Abstract

This paper studies how investor protection shapes firm-to-firm trade. In the model, production requires specialized inputs whose quality is difficult to verify in court. A supplier controlled by an entrepreneur may therefore profit from underperforming on a trading contract. Stronger investor protection mitigates this problem: by allowing outside investors to hold a larger claim on firm profits, it reduces the entrepreneur’s private gain from opportunistic behavior toward trading partners. Investor protection therefore affects not only external finance, but also the credibility of specialized outsourcing. The model yields predictions that connect and rationalize several empirical regularities. Stronger investor protection expands trade in specialized goods and supports shorter vertical span, especially where quality is difficult to verify and relationship-specific investments are important. Investor protection and contract enforcement are complements when weak institutions constrain outsourcing, but may become substitutes once most supplier-producer relationships reach the first best. The model also predicts that equity finance is especially important for specialized trade, while debt finance is better suited to standardized transactions. Finally, coordinated legal reforms generate larger gains than stand-alone reforms, because improvements in one legal domain change the return to reform in the other.