Product quality, incomplete contract and the product cycle

According to the traditional theory of product cycle, firms in the North usually produce goods by themselves when the goods are relatively new, but later move production to the South after they become mature. But why do some firms choose intrafirm production transfer before arm's length transfer, while others choose to skip the stage of intrafirm transfer and go straight to arm's length transfer? By introducing product quality into the incomplete-contract framework of the product cycle, we show that more capable firms choose high-quality intermediate inputs, produce high-quality products, and choose intrafirm transfer before arm's length. Conversely, less capable firms choose the latter in the product cycle.

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