Endogenous Fragility in Opaque Supply Chains

This paper investigates the role of supply chain unobservability in generating endogenously fragile production networks. In a simple production game, in which firms need to multisource to hedge against suppliers' risk under unobservability, firms underdiversify vis-a-vis the social optimum. The unobservability of suppliers' relations is the driver behind this. In production networks where upstream risk is highly correlated and supplier relationships are not observable, the marginal risk reduction of adding an additional supplier is low, because this additional supplier's risk is likely to be correlated to that of existing suppliers. This channel reduces firm incentives to diversify, which gives rise to inefficiently fragile production networks. By solving the social planner problem, I show that, if the risk reduction experienced downstream resulting from upstream diversification were to be internalised by upstream firms, endogenous production networks would be resilient to most levels of risk. Furthermore, I show that the opaqueness of the supply chain yields less fragile but more inefficient production networks. Despite its stylised form,the model identifies the trade-off firms face when diversifying risk and isolates the mechanism that aggregates these decisions into a production network. Furthermore, it maps the conditions of the trade-off, such as expected profits of the firm or the pairing costs, to the properties of the production network.