Global Supply Chains: Large Firms Aren’t Stingy

In today’s world, global supply chains are a sexy topic. As a large manufacturer, you can be more competitive if you expand your firm to remote countries where it is cheaper to produce some of your inputs. Why not? Obviously firms aim to minimize costs.

But the world is more complicated than a cost function. Firms also want to be the best at what they do and serve their clients in the best possible way. At least, that is true for firms that want to survive.

The following network figure from the recently published Inter-American Development Bank book “Synchronized Factories,” coordinated by Juan Blyde, makes for interesting reading.

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The network represents the links from the home countries of multinational corporations (MNCs) to the countries of their vertically linked foreign affiliates. The sizes of the nodes are proportional to the number of MNCs in the country (that own vertical subsidiaries abroad) and the thicknesses of the lines represent the number of vertical relationships between each pair of countries.

While we already knew that most of the FDI flows from rich to rich countries (what economists know as the Lucas Paradox) it is still striking to see this image. In particular two main empirical facts caught my attention.

First, rich countries often outsource to other rich countries. This suggests that the decision to outsource is not only a cost-related one; other variables are also driving this decision. Rich countries produce a lot of sophisticated goods that often require sophisticated inputs. Thus, firms must outsource to places that have the knowhow to provide such inputs.

Second, connections to and from poor countries are weak. There may be many reasons for this, such as inappropriate institutional frameworks, excessive regulation, among others. But in particular, it also says something about the productivity curse of these countries: by being marginalized from capital flows, they are also being marginalized from the diffusion of knowhow. The chicken and egg problem arises: firms in developing countries do not have the incentive to acquire knowhow for their foreign customers because there is no demand, which in turn happens because there is no proper knowhow to begin with. Lower costs are not enough to break the cycle.

In the era where many governments put their efforts into joining global supply chains, they must ask themselves what market failures have impeded them to do so and what else they can provide to their clients besides low costs.