Using unique information on firm level domestic outsourcing of manufacturing jobs by Indian firms, we propose two channels and their interaction as determinants of the fragmentation of production: import competition and labor market regulation.

We find that greater import competition from China is associated with a significant increase in domestic outsourcing of manufacturing jobs — a 10-percentage point increase in the import penetration ratio leads to a 11%–14% increase in the ratio of outsourcing expenses to the wage bill of a firm. This effect is driven by multi-product firms operating in states with pro-worker labor laws. We find a corresponding increase in the likelihood of sub-contracting among informal sector firms.

Our results are consistent with a model where forward-looking firms outsource more in response to an increase in import competition, when there are future firing costs that can be avoided through such outsourcing. We thus are the first to highlight that labor market regulation and its interaction with international trade can determine the organization of production.

Our findings have significant development implications that take the form of movement of manufacturing production towards the informal sector (and possible subsequent impoverishment of workers) as a consequence of a major trade shock.