Cascading Failures in Production Networks

I show how the extensive margin of firm entry and exit can greatly amplify idiosyncratic shocks in an economy with a production network. I show that canonical input-output models, which lack the extensive margin of firm entry and exit, have some crucial limitations. In these models, the systemic importance of a firm does not respond to productivity shocks, depends only on the firm’s role as a supplier, and is equal to or well-approximated by the firm’s size. This means that for every canonical input-output model, there exists a non-interconnected model that has the same aggregate response to productivity shocks. I show that when we allow for entry and exit, the systemic importance of a firm responds endogenously to productivity shocks, depends on a firm’s role not just as a supplier but also as a consumer, and a firm’s systemic influence is no longer well-approximated by its size. Furthermore, I show that nondivisibilities in systemically important industries can cause one failure to snowball into a large-scale avalanche of failures. In this sense, shocks can be amplified as they travel through the network, whereas in canonical input-output models they cannot.