IO in I-O: Competition and Volatility in Input-Output Networks

There is a growing literature suggesting that firm level productivity shocks can help understandmacroeconomic level outcomes. However, existingmodels are very restrictive regarding the nature of competition within sector and its implication for the propagation of shocks across the input-output (I-O) network. The goal of this paper is to offer amore comprehensive understanding of how firm level shocks can shape aggregate dynamics. To this end, I build a tractablemulti-sector heterogeneous firm general equilibrium model featuring oligopolistic competition and an I-O network. It is shown that a positive shock to a large firm increases both the average productivity and the Herfindahl Index in its sector. By reducing the sector price, the change in average productivity propagates only to downstream sectors. Conversely, the change in the Herfindahl Index, by increasing price and reducing demand for intermediate inputs, propagates both to downstream and upstream sectors. The sensitivity of aggregate volatility to firms’ shocks is determined by the sector’s (i) Herfindahl Index, which measures the volatility of the sector, (ii) position in the input-output network, which measures the direct and indirect importance of this sector for the household, and (iii) relativemarket power in the supply chain, which relates to the changes in demand to upstreamsectors.