Trade Policy — Uncertainty May Affect the Organization of Firms’ Supply Chains— Sebastian Heise, Justin R. Pierce, Georg Schaur, and Peter K. Schott

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Mike Norman
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Global trade policy uncertainty has increased significantly, largely because of a changing tariff regime between the United States and China. In this blog post, we argue that trade policy can have a significant effect on firms’ organization of supply chains. When the probability of a trade war rises, firms become less likely to form long-term, just-in-time relationships with foreign suppliers, which may lead to higher costs and welfare losses for consumers. Our research shows that even in the absence of actual tariff changes, an increased likelihood of a trade war can significantly distort U.S. imports. 

In a recent study, we examine how firms set up and operate their international supply chains, building on a theory of “optimal procurement” previously applied to firms’ domestic operations. In our framework, a U.S. firm chooses between two systems to import inputs at the lowest overall cost, while ensuring that suppliers provide high-quality inputs. Under the “inspection” system, the U.S. firm buys imported inputs from the lowest-priced foreign supplier, and then incurs additional costs to inspect each shipment for quality. Under the “relationship” system, a firm enters into a long-term relationship with a foreign supplier and, instead of inspections, incentivizes the supplier to provide high-quality inputs by paying a premium over the supplier’s costs. The foreign supplier values the relationship because of this premium. The U.S. sourcing firm prefers the relationship system if the premium it pays to incentivize the supplier is less than the inspection cost. 

The choice between these two systems depends on the cost of inspections relative to the premium paid to suppliers in a long-term relationship. This comparison highlights channels through which trade policy uncertainty can affect a firm’s supply chain decisions.
Consider the case of a foreign firm supplying inputs to a U.S. firm under the terms of an established relationship. If trade policy is certain, the foreign supplier believes the relationship can be long-lasting, and requires only a small premium over its costs to continue to supply high-quality inputs. If trade policy becomes uncertain, however, so that a trade war may end the relationship in the near future, the foreign supplier will require a higher premium to provide high-quality inputs. In this case, the U.S. firm may not engage in long-term relationships with its suppliers—forgoing the benefits associated with the relationship system—and instead opt for procuring goods via the inspection system.
Applying this framework to detailed, transaction-level U.S. import data, we are able to able to examine the implications of a past shock to U.S. trade policy uncertainty for U.S. firms’ sourcing decisions....