Value chain

Contagion in the value chain: are companies in difficulty?

Whether it’s a storm, fire, strike, management failure or business dispute, the risks facing businesses are many. There is also a danger if things go wrong for suppliers and customers. If a difficult-to-replace supplier goes bankrupt or if a major customer runs out of money, there is a crisis. The stronger the division of labor and the specialization of production, the more closely intertwined and interdependent firms are in a web of supply relationships. An interruption in the production chain can be all the more disastrous. Contagion in the value chain can affect entire sectors and exacerbate economic downturns. In order to build resilience to crises, companies can take precautions, for example with warehouses, supplier diversification and sufficient capital reserves.

Companies are closely linked by a large number of supply relationships. Consequently, a supplier’s financial difficulties can quickly turn into a business risk for its customers and even for an entire industry. The shocks and their effects can be so severe that they affect entire industrial sectors and thus aggravate the economic downturn. Until now, economic research has mainly dealt with the interdependence between particular industries and their influence on the overall economy. It is not yet known how complex value chains depend on the interdependencies between individual companies.

Shocks and Supplies

Each company is part of a more or less complex network of suppliers, subcontractors and customers. Companies source and sell their products on a common market. If any of these companies have to interrupt production or there are bottlenecks in deliveries for other reasons, their customers must react. This response is determined by two factors.

On the one hand, companies can offset a large part of these shocks through their own precautions and adjustments to their production. The distribution of purchases between different suppliers and warehousing are examples. Even in the face of major disruptions, delivery bottlenecks and price increases, many companies are flexible enough to adjust production or switch to alternative suppliers.

On the other hand, in the case of long-term supply contracts, the exclusivity of a supplier or patents can make these adjustments difficult. In this case, shocks in a specific firm propagate faster and stronger through the production network and can accumulate. If a business is struggling, its customers and suppliers will feel it. The larger the company concerned, the more rigid the production, or the more the network has branches with other companies, the more the shock spreads and the greater the impact on the economy as a whole.

Connections that existed at the beginning and end of the period have a dark background. All other relationships were broken before 2000 or started only after 1995. The distance between two points shows the geographical distance between the companies, the thickness shows the strength of the relationship.

According to the data, the complexity of a network of suppliers and customers reflects the consequences of a shock. Not all companies have the same importance in the value chain.

A production failure at one of the nodes, i.e. a heavily networked control facility, affects a large number of companies in the network. It is also known that relations with geographically close companies are privileged. A production shock therefore typically has a particularly severe impact on nearby customers and suppliers.

It is not always easy for economists to establish these chains of effects and to identify them empirically. A multitude of influencing factors often makes it almost impossible to isolate the direct effect on a single company. Events that affect a single company are rare and difficult to pin down. You can use a special trick to do this. For the United States between 1978 and 2013, they examine how local natural disasters such as fires, storms, floods or heavy snowfalls affected businesses and their upstream and downstream partners. Then they compare the course of business with similar companies that were not directly affected by the disaster, but are linked to the affected companies through their network. The stronger the shock and the greater the role of a company in the network, the more the effects of such a shock should be felt by other companies.

In the event of a local shock such as a natural disaster, the company’s sales growth drops by an average of 5 percentage points, and for customers by 2 to 3 percentage points.

Estimate per disaster

First, I estimate that the revenue growth of a business affected by a natural disaster will decrease by an average of 5 percentage points. This should have a direct impact on customer sales. I also estimate that such a shock reduces customer sales by 2-3 percentage points. This corresponds to a decline of 25% compared to the average growth rate over three quarters.

The vertical line indicates the time of the natural disaster and the vertical axis the loss in value of the share in percentage. In the first month after the shock, the market value of the affected supplier is reduced by an average of 3%, while that of the customer is reduced by up to 1%, or a third of that.

After a production shutdown, the stock market value of an affected company drops by an average of 3%. In a business network, this leads to a loss of value for customers of up to 1% of the market value.

Furthermore, a shock also spreads horizontally to other businesses that are not directly affected themselves, but supply customers who also buy from the directly affected suppliers. So other businesses, not directly affected, are also infected by having to accept up to 4 percentage points less sales growth through their customers. A company’s crisis not only propagates vertically along a value chain, but also horizontally between suppliers at the same level of transformation. An entire network or an entire industry can be infected.

My estimates are limited to the effects of natural disasters. With my approach, however, I can identify shocks that are initially limited to individual companies and can thus filter out the propagation effects separately. As I have pointed out, it is very likely that I will generalize my results to other interruptions in the value chain, for example following strikes, management changes or trade disputes. It does not depend on the cause of the production stoppage, but on the importance of the goods and services that a customer receives from its suppliers. The more difficult it is for a customer to replace a failing supplier, the more it will be impacted by an interruption of the previous processing step. This applies especially to industries that are tightly regulated and where patents are held by a few suppliers. This can significantly increase the contagion effects of firm-specific shocks.

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