Cascades and Fluctuations in an Economy with an Endogenous Production Network

Abstract This paper studies an economy in which the network structure of production is endogenously determined by the firms' extensive margin of operation. In the model, a finite number of firms are connected through input-output linkages and must pay a fixed cost to produce. When economic conditions are poor, some firms might decide not to produce, thereby severing the links with their neighbors. Together, the operating decisions of the firms therefore determine the structure of the production network. Since producers benefit from having access to additional suppliers, the economy features complementarities between the operating decisions of nearby firms. As a result, if a firm exits following a severe shock, a cascade of shutdowns might spread from neighbor to neighbor as the network reorganizes itself. While well-connected firms are better able to withstand shocks, they trigger larger cascades upon shutdown, a prediction confirmed by U.S. data. The theory also predicts how the structure of the production network interacts with the business cycle. As in the data, downturns feature less clustering among firms, and are associated with degree distributions with thinner tails. In addition, the endogenous reorganization of the network substantially dampens aggregate fluctuations relative to a scenario in which the network is kept fixed