Almost every firm has to decide what to produce in-house and what to purchase from the market (outsource). The outcome of this decision determines the boundaries of the firm, an issue that has been of keen interest to economists since at least Coase (1932). Not surprisingly, there have been numerous theoretical and empirical studies examining the determinants of outsourcing decisions of firms and the variation in the extent of outsourcing across industries and markets.
In recent years, there has been renewed interest in the subject because of the spectacular growth in the extent of outsourcing over the last two decades. However, the emphasis in many studies has shifted from analyzing the determinants of outsourcing to understanding the impact of outsourcing on other important phenomena such as employment, wage structure, and income inequality. For example, some researchers view the rise in the extent of outsourcing as an important determinant of the recent increase in the wage inequality.
While such efforts are pivotal to improving our understanding of the link between the extent of outsourcing and the wage inequality, the observed correlation is open to alternative interpretations. Specifically, it is not clear whether this correlation is causal or whether changes in both the extent of outsourcing and the wage inequality can be attributed to changes in some other factors such as the market size.
What is needed to address this concern is a conceptual framework in which the extent of outsourcing is jointly determined with other phenomena of interest. This paper makes first few steps in this direction. In particular, we analyze the equilibrium process by which the extent of outsourcing, the wage inequality, and the structure of firms are jointly determined. In addition, we also study the equilibrium relation of these variables with each other, and their dependency on the market size.