Offshore production and business cycle dynamics with heterogeneous firms *

•I model offshoring in a framework with firm entry and heterogeneous firms.•Offshoring is a firm-level decision driven by lower production costs abroad.•The offshoring output and its extensive margin are procyclical with output in home.•The offshoring exports are more procyclical than the regular exports.•Output comovement increases with the share of offshoring in trade, as in the data.

To examine the effect of offshoring through vertical FDI on the international transmission of business cycles, I propose a two-country model in which firms endogenously choose the location of their production plants over the business cycle. Firms face a sunk cost to enter the domestic market and an additional fixed cost to produce offshore. As such, the offshoring decision depends on the firm-specific productivity and on fluctuations in the relative cost of effective labor. The model generates a procyclical pattern of offshoring and dynamics along its extensive margin that are consistent with data from Mexico's maquiladora sector. The extensive margin enhances the procyclical response of the value added offshore to expansions in the home economy, as the number of offshoring firms mirrors the dynamics of firm entry at home. As a result, offshoring increases the comovement of output across economies, in line with the empirical evidence.