International value-chain linkages help to better understand competition and explain individual success

Competition is essential for economic growth, and nowadays companies and entire countries compete globally.  Ivan Savin and Philipp Mundt showed that forces of market selection are at work, but their identification in empirical data requires taking global value-chain linkages into account. Their results illustrate that superior value-chain partners are an important source of growth and may outweigh the disadvantages in productive performance at the individual level.

What determines producers’ market success in a competitive environment? One way to approach the process leading to economic success – usually measured in terms of market shares – is rooted in the evolutionary hypothesis of the “survival of the fittest,” which is consistent with Darwinian principles.

According to this view, market selection ensures that the fittest producers will see their share in the market grow, while others’ will shrink until they are driven out of the market.

 In an article with the same title, The Economist claimed that in the era of globalization and artificial intelligence, the role of competition will only be growing. Yet, until recently, economists barely succeeded in finding empirical evidence for this intuitive idea.

The reasons why the empirical evidence does not lend much support to the selection hypothesis are manifold, with the quality of the fitness metric ranking among the most widely accepted problems. Typically, fitness boils down to a single indicator reflecting the individual producer’s technological and economic characteristics (for example, productivity or unit costs).

In a recent article published in Industrial and Corporate Change, we consider recent evidence by the OECD on the spread and impact of global value chains (GVCs) and argue that production input interlinkages may undermine the selection mechanism at the individual level. This is because less productive firms and entire countries can still grow if they are linked to superior value-chain partners in related markets. Put differently, your success is not merely determined by your productivity, but also by the productivity of your suppliers.

Against this background, we empirically tested the selection hypothesis extended to GVCs. Since existing firm-level data on customer-supplier relationships in specific

industries or countries can only capture a small part of GVCs, we focused on data from the World Input-Output Database (WIOD) that covers 43 major economies – the current 27 member states of the European Union and 16 additional large economies such as the United States, China, Japan, India, Russia, Brazil, the United Kingdom and Canada – which together account for approximately 85% of world GDP. Compared to the prototypical example of firm-level value chains, the advantage of the WIOD data is not only its global coverage but also the fact that these data capture the full range of economic activities in the value chain, including all pre- and post-production phases before the output is sold to final consumers.

Our empirical analysis is restricted to manufacturing industries because (i) contrary to other sectors their output is tradable, which is essential for the measurement of competition in the international context; (ii) they provide more reliable estimates of output and value added; and (iii) they exhibit longer value chains. In a companion

 study, we also looked at other sectors like mining, services, and construction, and still reached broadly similar findings to those reported in this column.

Our main idea was to estimate the productivity of the entire value chain, which represents a more thorough measure of productive performance than the individual productivity of the last producer that sells to final consumers. The explicit comparison between the two productivity measures enabled us to assess the gains in explanatory power arising from the shift of attention away from individual producers and towards value chains. Building on this approach, we conducted three different tests for market selection:

• First, we investigated how much of the aggregate productivity change in an industry originates in (i) individual productivity improvements and (ii) the reallocation of market shares between producers with heterogenous productivity. Our results show that the reallocation effect accounts for around

40 percent of sectoral productivity change when value-chain linkages are ignored. When GVC linkages are accounted for, however, we find evidence for a dominant selection effect (85%), reflecting the crucial role of competition.

• Second, we turned to a more direct test for market selection by estimating the relationship between productivity and output growth using econometric analysis. Again, our results support the selection hypothesis as the productivity of the entire value chain can explain more variation in growth than the individual productivity.
• Third, we assessed the influence of upstream suppliers on the growth of the focal producer. Our results indicate that the effect pertaining to suppliers’ productivity is at least as strong as the direct influence of the individual productivity. Therefore, neglecting the former leads to a systematic underestimation of the strength of market selection, and can explain the weak empirical support for the market selection hypothesis in prior work.

Overall, our results testify to the importance of value chains in shaping the success of producers in competitive markets. Careful selection of the upstream suppliers is thus a major determinant of individual growth. The findings also suggest that a systemic perspective on production networks is necessary to properly measure the strength of competition.

About the Authors

Ivan Savin

Professor of Quantitative Analytics at ESCP Business School (Madrid campus), research fellow at the Institute of Environmental Science and Technology (ICTA

• UAB)

Philipp Mundt

Postdoctoral researcher, Department of Economics, University of Bamberg