Flexibility Value of Reshoring Capacity under Policy Uncertainty and Domestic Competition

Abstract

Problem definition: 

Companies operating global supply chains face growing policy uncertainties that affect the costs of importing raw materials (RM) and finished goods (FG) from low-cost to developed countries, as well as the relative profitability of production in different countries. This has prompted the need for diversified global supply chains often involving the addition of onshore production alongside existing offshore facilities. Motivated by recent developments in the U.S. clean energy sector, this paper adopts a game-theoretic model to analyze a global firm's reshoring capacity decision and output quantity competition with a domestic manufacturer under policy uncertainty. We examine the effects of these policies on operational decisions and profitability for both firms. 

Methodology/results: We show that the impact of FG tariffs depends on two opposite effects: an output quantity effect that leads to reduction of reshoring investment as the expected unit cost in serving the market increases, and an overflow demand effect that encourages more reshoring investment to minimize the overflow of unsatisfied production to offshore locations. RM tariffs do not affect overflow production, and the output quantity effect will always dampen reshoring investment. Since consumer tax credits directly influence market demand, when firms' output decisions are made after demand and therefore policy realization, the output quantity effect is absent. The overflow demand effect and stimulated higher demand will incentivize higher reshoring investment. Furthermore, we show that higher tariffs hurt the global firm's profit as tariffs increase its average output cost, whereas generous tax credits can benefit the firm. Although both policies are intended to protect domestic firms, they may negatively affect their profit when the global firm's reshoring capacity is high, intensifying competition between them. Finally, the existence of domestic competition will reduce reshoring investment when domestic manufacturing is efficient. However, when global firms have significant cost advantage, the presence of domestic competition may encourage aggressive reshoring investment. 

Managerial implications: For global firms, investing in reshoring capacity creates a "real option" in production allocation in serving the market, and the provided operational flexibility enhances competitiveness in an uncertain environment. For policymakers, it is crucial to carefully consider the tariff level, which stage of a supply chain to execute trade restrictions on, and tax credit amounts to be used. Very high tariffs on moderate size markets may have unexpected effect on reshoring. Trade and industrial policies should be carefully analyzed for their effectiveness, accounting for cost disadvantages of domestic competitors and market demand strength.

Keywords: global supply chain, reshoring, cost uncertainty, competition, industrial policy