February 15, 2018
The International Organization of Production in the Regulatory Vacuum
Sebastian Krautheim, University of Passau
Multinational firms can exploit cross-country differences in environmental and labor regulation in ways that some civil society actors consider `unethical'. This may trigger advocacy NGO campaigns and consumer boycotts, a threat for demand and reputation many firms faced over the last decades. We introduce an `unethical' technology, ethically concerned consumers and consumer boycotts into a property rights model of the firm. A headquarter contracts with a foreign supplier for the production of a customized input. Contracts are incomplete, so the headquarter can neither control the supplier's investment nor whether the `ethical' or `unethical' technology is implemented. We show that international outsourcing and `unethical' production are linked through a novel unethical outsourcing incentive. Moreover, we find cases in which the headquarter would prefer `ethical' sourcing, but, somewhat paradoxically, incentivizes the supplier to expand `unethical' production. We provide empirical support for a central prediction of our model: a high cost advantage of `unethical' production and a low regulatory stringency in the supplier's country favor international outsourcing (as opposed to vertical FDI). We also provide a microfounded model of investment and pricing under incomplete contracts when the production technology is a credence characteristic of the final good and an NGO may initiate a consumer boycott.