The Missing Links: Formation and Decay of Economic Networks

3. The Formation of Industrial-Supply Networks

Chapter 3 The Formation of IndustrialSupply Networks Rachel Kranton and Deborah Minehart* In the past two decades, the business press in the United States has been full of reports that manufacturers are reducing their supplier base, but until recently there has been no economic theory that can explain this phenomenon. Indeed, it is a puzzle: Why would a manufacturer ever want to reduce the number of its suppliers? Typical theories of industrial organization—which focus on markets, monopolies , or on hierarchies and single vertically integrated firms—cannot help us here. We need a new theory, a new way to understand the many industries, such as the automobile industry, that involve small numbers of manufacturers and small numbers of suppliers. To study these industries, we need a theory of industrial networks. This chapter provides such a theory. With it we can understand why manufacturers might want to decrease their supplier base. By committing to buy only from a limited set of firms, the manufacturers commit to pay high prices in the future. Hence, suppliers are guaranteed returns from any investments in new quality-enhancing technology. This outcome fits with the stated goal of such policies: reducing a supplier base can yield greater investments in quality and design improvements. The analysis yields several new insights into supply relations. We *The views expressed do not purport to represent the views of the United States Department of Justice. find that when the sellers’ investments are inexpensive, buyers will want to link with many suppliers who are linked to many other buyers; the result looks very much like a market where the supply is able to meet total demand. In contrast, when suppliers’ investments are expensive, a few supply networks, each serving a subset of the buyers, are optimal. The supply is limited and often is not sufficient to meet demand. Buyers end up paying a price premium, but they may actually prefer this situation, since sellers have the incentive to make investments. The best outcome, then, can involve several buyers sharing a restricted supply base. This analysis shows the importance of a network model of firms. We see interactions and outcomes that we could not see with previous theories. First, we see that the interaction between a single buyer and a single supplier depends not only on their own relationship but also on the supplier’s connections to other buyers, and vice versa. Second, buyers may prefer to share suppliers rather than maintain exclusive supply networks. Finally, whether or not buyers prefer to share suppliers may depend on suppliers’ investment costs. This chapter also illustrates a typical economic approach to the study of networks. In this volume we see much evidence that individuals ’ decisions and opportunities are shaped by social and economic networks. A question that immediately leaps to an economist’s mind is this: If networks affect individual opportunities and constraints, wouldn’t people have incentives to shape their networks? This chapter provides a simple model where agents form network links strategically. The industrial-network example gives a precise business context which guides our modeling. We follow the general game-theoretic methodology to study the formation of networks as that discussed in Matthew Jackson’s overview (chapter 2, this volume).1 In our model, to produce inputs that are valuable to a buyer, both a buyer and a supplier must first have links. Firms that are not “linked” cannot profitably trade.2 This feature captures an important process that occurs in many industries. Many manufacturers only buy from suppliers they have “qualified” in advance; “qualified” suppliers meet certain standards and other criteria. Manufacturers must decide how many and which suppliers to “qualify.” After qualification , in our model suppliers then decide whether or not to inThe Formation of Industrial-Supply Networks 45 vest in equipment that makes their product more valuable to a buyer. These investments determine the network of possible trading relationships. With this network in place, in the second stage buyers and suppliers bargain over prices and sales of inputs. A firm’s bargaining power—its ability to sell or buy a good at an appropriate price—depends on the number and distribution of links and investments . For example, buyers face more competition when there are more buyers linked to the same suppliers. Hence, firms must consider in the first stage how the network structure impacts the prices in the second stage and the incentive to invest in value-enhancing...