O-Ring Production Networks

We study a production network where quality choices are interconnected across firms. High-quality firms are skill intensive and trade more with other high-quality firms. Using data from Turkish firms, we document strong assortative matching of skills in the production network. A firm-specific export demand shock from a rich country increases the firm's skill intensity and shifts the firm toward skill-intensive domestic partners. We develop a quantitative model with heterogeneous firms, endogenous quality choices, and network formation. An economy-wide export demand shock of 5 percent induces exporters and non-exporters to upgrade quality, raising the average wage by 1.2 percent. This effect is about nine times the effect in a special case of the model with no interconnection of quality choices.