Private and social incentives for investments in supply chain resilience “are not fully aligned”

Supply chain disruptions have become the new normal in the current geopolitical and economic landscape: chip shortage, Suez Canal blockage, US west coast ports congestions, China’s lockdowns and the ripple effects… 

To find trade-offs between cost, speed and demands, 87% of global supply chain professionals were planning to “invest in resilience” in 2021, according to the survey published by Gartner in February last year. Enterprises and industries were planning either to bring material sourcing and manufacturing closer to home or to diversify their supplies.  

Are the private - market or profit - incentives sufficient for attaining global supply chain resilience? Do we need government interventions at all, for improving supply chain resilience? Get insights from Gene Grossman, Professor of Economics at Princeton University in this interview. 

Supply chain disruptions are costly and harmful to consumers and businesses. What are some of the private investments in increasing supply chain resilience?  

Gene Grossman: There are several methods to increase supply chain resilience. Some firms have diversified their sourcing and added redundancies to their supplier base. Others have adopted the approach of “friend shoring”, moving their sources to more politically secure locations. A few firms have chosen “near shoring” or “in-shoring”, meaning they relocated sourcing closer to home, to reduce the risks of shocks to the transportation systems. Often, they invest in inventories of critical parts and components, so that production operations might continue during periods of supply disturbances.  

An increasingly common practice has been to pursue vertical integration: to build capacity within the firm to produce needed inputs. This approach has been prominent of late in the automobile industry, following Tesla’s successful business model. With integration, firms gain control of their suppliers and can set priorities about scarce supplies’ distribution.  

Whether these practices will prove to be temporary or permanent adjustments is unclear. The last few years have seen a sharp rise in disruptions due to the pandemic, increasing regularity of severe weather events, heightened geopolitical and trade policy frictions, and of course, the war in Ukraine. Firms’ long-term responses will be based on their perception of the risks during “normal” times, not the worst-case scenarios that have been all-too-common of late.  

Are these profit-maximising choices proven to be efficient?  

Gene Grossman: It is too early to say as the return to these investments can only be gauged over a much longer horizon. Investments in resilience are expensive, and we need more data to know if the benefits justify the cost. Mainly, on how much extra output results from the more secure supply chains and how regular and severe are the disturbances that firms will face in the “new normal.”  

From my reading of the trade evidence, American companies have been keener to shift sourcing from China to other emerging markets, especially Vietnam than they have been to bring input sourcing back home. Anecdotally it seems that many firms are pleased with their new trade partners.  

According to your research, sometimes government intervention and encouragement in supply chain formation could lead to what you call “too many” incentives compared to what is socially optimal. Why? What should we do about it?  

Gene Grossman: When we think about investments in supply chain resilience, private and social incentives are not fully aligned. On the one hand, there is what economists call this “consumer surplus”. For example, we all experienced toilet paper shortages early in the pandemic. My favorite brand (Proctor Gamble) wasn’t available, and I had to purchase another one (Kimberly-Clark). However, I would have been more than willing to pay a slightly higher price to get my usual product. When consumers reap surplus from product availability and lose surplus when products become unavailable, the market will underprovide resilience.  

On the other hand, when firms invest in resilience, part of their benefit comes at the expense of their competitors. An investment that creates profits for some firm at the expense of others may be privately attractive but not socially so. Here, some of the profit that Kimberly-Clark earned was not a net addition to industry profits, but rather earnings that otherwise would have gone to Proctor Gamble. When that part of the incentive for investment in resilience comes from “profit shifting,” the market may overprovide resilience. Subtle features of the market demand for a product determine whether the consumer surplus compares to profit shifting, thus whether market incentives for investments in resilience or inadequate or, in fact, excessive. 

Our research shows that common arguments in favour of pro-resilience government policies are not as straightforward as they might seem at first. We don’t know enough about the details of many markets to be confident that these policies would justify their costs. However, where the costs to society of product unavailability are obviously great (i.e., vaccines or infant formula), then government intervention is clearly warranted.