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Summary
The theory about reducing risk via portfolio diversification is so well-known that it has become financial conventional wisdom. Less well-known is the economic theory about partners along a supply chain and why partnering is more efficient than doing it all on your own. “How do firms choose trade partners?” is not an easy question to answer, but, as it turns out, is related to the theory of portfolio diversification. Understanding both of these theories is important to understanding how trade agreements impact market structure.</p><p>Firms interacting with each other along a supply chain–taking advantage of the benefits of specialization–reduces transactions costs. The profitability of value-added products is incentivized in these supply-chain relationships as trust along the chain increases. Contracts, especially those that are long established and with legally enforceable provisions, increase trust. With binding contracts, firms are able to meet the needs of other actors along the supply chain and tailor their products for specific needs thus increasing the value of the good.</p><p>What happens when the contracts cannot be relied upon? Two possibilities emerge. When partnerships become unreliable, to mitigate risk firms either 1) go looking for other partners or 2) try to manage more of their supply chain internally.