Authors: Rebecca Hellerstein and Sofia Berto Villas-Boas

A large share of international trade occurs via intra-firm transactions—transactions between domestic and foreign subsidiaries of a multinational firm. The difficulties associated with writing and enforcing a vertical contract compound when a product must cross a national border and may explain the high rate of multinational trade across such borders. We show that this common cross-border organization of the firm may have implications for the well-documented incomplete transmission of shocks across such borders. We present new evidence of a positive relationship between an industry’s share of multinational trade and its rate of exchange-rate pass-through to prices. We then develop a structural econometric model with both final assemblers and upstream parts suppliers to quantify how firms’ organization of their activities across national borders affects their pass-through of a foreign cost shock. We apply the model to data from the auto market. Counterfactual experiments show why cross-border transmission may be higher for an intra-firm than for an outsourced transaction. In the structural model, firms’ pass-through of foreign cost shocks to intermediate inputs is on average 12 percentage points lower given a one-standard-deviation increase in the share of value added that is produced via outsourced rather than in-house production, as the higher markups from two optimizations along the supply chain create more opportunity for markup adjustment following a shock.