed in the highly industrialised countries because their sophisticated legal systems allow contracts to be enforced. Even then, in industrialised countries, the difficulties of writing and enforcing complicated contracts over the quality of new products early in the product life cycle encourages firms to make those products internally within the firm. Early in the product life cycle, if sub-contractors were used for key imports,  there would have to be continual renegotiation of contracts contracts to incorporate new innovations and learning by doing. As Antras says:

Global production networks necessarily entail intensive contracting between parties located in different countries and thus subject to distinct legal systems0

As the new product standardises, and product quality in consequence becomes easier to measure and contract over, initially the innovating firm will sub-contract within the industrialised country but in time will import from developing countries. In the first instance, these imports may be from affiliates established in the developing country to ensure greater control of product quality through direct ownership of the factory. As Antras says:

Firms contemplating doing business in a country with weak contracting institutions might decide to do so within firm boundaries to have more control.

The size and shape of the firm is a direct response to mitigate the costs of contracting over quality that is hard to measure  and which is constantly changing early in the product cycle. By assigning ownership rights to the party undertaking the more important investment in quality early in the product life cycle, entrepreneurs  and innovators can minimise the losses caused by lack of enforceable contracts over quality when quality is changing rapidly as the firm moves through the product life cycle.

Boeing blamed the delays on the delivery of the Dreamliner on an unwillingness of sub-contractors to stand by their contractual obligations. In response, Boeing acquired some of the key sub-contractors to ensure that they delivered as promised. This is a classic operation of the theory of the firm  where the entrepreneur brings within the firm what is too expensive to transact on the market because of difficulties in measuring quality and defining and enforcing property rights over what has been contracted.