Working Papers

Abstract. In establishing the optimal organizational design, we look at the role played by bargaining order within a property rights model of firm boundary. A final output is produced with a Cobb-Douglas technology using two intermediate inputs under monopolistic competition. Contracts are incomplete and inputs require relationship-specific investments from suppliers. Firms procure inputs sequentially through bilateral negotiations with suppliers using cash-offer contracts and choose the bargaining order under two scenarios: (1) When the order of bargaining is contractible, in which case suppliers know this order before making their investments, and (2) When the order of bargaining is not contractible, in which case any credible negotiation sequence is determined ex post, once suppliers make their investments. In this setting, there is a standard hold-up problem, and the property rights approach suggests that the allocation of ownership rights is crucial to provide the right investment incentives to parties involved. This paper analyzes how endogenizing the bargaining order affects the allocation of ownership rights in achieving the optimal organizational design. We show that in the presence of commitment to the bargaining order, the flexibility in choosing the sequence of negotiations allows the final-good producer to better fine-tune operations, whereas the lack of commitment hampers this fine tuning by constraining viable options for organizational design. Moreover, the comparison of the two scenarios reveals that under commitment, vertical integration is less likely to occur. This latter finding suggests that in analyzing firms' organizational decisions, empirical studies need to control for the presence/absence of commitment. We also consider the open-economy implications of our model.

Refereed Journal Articles

Abstract. In a North-South model of international trade in intermediate inputs, we analyze the ways firms procure their inputs in the presence of relationship-specific investments and incomplete contracts. Production process is sequential such that an upstream input is used to produce a downstream input, which is then used to produce a final output. Three types of agents are involved in this production: upstream suppliers, downstream suppliers and final-good producers (firms). Based on their productivity, final-good producers decide where to source inputs in each production stage and while doing so, they also choose their organizational mode (vertical integration versus outsourcing) to alleviate the hold-up problem that stems from contract incompleteness. We show that these decisions are connected between sequential production stages such that the sourcing location of the input in the upstream stage may affect the organizational choice in the downstream stage due to the asymmetry in the hold-up friction between the North and South. We then examine how within sectoral heterogeneity and variations in industry characteristics influence the relative prevalence of firms that choose to (i) procure inputs from different locations, and (ii) form different organizational structures.

Abstract. We study the optimal organizational structure of a firm in a sequential supply chain when investments are relationship specific and contracts are incomplete. The market structure for the final product is monopolistic competition. Production follows a preordered sequence and exhibits high complementarity between stages. There are three types of actors: upstream suppliers, downstream suppliers and final-good producers (firms). In designing their organizational structure, firms in each stage choose not only the ownership structure, i.e., vertical integration versus outsourcing, but also the input-procurement strategy, i.e., delegation versus control. The separation of asset ownership and input-procurement rights leads to a novel organizational mode, which we call `outsourcing with delegation.' We determine the implications of this new organizational mode in firms' global sourcing decisions.

Abstract. As part of their commitments under the World Trade Organization’s Agreement on Trade Facilitation, many developing countries are set to adopt risk management, a strategy for selecting import shipments for inspection. In this paper we formalize key enforcement issues related to risk management. We argue that the complexities of international trade oversight mean that inspecting agencies lack certainty about the conditional probability that a given shipment will not comply with import regulations. Ambiguity of this sort is likely to be especially important in developing countries that lack the sophisticated information technology (IT) used in advanced risk management systems. We first show empirically that infrequent shipments have conditionally higher inspection rates, a finding that is consistent with our ambiguity hypothesis. We then formalize a role for ambiguity in a theoretical model of border inspection. Finally, we calibrate the model and shock the ambiguity parameters to illustrate the consequences of an IT-driven improvement in risk management capabilities for equilibrium rates of search and compliance.

Abstract. A central institution of US trade policy is Fast-Track Authority (FT), by which Congress commits not to amend a trade agreement that is presented to it for ratification, but to subject the agreement to an up-or-down vote. We offer a new interpretation of FT based on a hold-up problem. If the US government negotiates a trade agreement with the government of a smaller economy, as the negotiations proceed, businesses in the partner economy, anticipating the opening of the US market to their goods, may make sunk investments to take advantage of the US market, such as quality upgrades to meet the expectations of the demanding US consumer. As a result, when the time comes for ratification of the agreement, the partner economy will be locked in to the US market in a way it was not previously. At this point, if Congress is able to amend the agreement, the partner country has less bargaining power than it did ex ante, and so Congress can make changes that are adverse to the partner. As a result, if the US wants to convince such a partner country to negotiate a trade deal, it must first commit not to amend the agreement ex post. In  this situation, FT is Pareto-improving.

Abstract. This paper examines the effects of various labor market institutions on the welfare of workers and employers. We consider self-enforcing contracts between risk-averse workers and risk-neutral employers in a labor market with search frictions. Employers promise to smooth out shocks to wages while workers promise long-term commitment to employers. In this environment, any regulatory policy can make it easier or harder for employers to keep their promise of wage smoothing, thus influencing the benefit accruing to each party. In our approach, we analyze the joint effect of policies by distinguishing between the financing and spending of funds used in the regulation of the labor market. With regard to financing, firing taxes strictly dominate hiring and payroll taxes on efficiency grounds, whereas the relative ranking of hiring and payroll taxes depend on the type of equilibrium that realizes. On the spending side, while unemployment payment increases workers' welfare at the expense of employers, hiring payment leaves workers' welfare intact but may increase the welfare of employers.

Abstract. We study the role of search efficiency on wage dynamics and welfare. There are two sectors in the economy: a risk-free sector that employs workers only, and a risky sector with matching frictions that employs both workers and employers. Workers are risk-averse, whereas employers are risk-neutral. In the risky sector, contracts are incomplete; hence self-enforcing contracts are the only means to share risk. We show that improvements in search efficiency in the risky sector increases the average real wage and wage volatility in that sector as well as raising the (expected) real wage and wage volatility in the whole economy. Further, while the increase in search efficiency makes workers better off, its effect on employers depends on the parameters of the model. If the welfare of employers also improves, then this is a Pareto improvement.

Abstract. This paper analyzes the optimal collusion-proof mechanism for the regulation of multinational firms (MNFs) in foreign direct investment (FDI) projects. There is a host country with a profitable investment opportunity. Either a multinational firm (MNF) or a local firm (LF) can undertake this project nonetheless due to its firm-specific advantage, the MNF has the potential to create a larger surplus. The host government faces an informational constraint such that it cannot observe the extra surplus the MNF can generate. Using this setup, Karabay (2010) shows that employing foreign ownership restrictions to force a joint venture (JV) can help the host government to partially overcome its information disadvantage. In this paper, we extend Karabay (2010) by studying the host government’s optimal regulatory policy when the MNF and the LF can collude. It turns out collusion imposes no cost on the host government and the expected welfare attained in the absence of collusion can still be secured under collusion.

Abstract. The Baron-Ferejohn multilateral bargaining model predicts a payoff-unique stationary subgame perfect equilibrium (SSPE) in which players’ equilibrium strategies are not uniquely determined. In this note, we present a modified version of the Baron-Ferejohn model by introducing veto players and provide a sufficient condition to obtain a truly unique SSPE.

Abstract. With fast-track authority (FTA), the US Congress delegates trade-policy authority to the President by committing not to amend a trade agreement. Why would it cede such power? We suggest an interpretation in which Congress uses FTA to forestall destructive competition between its members for protectionist rents. In our model: (i) FTA is never granted if an industry operates in the majority of districts; (ii) The more symmetric the industrial pattern, the more likely is FTA, since competition for protectionist rents is most punishing when bargaining power is symmetrically distributed; (iii) Widely disparate initial tariffs prevent free trade even with FTA.

Abstract. In democracies, trade policy is the result of interactions among many agents with different agendas. In accordance with this observation, we construct a dynamic model of legislative trade policy-making in the realm of distributive politics. An economy consists of different sectors, each of which is concentrated in one or more electoral districts. Each district is represented by a legislator in the Congress. Legislative process is modeled as a multilateral sequential bargaining game à la Baron and Ferejohn (1989). Some surprising results emerge: bargaining can be welfare-worsening for all participants; legislators may vote for bills that make their constituents worse off; identical industries will receive very different levels of tariff. The results pose a challenge to empirical work, since equilibrium trade policy is a function not only of economic fundamentals but also of political variables at the time of congressional negotiations.

Abstract. We study the effect of globalization on the volatility of wages and worker welfare in a model in which risk is allocated through long-run employment relationships (the ‘invisible handshake’). Globalization can take two forms: International integration of commodity markets (i.e., free trade) and international integration of factor markets (i.e., offshoring). In a two-country, two-good, two-factor model we show that free trade and outsourcing have opposite effects on rich-country workers. Free trade hurts rich-country workers, while reducing the volatility of their wages; by contrast, offshoring benefits them, while raising the volatility of their wages. We thus formalize, but also sharply circumscribe, a common critique of globalization.

Abstract. This paper examines host governments’ motivations for restricting ownership shares of multinational firms (MNFs) in foreign direct investment (FDI) projects. A host country has a profitable investment opportunity such as an advantage in producing a particular good. If the MNF undertakes this project it can create a higher surplus than local firms due to its firm-specific advantage. The magnitude of this additional surplus depends on the effort level chosen by the MNF and the size of the firm-specific advantage the MNF has. The host government wants to capture the project’s rent yet cannot observe the extra surplus created by the MNF. In contrast, in the case of a joint venture (JV), a JV partner can observe this surplus. The host government can alleviate its informational constraints by using ownership restrictions to force a JV. This calls into question the wisdom of calls for ‘liberalizing’ FDI flows by the wholesale elimination of domestic JV requirements. We show that the optimal mechanism involves ownership restrictions that decrease as the size of the MNF’s firm-specific advantage increases. 

Abstract. We examine self-enforcing contracts between risk-averse workers and risk-neutral firms (the ‘invisible handshake’) in a labor market with search frictions. Employers promise as much wage smoothing as they can, consistent with incentive conditions that ensure they will not renege during low-profitability times. Equilibrium is inefficient if these incentive constraints bind, with risky wages for workers and a risk premium that employers must pay. Mandatory firing costs can help, by making it easier for employers to promise credibly not to cut wages in low-profitability periods. We show that firing costs are more likely to be Pareto-improving if they are not severance payments, or (for affluent economies) if the economy is open.

Abstract. This paper analyzes an informational theory of lobbying in the context of strategic trade policy. A home firm competes with a foreign firm to export to a third country. The home country’s policymaker aims to improve the home firm’s profit by using an export subsidy. The optimal export subsidy depends on the strength of the demand in the third country which is unknown to the policymaker. The home firm is given a chance to convey this information to the policymaker via lobbying. However, lobbying is not free. Surprisingly, the presence of lobbying costs in the form of a transfer from the home firm to the policymaker can be advantageous for both: It makes the home firm’s lobby effort credible by functioning as a costly signal that can reveal its private information and eases the policymaker’s information problem. Yet, this result may not hold under different assumptions about the nature of the lobbying costs. We identify the conditions under which lobbying is beneficial on balance, and the conditions under which it is harmful.

Abstract. In this paper, we analyze the reason behind the use of foreign ownership restrictions on inward Foreign Direct Investment (FDI). We extend the results developed in Karabay (2010) by changing the condition on share distribution in the model. Due to this change, we are able to analyze the political economy aspect of this restrictive policy, i.e., we can study the effect of the host government’s welfare preference on the optimal foreign ownership restriction. Since the analytical solution to the optimal share restriction policy cannot be specified in general, we use a numerical approach based on collocation to approximate the solution to the problem. Within this framework, under certain conditions, it turns out that the rent extraction-efficiency trade-off is sharper the less the host government favors the local firm. We show that not only economic factors but also political factors play an important role in the determination of the foreign ownership restrictions.

Book Chapters 

Trade Policy Making by an Assembly (pdf) (joint with John McLaren) (published at D. Mitra and A. Panagariya (eds.), The Political Economy of Trade, Aid and Foreign Investment Policies, Elsevier (2004))

Abstract. Economists’ models of trade-policy determination generally assume unitary government. We offer a congressional model. Under assumptions guaranteeing a median-voter outcome under a unitary model, we find a wide range of possible outcomes: Any policy from the 25th to the 75th percentile voter’s optimum can emerge in equilibrium, depending on how voters are divided up into voting districts. The equilibrium policy is the optimum of the median voter of the median district. Protection is most likely if import-competing interests are not too geographically concentrated or too disperse. We discuss implications for the American electoral college system, and for empirical work.


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