March 2010

Offshore Production and Business Cycle Dynamics with Heterogeneous Firms

Andrei Zlate


Cross-country variation in production costs encourages firms to relocate production to other countries, a process known as offshoring through vertical foreign direct investment (FDI). To examine the effect of offshoring through vertical FDI on the international transmission of business cycles, I propose a model that distinguishes between fluctuations in the number of offshoring firms (the extensive margin) and in the value added per offshoring firm (the intensive margin) as separate transmission mechanisms. In the model, firms face a sunk cost to enter the domestic market, and an additional fixed cost to produce offshore. The offshoring decision depends on the firm-specific productivity and on fluctuations in the relative cost of effective labor. The model replicates the procyclical pattern of offshoring, as well as the dynamics along its extensive and intensive margins, which I document using data from U.S. manufacturing and Mexico's maquiladora sector. In addition, offshoring enhances the co-movement of output across countries, in line with existing empirical evidence. The result is closely related to the dynamics of offshoring along its extensive and intensive margins.

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Keywords: Offshore production, extensive margin, heterogeneous firms, firm entry, business cycle dynamics, terms of labor

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