MIT Sloan research shows effects of natural disasters on production networks

New England weather likely to have broad economic impact

CAMBRIDGE, Mass., March 5, 2015 – With New England facing one of the coldest and snowiest winters on record, the economic consequences of this natural disaster are a common topic of local discussions. However, research by MIT Sloan School of Management Prof. Jean-Noel Barrot shows that natural disasters can have a significant economic impact beyond the disaster zone. In his study, he found that customers of suppliers hit by a natural disaster experience a large drop in sales growth and stock price. He also observed a negative economic effect on other suppliers not located in the natural disaster zone.

In his study, Barrot and a colleague studied natural disasters in the past 30 years in the U.S. to shed light on how idiosyncratic shocks to individual firms spread along supply chains. “You might expect shocks to easily be absorbed in production networks, as firms could adjust their production mix or switch to other suppliers,” he says. “However, our research shows that that when a supplier is hit by a natural disaster, there are important disruptive effects along the supply chain.”

First, they found that the sales growth of supplier firms directly hit by a natural disaster drops by around five percentage points. The customers of these suppliers are also disrupted, as their sales growth drops on average by two percentage points when one of their suppliers is hit by a natural disaster. “This is a strikingly large effect,” says Barrot, noting that the effect is concentrated among customers with lower inventories.

Then they investigated whether the drop in firms’ sales caused by supply disruptions translates into value losses. The study shows that supply disruptions caused a one percent drop in customer firms’ equity value. This effect is almost twice as large when the disrupted supplier is a specific supplier, meaning a supplier producing differentiated goods, generating high R&D expenses, or holding patents.

Finally, they looked at whether the shock originating from one supplier propagates to other suppliers of the same firm, which were not directly affected by the natural disaster.“You might expect that firms would continue to buy from other suppliers outside of the natural disaster zone, or that the other suppliers would find alternative buyers. However, our research shows large negative spillovers of the initial shock to other suppliers. Surprisingly, we found that other suppliers of a main customer see a drop in sales growth by roughly three percentage points,” observes Barrot.

He notes that these results are only seen when the supplier is in an active relationship with the customer. When the connections aren’t active, then there is no effect.

“Our findings highlight the presence of strong interdependencies in production networks,” says Barrot. “In other words, production networks matter. When one of your suppliers or customers is experiencing a negative event, there will be important implications for you.”

He adds that this research likely applies to contexts beyond natural disasters, such as strikes and financial crises. As for the economic impact of the weather in New England this winter, “there is good reason to think that the effects will be propagated to other parts of the economy through relationships that Massachusetts firms have with customers all over the country,” says Barrot.

Jean-Noel Barrot is the coauthor of “Input specificity and the propagation of idiosyncratic shocks in production networks” with Julien Sauvagnat of ENSAE-CREST. To read the full article, please visit: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2427421

Barrot also coauthored a column on this topic on the VOX CEPR’s Policy Portal: http://www.voxeu.org/article/input-specificity-and-propagation-idiosyncratic-shocks-production-networks

The MIT Sloan School of Management is where smart, independent leaders come together to solve problems, create new organizations, and improve the world. Learn more at mitsloan.mit.edu.