In November 2008, Alan Mulally, chief executive of Ford Motor Company, appeared before the Senate Banking Committee and requested emergency government support for General Motors Company and the Chrysler Group, Ford’s biggest domestic rivals. Mulally argued that given the significant overlap in the suppliers and dealers of the three automakers, the collapse of either GM or Chrysler would have a ripple effect across the industry, leading to a severe disruption of Ford’s production operations within days.
Professor Alireza Tahbaz-Salehi says the case made by Mulally is a reminder of how shocks to a one firm or sector can severely affect others. Salehi, along with Daron Acemoğlu and Asuman Özdağlar of MIT, and Vasco Carvalho of CREI and Pompeu Fabra University in Barcelona, set out to model how interconnections among firms and sectors via their supply chains can cause microeconomic shocks to spread throughout the economy.
The researchers used input-output data from the US Bureau of Economic Analysis, which captures the extent of trade among different sectors in the economy. This provides a clear picture of the relationship structure among different sectors. They then created a mathematical model to capture how such interactions among sectors may act as mechanisms for spreading shocks.
“Industry insiders, as in the case of Ford, already know that these relationships exist and that they’re very important,” Salehi explains. “But macroeconomists have largely ignored the role that such interactions may play in creating business cycles. We are providing a framework to effectively study and understand the macro effects of these input-output relationships.”
In addition, the researchers characterize how connections between firms and sectors determine the broader impact of shocks. Small shocks to the most central sectors those with the greatest number of direct or indirect downstream sectors, such as the financial industry, wholesale trade, and real estate are more likely to set off cascade effects throughout the economy. Small events occurring in less central sectors with fewer connections are less likely to set off such cascades.
Salehi says that their model could be used by macroeconomists to better understand the origins of business cycles and help policymakers identify shocks to which sectors may have a larger impact on the economy as a whole. It’s also a reminder to business owners and leaders to consider the possible domino effects in their industry even if a problem at first seems small.
“In order to understand business cycles and their origins properly, one really needs to dig deep and look into these input-output relationships between different sectors,” Salehi says.
Alireza Tahbaz-Salehi is assistant professor of decision, risk, and operations at Columbia Business School.