Abstract

We view outsourcing as a relationship between firms that requires communication and coordination (management). Some workers have comparative advantage in management, while others have comparative advantage in the production of outsourcing services. Production skills of workers are observable, but there is symmetric learning about management skills that varies by employment sector. Labor supply decisions of workers, in addition to the outsourcing decisions of firms, determine the equilibrium extent of outsourcing, the size and hierarchical structure of firms, and the wage inequality. We show that these equilibrium outcomes tend to be positively correlated with each other, and that they vary systematically with the market size. We examine these propositions empirically using the data on the market for legal services in the U.S. and find strong support for the model. The model can be used to interpret recent increases in both the extent of outsourcing and the wage inequality and attendant changes in the structure of firms.

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