- Theory of supply chains: a working capital approach
Production takes time, especially when conducted through long supply chains. Working capital in the form of inventories and receivables bridges the timing mismatch between incurring costs and receiving cash from sales. This paper lays out a theory of supply chains where financial conditions play a pivotal role in the determination of the length of supply chains.
The paper develops a tractable theory of supply chains that derives closed-form solutions for the extent of supply chain activity as a function of credit conditions. Key macro variables such as output, productivity and wages can also be solved in closed form. In an application to international trade, we solve for the ratio of trade to GDP, which serves as a key summary measure of the extent of global value chain (GVC) activity.
The extent of global value chain activity fluctuates with financial conditions, with more accommodative financial conditions being associated with higher investment in working capital, longer supply chains, a higher trade-to-GDP ratio and higher productivity and wages.
This paper presents a ＂time-to-build＂ theory of supply chains which implies a key role for the financing of working capital as a determinant of supply chain length. We apply our theory to offshoring and trade, where firms strike a balance between the productivity gain due to offshoring against the greater financial cost due to longer supply chains. In equilibrium, the ratio of trade to GDP, inventories and productivity are procyclical and closely track financial conditions.