Disruption and Rerouting in Supply Chain Networks

Abstract

We study systemic risk in a supply chain network where firms are connected through purchase orders. Firms can be hit by cost or demand shocks, possibly leading to defaults. These shocks propagate through the supply chain network via input-output linkages between buyers and suppliers. Firms endogenously take contingency plans to mitigate the impact generated from disruptions. They reroute undelivered orders to alternative buyers and switch excess demand to different suppliers. We show that, as long as firms have large initial equity buffers, network fragility is low if both buyer and supplier diversification is low. We argue that horizontal mergers may lead to a more fragile network if firms have small initial equity buffers. We find that a single sourcing strategy is beneficial for a firm only if the default probability of the firm's supplier is low. Otherwise, a multiple sourcing strategy is ex-post more cost effective for a firm.