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.

► Explore the “make or buy” decision when offshore input production involves costly technology transfer.
► Mode of organizing offshoring critically determines technology transfer cost.
► Low-tech inputs are outsourced only at extreme ends of technological complexity.
► At intermediate range of technological complexity, the input may be offshored intra-firm.
► Irrespective of the type of good, outsourcing is optimal at higher ends of technological complexity.