PNAS: “Economic progress is aided by longer supply chains and deeper networks”

Madrid, February 14, 2022.- PNAS, Proceedings of the National Academy of Sciences of the United States of America, has published an analysis of the structure of production in the American economy, and how it affects its growth. Without a doubt, it is a well-documented and useful reflection in the current situation.

Economic output is the result of a network of industries that buy goods from one another, convert them to new goods, and sell the output to households or other industries. Since work by Leontief increasingly rich data have become available to study these networks, and research has revealed characteristics that hold across diverse economies, such as their link weight and industry size distributions community structure and path length properties. Economies typically have a few highly central industries that are strong suppliers to the rest of the network a feature that has been incorporated into models where short-term fluctuations in output are generated by shocks to individual industries. 

In this paper we study how the network structure of production affects an economy’s long-term growth. Our argument proceeds in two steps. First, we show that the rate of change of an industry’s price is a function of its position in the production network. This happens because productivity improvements accumulate along supply chains. As a result, industries that rely on longer supply chains experience stronger price declines than others. Second, we show how this observation can help explain cross-country differences in economic growth. Because an industry’s position in the production network and the industrial composition of a country are slow-moving variables, aggregate growth can be predicted from the structure of a country’s production network. Intuitively, countries whose final demand relies relatively more on industries with longer supply chains should grow more quickly. We find that detailed observations across industries and countries are consistent with both predictions and help explain why some countries grow faster than others.

A large body of literature stresses that technological improvements are the main driver of long-term growth. Over time, improvements to productivity—the amount of output that can be made with a given amount of inputs—significantly alter prices and production flows in an economy. Classic work by Domar and Hulten showed that as an industry’s productivity improves, the presence of intermediate input trade—i.e., goods and services flowing through a production network—amplifies the aggregate benefit for an economy. Productivity growth in an industry not only reduces the price and raises the output of its goods, but some of this output can be used as inputs by other industries, enabling further increases in output, and so on.

However, other predictions about the role of production networks have escaped notice. Using a simple model, we show that as the effects of productivity changes propagate, each industry’s price declines at a rate that depends on its network position. An industry’s price should fall in proportion to its output multiplier, a centrality metric that can be understood as the average length of an industry’s production chains where every production path is weighted by the relative size of the expenditures it represents. An industry benefits from both its own productivity growth and the accumulation of productivity improvements in its upstream suppliers. As a result, the longer its chains of production, the faster its expected rate of price reduction.

The connection to output multipliers is significant because these variables convey structural information about an economy. Particular industries, especially in manufacturing, are known to have larger output multipliers, while others, especially in services, tend to have smaller ones. This is largely because manufacturing typically devotes a greater fraction of expenses to intermediate goods and a smaller fraction to labor than services do. Output multipliers can change with time as prices and technology evolve and as industries substitute some inputs for others. However, output multipliers change much more slowly than other key variables in our analysis, in particular productivity growth rates and price changes. This conforms with the idea that output multipliers capture a hardwired aspect of production. A producer of fabricated metal parts, for example, will largely remain the supplier to an automobile maker and not the other way around, even if the detailed pattern of input flows changes with time.

The relative persistence of output multipliers means that the predicted price changes noted above should correlate with enduring features of network structure. In particular, it suggests that output multipliers should be able to predict industry price changes over long horizons. The mechanism we study (the passing of the benefits of productivity improvement along production chains) carries other implications as well. We derive a number of predictions that are implied by production network models, including predictions for the cross-industry variation of price changes around the expected value.

We compare these predictions with data on output multipliers and prices from 35 industry categories and 40 countries (1,400 industries in total) from the World Input–Output Database (WIOD). First, we verify the basic mechanism of the model, observing the price reduction that industries inherit through reductions in the prices of inputs. We document a remarkable fact: not only do inherited price reductions contribute significantly, but for the majority of industries, inherited price reductions exceed those originating locally in the network from the productivity growth of an industry. For most industries the better part of the explanation of price reduction lies in processes happening outside the industry, in other parts of the network.

We then test predictions related to output multipliers. We do our exercises under the assumption of constant output multipliers, holding values fixed in an initial year, and studying subsequent price changes. The data agree with predictions for both the expectation value of price changes and cross-industry variation around it. This variation shrinks with time, causing predictions based on the expected value to become more accurate and making the output multiplier more relevant as one looks further into the future. This means that our results also enable a simple method to forecast changes in prices.

We then explore macrolevel implications of the network’s influence on prices. We show that a consequence of the relationship between prices and output multipliers is that a country’s gross domestic product (GDP) is predicted to grow at a rate in proportion to the average of its industries’ output multipliers. Intuitively, falling prices translate into economic growth to the extent that economies enjoy price reductions by consuming more. Production network models thus predict that all else equal, a country’s rate of growth will be higher the longer its production chains are. To test the macrolevel predictions we again turn to WIOD data. We show that a country’s average output multiplier is, like industry-level output multipliers, a slow-moving variable. This is not surprising, as episodes of structural transformation and large-scale reorganization of production play out over many years. This in turn implies that initial cross-country variations in average output multipliers can be used to predict cross-country differences in future growth.

Taken together, the results suggest that the network structure of production plays a major role in the long-term evolution of economies. We relate the results to two longstanding observations. First, a well-known observation about technology evolution is that while most industries gain in productivity over long periods, some industries, especially manufacturing, improve more quickly than others. Over time, this difference causes price increases in slower-improving industries, an effect known as Baumol’s cost disease. The findings here provide a reason why some industries would sustain faster improvement than others over long periods. Second, the results suggest that production chains are an important factor in the process of structural change, in which economies undergo large-scale shifts in production activity over time, often from agriculture to manufacturing to services. If a shift from traditional agriculture into manufacturing increases the overall length of an economy’s production chains, then the predictions here imply a natural mechanism for growth to accelerate as a country industrializes and to move toward secular stagnation as it shifts into services.

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