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Supply chain formation and fragility

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Matthew Elliott, Benjamin Golub and Matthew Leduc

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Modern production is complex: For instance, building an airplane requires combining many indispensable types of components/engines, navigation systems, etc. In turn, these components are themselves complex, made up of many essential subcomponents, and so on. Thus, when the supply chain is disrupted and some goods cannot be sourced successfully, the ripple effects can destroy a great deal of value. Sourcing disruptions happen for a variety of reasons: a delivery vehicle crashing, a misunderstanding about the requirements the input must meet, or a fire in the supplier’s factory. Because such failures can destroy considerable value, firms have incentives to insure against them, in two key ways. One way is multi-sourcing: securing more potential suppliers of each essential type of input, in case one supplier cannot deliver. Another way involves investing in one’s supply chain, e.g., via more vigilant management of supplier relationships.

In this paper, Matthew Elliott, Benjamin Golub and Matthew Leduc use economic theory to model incentives for investment in supply chains. The aim of the work is to understand whether individual firms’ incentives to keep their supply relationships robust yield a globally robust supply network. They develop a new theory of the strategic formation of supply networks for the production of complex goods, in which firms decide both whether to enter the market and how robust to make their supply relationships. Substantively, the modeling framework allows them to uncover several insights about the robustness of production chains. Their main finding is that, despite multi-sourcing and endogenous investment in reliability, production chains can exhibit very stark fragilities at the aggregate level. Small changes in the macroeconomy---for instance, a change in consumer demand---can lead to a dramatic drop in output. Two features of the authors’ model are essential to these predictions: (i) complexity, specifically that many varieties of inputs are essential at each stage of the production chain, and (ii) that firms contract with specific suppliers that can fail to deliver, rather than buying their inputs off-the-shelf.

There are forces driving the economy to settle into such a fragile configuration. Indeed, there is a so-called “free-riding problem”: any firm tends to rely too heavily on the investments in the reliability of supply relationships made by other firms in the supply chain. As more firms enter, competition increases and profits are reduced. This further undermines firms’ incentives to invest in the robustness of their supply relationships and exacerbates the free-riding problem. The authors find that often entry occurs up to the point where supply chains are on a precipice, and investments cannot decrease further without supply chains collapsing. Supply chains are then very fragile, i.e. very susceptible to small macroeconomic shocks.

The results are relevant to the regulation of a complex economy: industries in which too many firms can profitably enter are more vulnerable to the fragility described. Indeed, the problem of endogenous underinvestment in the reliability of sourcing is exacerbated in a congested industry. Competition has obvious advantages: more production and lower prices. But a policy implication of the authors’ results is that it also has a potential downside in the fragilities it creates. As a result, rationing entry more severely than a competitive market would normally do could be justified by macro-prudential considerations.

Original title of the article: Supply network formation and fragility
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