Vertical FDI versus outsourcing: The role of technology transfer costs

The effect of technology transfer cost on the choice between horizontal foreign direct investment (FDI) and licensing is well established. We explore this “make or buy” decision in the offshoring context when offshore input production involves costly technology transfer. The burden of technology transfer cost that falls on the sourcing firm depends not only on the technological complexity of the offshored input but also on the mode of organizing offshoring. Outsourcing entails low technology transmission cost but a higher distortion in input production by the arm's length supplier while vertical FDI involves a higher technology transmission cost but a lower distortion in input production by the affiliated supplier. Contrary to the existing literature, we find that, irrespective of the type of good, outsourcing is the preferred mode at higher ends of technological complexity.