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Market-Based Solutions to Vital Economic Issues


Market-Based Solutions to Vital Economic Issues
Jan 17, 2018

Production Networks and Stock Returns: The Role of Vertical Creative Destruction


We study creative destruction in production networks and its implication for firms’ risk profiles. Empirically, upstream firms with the longest distance to consumers earn an excess return of 105 basis points per month relative to downstream consumption producers. We explain this novel spread quantitatively using a general equilibrium model with multiple layers of production. The spread arises endogenously due to vertical creative destruction — innovations by direct and indirect suppliers devalue the installed capital of customer firms. Consistent with our model predictions, the spread is smaller among firms that belong to supply chains with lower competition, and is larger among firms whose assets-in-place account for a larger fraction of firm value. We document other new facts that can be reconciled via vertical creative destruction: (1) a diminished value premium among downstream firms; (2) a positive relation between the return of downstream firms and the market power of their direct and indirect suppliers. Overall, we explore a novel channel of creative destruction and demonstrate its significant impact on firms’ cost of capital.

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