UC Berkeley

This paper develops a model of global sourcing with culturally dissimilar countries. Production of final goods requires the coordination of decisions between the headquarter of a multinational firm and managers of their component suppliers. Managers of both units are assumed to have strong beliefs about the right course of action and are reluctant to adjust their decisions. We then characterize the optimal allocation of decision rights across firms when contracts are incomplete. Our theoretical model delivers two key predictions: An incentive of a firm to integrate (rather than outsource) its input supply is decreasing in cultural distance between the home and the host country and decreasing in trade cost between the two countries. Combining data from the U.S. Census Bureau s Related Party Trade with various measures for cultural distance and trade cost, we find empirical evidence broadly supportive of these two predictions.