The Fruits of Civilization (26-5) Network Effects

Network Effects

Network-based propagation is larger than the direct effects of shocks, sometimes by severalfold. ~ Turkish-born American economist Daron Acemoğlu

The political economy of trade is treacherous. Its benefits are diffuse, but its costs are often concentrated.

Inequality is exacerbated by free trade. While multinational rent-seeking companies prosper, severe unemployment can strike distant regions or labor markets that fail to successfully compete.

Thanks to globalization, modern economies are a web of interrelated activities, both through the supply-to-demand chain and between production/consumption and finance. Economic entanglement has been repeatedly demonstrated, most emphatically by shocks in one sector that ripple into others.

A shift or shock may occur on the demand side or on the supply side. The propagating effects of each differ in vector.

Supply-side shocks propagate downstream toward consumers much more strongly than upstream to producers, as the prices that customers must pay for products from affected firms and industries ratchet upward. Oil supply shocks are exemplary, as are financial crises: when the cost of borrowing jumps or funds are simply unavailable to finance operations.

In contrast, demand-side shocks, such as from imports or government spending, more powerfully propagate upstream, toward suppliers and manufacturers. Demand shocks have little or no effect on prices. Instead, the effects ripple upstream: affected firms or industries adjust their production levels, and their demand of material and labor inputs.

Toward the end of the 20th century, low-cost imports began to flood into the United States from China, owing to that country’s relatively cheap labor and lack of environmental protection. American manufacturers were distressed by this foreign competition, as were workers in affected industries. But that was just the beginning of the network effects. The overall economic impact of China’s burgeoning exports to the US was ~6 times greater than it was to manufacturing alone.

Relatively small shocks can become magnified. ~ Daron Acemoğlu

Network effects are not just felt in economic shocks. They can also be the basis for growth, at least until the inevitable shock occurs.