Subcontractors for tractors: Theory and evidence on flexible specialization, supplier selection, and contracting

Buyer-Seller networks are pervasive in developing economies yet remain relatively understudied. Using primary data on contracts between the largest tractor assembler in Pakistan and its suppliers we find large variations in prices and quantities across suppliers of the same product. Surprisingly, "tied" suppliers those that choose higher levels of specific investments - receive lower and more unstable orders and lower prices. These results are explained by developing a simple model of flexible specialization under demand uncertainty. A buyer faces multiple suppliers with heterogeneous types to supply customized parts. Specific investments raise surplus within the relationship but lower the seller's flexibility to cater to the outside market. Higher quality suppliers have a greater likelihood of selling outside and so this cost is greater for them. Therefore even if a buyer typically prefers high types, some low type suppliers might be kept as marginal suppliers because of their greater willingness to invest more in buyer-specific assets. Further empirical examination shows that the more tied suppliers are indeed of lower quality. (c) 2006 Elsevier B.V. All rights reseved.