Endogenous Production Networks

Endogenous Production Networks

We develop a tractable model of endogenous production networks. Each one of a number of products can be produced by combining labor and an endogenous subset of the other products as inputs. Different combinations of inputs generate (prespecified) levels of productivity. Markets are “contestable” in the sense that production technologies are available to a large number of potential producers. We establish the existence and uniqueness of an equilibrium with an endogenous production network and provide comparative static results on how prices and endogenous technology choices (and thus the production network) respond to changes in parameters. These results show that improvements in technology (or reductions in distortions) spread throughout the economy via input-output linkages and reduce all prices, and under reasonable restrictions on the menu of production technologies, also lead to a denser production network. Using a dynamic version of the model, we show that the endogenous evolution of the production network could be a powerful force towards sustained economic growth. At the root of this result is the fact that the arrival of a few new products expands the set of technological possibilities of all existing industries by a large amount — that is, if there are n products, the arrival of one more new product increases the combinations of inputs that each existing product can use from 2 n-1 to 2 n , thus enabling significantly more pronounced cost reductions from the choice of optimal technology combinations. These cost reductions then spread to other industries that benefit from lower input prices and are further incentivized to adopt additional inputs.

This article studies the efficient allocation in an economy in which firms are connected through input–output linkages and must pay a fixed cost to produce. When economic conditions are poor, some firms might decide not to operate, thereby severing the links with their neighbours and changing the structure of the production network. Since producers benefit from having access to additional suppliers, nearby firms tend to operate, or not, together. As a result, the production network features clusters of operating firms, and the exit of a producer can create a cascade of firm shutdowns. While well-connected firms are better able to withstand shocks, they trigger larger cascades upon exit. The theory also predicts how the structure of the production network changes over the business cycle. As in the data, recessions are associated with more dispersed networks that feature fewer highly connected firms. In the calibrated economy, the endogenous reorganization of the network substantially dampens the impact of idiosyncratic shocks on aggregate fluctuations.

Business cycles are often regarded as aggregate phenomena. However, against the backdrop of rapid structural transformation in Chinese economy, they are also influenced by cyclical changes in various sectors and the evolution of the economic network structure. From the perspective of production networks, this paper analyzes the causes of business cycles in China. Firstly, a theoretical model is constructed to discuss the impact of structural characteristics and transformation processes of production networks on the relationship between sectoral shocks and economic fluctuations. Subsequently, using Bayesian structural vector autoregressive (SVAR) model with heterogeneous constraints, based on the China Industry Productivity Database (CIP/China KLEMS), the paper empirically identifies the source sectors of China’s business cycles from 1978 to 2018. The research findings are as follows: (1) Business cycles can be attributed to a combination of a few sectoral shocks, which are propagated and amplified through input-output linkages; (2) As China’s production network evolves, sectors that drive business cycles vary across times, transiting from labor-intensive sectors to capital-intensive sectors; (3) Construction and real estate sector is the key node in the production network. On the one hand, shocks to the key node sector are widely propagated to other sectors. On the other hand, shocks to their upstream and downstream sectors, in turn, affect the macroeconomy through the key node. These structural dynamics have shaped China’s business cycles. This paper reveals the structural characteristics of China’s business cycles, providing significant academic and policy value for understanding the relationship between macroeconomic performance and sectoral structure, as well as for maintaining stable economic growth.

We examine the macro implications of commodity price shocks in a small open economy model with input–output linkages for a commodity‐exporting small open economy. In the model, fluctuations in commodity prices have impacts on aggregate output not only through resource reallocation, currency value changes and monetary policy reaction but also through upstream and downstream input–output linkages (both domestically and with the rest of the world). We show the importance of input–output linkages as a shock transmission mechanism. We find that production linkages with the rest of the world play a significant role in amplifying the shock's aggregate impact.

How do imports from China affect local labour markets in Japan? We examine this question using commuting zones as regional units and analysing shock propagation through supply chains and co‐location patterns. Applying the method proposed by Autor et al. (American Economic Review, 103, 2121, 2013) and Acemoglu, Autor et al. (Journal of Labor Economics, 34, S141, 2016), we examine the impact of import shocks on regional manufacturing employment using input–output tables which allows us to investigate the propagation of shocks to both upstream and downstream industries and to relate the regional impact to industry co‐location patterns. We find that the negative direct effect on local employment is underestimated in previous studies that do not consider the regional propagation of the shock through supply chains, especially the positive shock to downstream industries. Downstream industries in Japan, for example, significantly benefit from imports from China as they lower input prices and increase employment. In contrast to downstream industries, we find no significant impact on upstream industries. Our results imply that the direct negative effect on local labour markets is somewhat mitigated by effects on downstream industries within the same region.

Self-fulfilling Business Cycles with Production Networks

We study how production networks shape the severity of Sudden Stops.We build a small open economy model with collateral constraints and input-output linkages, derive a sufficient statistic that maps network structure into the amplification of tradable shocks, and show that a planner optimally introduces sectoral wedges to reduce amplification.Using OECD input-output data and Sudden Stop episodes, we document systematic network differences between emerging and advanced economies and show they predict crisis severity.A calibrated three-sector DSGE model disciplined by these differences reveals that endowing an advanced economy with an emergingmarket production network moves most of the way toward the observed emerging-advanced Sudden Stop gap.

This paper presents the theoretical framework developed by Liu (2019) for analyzing the impacts of industrial policy, with applications to South Korea, China, and Brazil. Using a general equilibrium model that incorporates market imperfections and input-output linkages, Liu (2019) demonstrates the existence of a synthetic measure – distortion centrality – related to a sector’s position within the production network. This measure indicates: a) which sectors should receive targeted subsidies; and b) the optimal priority ranking among them. We discuss Liu’s (2019) main findings when applying this framework to assess industrial policies in South Korea during the 1970s and in modern-day China. The results show a strong correlation between the sectors prioritized in these historical experiences and the ranking recommended by the theory. As an original empirical application, we compute the sectoral ranking for Brazil in 2019, identifying the industries that, according to this framework, should be prioritized for government support. The key findings are: i) industrial sectors dominate among those classified as high-priority, but some industries fall outside the group recommended for subsidies; ii) in the service sectors, there are both intermediate-priority sectors and those for which government support is not advised; and iii) agricultural sectors are within the eligible range for support but rank at the lower end of the priority scale.

This paper presents a tractable model of endogenous production networks with fixed costs associated with the formation of links between firms.The model consists of a finite number of firm types producing differentiated products.Each firm is characterized by firm-specific parameters describing its CES production function, firm-specific domestic and foreign demand shifters, and a firm-specific set of potential suppliers and buyers.We consider versions of the model in which either the buyer or the supplier initiates the formation of links, and versions in which the production network can be cyclic or acyclic.Our main theoretical result is that the closed economy equilibrium is unique if the set of feasible networks consists only of networks that are acyclic and the buyer initiates the link formation while having full bargaining power in price negotiations with the supplier.We provide examples of multiple equilibria if the supplier initiates the link formation in both cyclic and acyclic feasible networks or if the buyer initiates the link formation in a cyclic production network.We take the acyclic production network model to Belgian data on firm-to-firm production networks and show that it approximates well the salient features of the network.The endogenous network model generates substantial churn in domestic firm-to-firm linkages in response to trade shocks.However, the endogenous network model generates only moderately different welfare changes compared to a model with fixed linkages, suggesting that exogenous production networks can approximate the welfare response to trade shocks reasonably well.

Which sectors should be covered by the EU Carbon Border Adjustment Mechanism?

What is the role of production networks in inducing self‐fulfilling business cycles? We construct a multisector business cycle model that features both input–output linkages and credit constraints. Our theoretical framework demonstrates that a single aggregate financial multiplier is sufficient to characterize equilibrium determinacy, which hinges on the network structure. By quantitatively assessing the possibility of indeterminate equilibria in the United States from 2000 to 2020, we discover that the economy was prone to self‐fulfilling fluctuations in the period of pre‐2007.

Upstream subsidy or downstream subsidy? A quantitative analysis of credit subsidy in China

Price connectedness and input–output linkages: Evidence from China

A note on optimal sectoral policies in production networks