Vertical expansion occurs when the firm locates assets or employees in a foreign country with the purpose of securing the production of a raw material, component or input (backward vertical expansion) or the distribution and sale of a good or service (forward vertical expansion). The necessary condition for a firm to engage in vertical expansion is the presence of a comparative advantage in the foreign location. The advantage typically has to do with the prices or productivities of production factors such as capital, labor or land. For instance, a clothing firm may consider production in a foreign location due to lower labor costs.
It is important, though, to realize that the mere existence of a comparative advantage in a foreign location does not mean that the firm ought to vertically expand. The necessary condition of lower factor costs or higher factor productivity, or both, is not sufficient. After all, the firm may benefit from the comparative advantage in the foreign location simply by asking a local producer to become its supplier. The sufficient condition justifying a vertical foreign investment refers to the possible reasons encouraging the firm to undertake foreign production by itself rather than rely on others to do the job. The main two reasons are uncertainty about the supply or asset specificity. If uncertainty is high, the firm would prefer to integrate backward into the foreign location so as to make sure that the supply chain functions smoothly, and that delivery timetables are met. Asset specificity is high when the firm and the foreign supplier need to develop joint assets in order for the supply operation to take place. In that situation the firm would prefer to expand backward in order to avoid the “hold-up” problem, i.e. opportunistic behavior on the part of the foreign supplier trying to extract rents from the firm. These necessary and sufficient conditions also apply in the case of forward vertical expansion into a foreign