Supply Disruptions and Optimal Network Structures

This paper studies multi-tier supply chain networks in the presence of disruption risk. Firms decide how to source their inputs from upstream suppliers so as to maximize their expected profits, and prices of intermediate goods are set so that markets clear. We provide an explicit characterization of equilibrium prices and profits, which allows us to derive insights on how the network structure, i.e., the number of firms in each tier, production costs, and disruption risk affect firms’ profits. We discuss the prescriptive implications of our findings by exploring how a firm should prioritize among its suppliers (direct and indirect) when investing in improving their production reliability. Furthermore, we establish that networks that maximize profits for firms that operate in different stages of the production process, i.e., for the upstream supplier and the downstream retailer, are structurally different. In particular, the former have relatively less diversified downstream tiers and generate more variable output than the latter. Finally, we study the question of endogenous chain formation by considering a game of entry, i.e., firms decide whether to engage in production by forming beliefs about their profits in the post-entry supply chain. We argue that endogenous entry leads to chains that are inefficient in terms of the number of firms that engage in production.