Strengthening The Supply Chains

By Morgan Anthony

For many people it was the shortages of fuel at the petrol stations, for others it was the dearth of semiconductors which meant consumer electronics couldn’t be bought. Regardless of who you were and where you lived, for most people in 2021, shocks to global supply chains loomed large.

In 2021, a cascade of reasons led to the plight of a severe supply chain crisis. As highlighted in a previous article for the St Andrews Economist, the continuation of the Covid-19 pandemic, workers being unwilling to return to the labour force, a spike in energy prices and economic protectionism were the four main reasons which compounded the crisis. This led to a rise in economic instability, inflation, economic growth stagnating and policymakers scratching their heads about what can be done.

However, as we move into 2022, severe supply chain disruptions are likely to persist and are likely to get worse as time goes on. In the short run, the spread of the Omicron variant will be the primary cause of disruptions. Outbreaks of the highly transmissible variant across the world will lead to workforces having to self-isolate causing production of goods to become less consistent, thus hampering firms’ capability to fulfil contracts to those they supply to. Outbreaks have already caused severe disruption, with US retailers Walmart, Macy’s and Apple reducing open hours and closing stores.

Despite the pains of 2021, there are reasons to expect supply chain disruptions to only become more prevalent beyond 2022. Such disruptions may occur as a result of an increase in the occurrence of natural disasters (such as storms, wildfires and floods) due to the worsening effects of climate change, and cyber attacks by more sophisticated state and non-state actors. A litany of other smaller-scale events such as transportation failures, human error and labour shortages will also contribute to supply chain shocks. A study by McKinsey in 2020 found that companies can expect to lose 42% of one year’s earnings per decade from supply chain issues complications. With the severity and frequency of these shocks increasing, the public and politicians may fret and question whether our increasingly globalised world with its complex and lengthy supply chains are fit for the rest of the 21st century, with politicians publicly discussing upending the free trade consensus.

But why are supply chains not resilient to shocks in the first place? Firms know that supply chain disruptions can cause severe reductions in income as inputs fail to arrive in a timely manner for efficient production. Because of this, we would expect firms to be highly incentivised to ‘fully insure’ themselves against the drastic cost of supply chain shocks. To prepare against supply chain disruptions, firms and countries can look to diversify away from reliance on single countries and firms, strengthen relationships with current suppliers by hiring lawyers to oversee contracts, invest in technologies and expertise to better predict shocks and develop greater personal relationships with suppliers. However, there is a key wedge which reduces firm’s incentives to strengthen supply chain relationships and risks drastic shocks to output.

In a paper by Ben Golub, Matt Elliot and Matt Leduc, they find that there is a threshold of supply chain relationship strength (or probability that a firm will be able to produce its input). Below this threshold level, a firm will find it almost impossible to produce a good due to the likelihood that at least one necessary input won’t be able to be produced somewhere in the highly complex supply chain. Above this point, production will happen most of the time. This relationship between supply chain strength and probability of finished goods being produced means that if there is even a small shock and firms’ supply chains strengths are close to this precipice, production could grind to a halt, and the consequences amplified across the economy.

Nevertheless, this doesn’t explain why supply chain strengths are often close to this point. On the contrary, it would suggest that firms would be highly incentivised to invest in supply chain strength as the loss in income from a small drop in supply chain strength is so high. The main wedge, which prevents firm’s from moving their supply chains away from this precarious point is the inability for firms to receive the gains from strengthening their supply chains.

If a firm near the start of the supply chain was to strengthen its relationship with its suppliers, there is a big externality for firms further down the supply chain as they are much more likely to receive their inputs which increases their expected profits. This means that as the benefit of strong relationships cannot be internalised to this firm high up the supply chain, the extra expected profit they get from investing in relationship strength is often less than the cost of the strengthening the relationship. As this is the case, firms are not incentivised to increase relationship strength and move away from the threshold. A consumer good producing firm would be incentivised to contract with and pay firms further up the supply chain to improve supply chain strength with their suppliers but there is no easy way to do this so firms up the supply chain cannot internalise the profits of extra supply chain resilience and are not incentivised to do so.

Given the likelihood of more shocks causing greater supply chain crises, what can policymakers do about this? During the Covid-19 pandemic, governments put pressure on firms to re-shore production and move it outside of China. Factories for the aforementioned semiconductors were built in Japan and the USA to reduce reliance on importing semiconductors from South Korea and Taiwan and to bring high skilled production back to these countries. Furthermore, the political mood has turned towards creating shorter supply chains with more domestic or nearby production of inputs and goods through quotas and other restrictions on inputs of an ever-expanding list of ‘national security critical’ products. This geopolitical issue is a big concern for many western countries who do not want to be held hostage by volatile political systems.

However, the use of quotas and protectionism to increase supply chain resilience may cause more harm than good. The use of protectionist trade policies generally increases the cost of any inputs if produced domestically or subject importers to greater importing costs, and fails to take into account the further productivity losses by reshoring. Additionally, by segmenting the international supply chain through protectionist policies, countries may be unable to effectively specialise in their production.

An alternative solution is subsidising diversification. As consumers prefer to have a range of goods be available to them, (i.e., firms having relationships with suppliers both domestically and abroad) subsidising diversification may offer the best policy. In doing so, the government overcomes the two costs associated with it. These costs are both the extra investment required to build a relationship with a firm but also the more subtle cost of profits being lower when one supply chain fails as more firms are diversified in their supply chains and can therefore produce when one fails leading to greater competition and less market power and lower profits. Thus, the policy to subsidise diversification benefits consumers as it means that they still can benefit from the lower cost of international supply chains while mitigating the drastic costs when a shock (even small) hits production somewhere in the world and reduces the geopolitical reliance on other powers with political volatility.

2022 will usher in an unprecedented era of shocks to supply chains which will dwarf the disruption caused in 2021. However, as firms are not incentivised to make supply chains more resilient as there are major spill overs to this investment, fragile supply chains are now increasingly prevalent. Hence, it will take government intervention to promote diversification to improve supply chain strength and avert the next major crisis caused by a small shock somewhere in our interconnected world.

The views expressed in this article are the author’s own, and may not reflect the opinions of The St Andrews Economist.

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