Subcontractors for Tractors: Theory and Evidence on FlexibleSpecialization, Supplier Selection, and Contracting

Buyer-Seller networks are pervasive in developing economies yet remain relatively under-studied. Using primary data on contracts between the largest tractor assembler in Pakistanand its suppliers we …find large variations in prices and quantities across suppliers of the sameproduct. Surprisingly, "tied" suppliers - those that choose higher levels of specifi…c investments- receive lower and more unstable orders and lower prices. These results are explained bydeveloping a simple model of flexible specialization under demand uncertainty. A buyer facesmultiple suppliers with heterogeneous types to supply customized parts. Speci…fic investmentsraise surplus within the relationship but lower the seller's flexibility to cater to the outsidemarket. Higher quality suppliers have a greater likelihood of selling outside and so this cost isgreater for them. Therefore even if a buyer typically prefers high types, some low type suppliersmight be kept as marginal suppliers because of their greater willingness to invest more in buyer-speci…fic assets. Further empirical examination shows that the more tied suppliers are indeed oflower quality.[...]