Theory of supply chains: a working capital approach

(January 2023, revised October 2024)

Summary

Focus 

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.

Contribution 

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.

Findings 

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.

Abstract

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 global value chains (GVCs) and trade, where firms strike a balance between the productivity gain from longer GVCs against the greater financial cost due to longer supply chains. In equilibrium, we show the duality between GVC length and financial conditions, where more accommodative financial conditions are associated with longer GVCs.

JEL classification: F23, F36, G15, G21, L23

Keywords: global value chains, offshoring, trade finance