Follow the Money Trail

“Follow the money” is what mysterious informant Deep Throat told investigative journalists Woodward and Bernstein to unravel president Nixon’s Watergate. At least, that is the catchphrase used in the 1976 docudrama “All the President’s men”. It forever stuck as a very effective shortcut to describe the power of money in shaping events and society. In economics they prefer to say ‘follow the value chain’. Money, after all, is just a means to measure value. But what is a value chain? I have used the beer-chain as an example of a value-chain since 2008, and it may have left a trail in its wake. When you think of your business as part of a value chain, it allows you to think creatively about your business.

Forward linkages

So let’s do that: think of yourself as owning a microbrewery in a small college town surrounded by farm land. If you follow the formula of a simple brew-pub, you sell your beer mainly to dining customers, and perhaps in jugs for take-out. You can, of course, follow the value-chain forward and sell your beer through other outlets that cater to people that know your beer, like local restaurants and bars. Or through local stores and supermarkets.

Selling through stores will require you to add a bottling operation to your business, which may not be financially worthwhile with only local demand. Scaling up for export might do the trick. Export allows your quantities to scale beyond local demand, so maybe you try exporting to outlets in a nearby metropolis. Or you  can try trailing the local college’s alumni and do subscription-shipping. Now you scaled your customer base from a small group of diners to the entire local population and beyond. How do you do this? Is there local know-how on bottling? Perhaps with the local college? Can the local bank help with the investment? Or are their local ‘angel investors’?

Backward linkages

Forward linkages in your value-chain are important, since they allow you to scale your sales – locally, regionally, and if your beer is good enough, even nationally. Backward linkages are equally important, but focus more on your operations. A simple beer-chain takes hops, brewers yeast, malted barley or wheat, adds water and turns it into beer. If you build relationships with your suppliers, you may be able to better control the quality of your beer. Farmers may be able to supply you with special varieties of hops that make a unique beer, differentiating you from competitors.

How about malting your own barley? Malting operations are geographically concentrated in only a few places in the US. Those few places supply all beer brewers in the nation, making it harder to have a product stand out. Can malting be done competitively at a small scale? Maybe – until 1984 they did not think beer brewing could be done at a small scale until the Samual Adams brewery proved everyone wrong! Maybe an alliance with the local college could result in a “micro-maltery”?

If backward linkages are local, they can have a huge impact on the regional economy. When you sell more beer, the local farmers need to grow more hops, barley and wheat. Employment goes up and local spending goes up. Local linkages make for a deep and robust economy. But there is a downside as well…

The value chain in a local economy

Local economies often start from value chains favorable to their area. Many industries in the east and south-east of the US, for example, focused on textile and started from the “cotton-chain”. Intermountain communities often started because of mining interests, but usually settled on the timber-chain through one or more local saw mills. Coastal regions were a bounty for fish canneries in the 1800s and 1900s. Most rural communities had farms that supplied wheat to local gristmills, or milk and cattle to local dairy and meat processors.

The multiplier effect

These economies represented linked industries in close proximity to each other where ideas or problems of one spurred innovation at others. Most companies started out locally owned. Profits were reinvested and owners and employees fueled local retail, services, arts and crafts. This multiplying power of the value chain often resulted in decades of local growth and wealth generation. Those value-chains can also represent vulnerability, especially if a region relies on only one value chain. When that value-chain declines, the same multiplying effect that created the wealth now acts in reverse; it can then destroy a local economy. The disruption ripples through the entire economy: to suppliers and truckers, engineers and cleaners, restaurants, retail, doctors & dentists.

Curse of natural resources

Plentiful resources can invite overuse and dry up the value-chain, especially with remove ownership. Specifically regions rich with natural resources (minerals, timber, marine life, etc) have shown this boom-and-bust cycle^[1]Sachs, Jeffrey D., and Andrew M. Warner. “The Curse of Natural Resources.” European Economic Review 45, no. 4–6 (May 2001): p827–38.; it even led economists since the 1990s to use the phrase “the curse of natural resources”^[2]The first use of the term “curse of natural resources” was in 1993 by Auty: Auty, R. M. Sustaining Development in Mineral Economies: The Resource Curse Thesis. London; New York: Routledge, 1993. Other value-chains generate entirely different constraints: just search for “affordable housing in Silicon Valley“.

Technological disruption

New technology or changing transportation costs can be equally disrupting. The first industries in the US revolved around textile, with water-wheel driven mills scattered around New England. The steam engine, lower wages in other regions and declining transportation cost displaced the New England mills. The disruption took down entire local economies and many of New England’s mill-towns still show the scars ^[3]a number of case studies on New England’s mill towns can be found at scholarworks.umass.edu/larp_faculty_pubs.

Economic ‘ecosystems’

So how can we let the value-chains work for our local economies without incurring the downsides? First of all: we will always have to deal with disruptions. Disallowing disruption would disallow progress. The question is how local economies deal with disruption. In order to better understand that we need to leave behind the simple rules of “supply & demand” thinking, and think larger.

Natural resources and the value-chain

When we discovered the bounty of salmon, sardines and tuna in the pacific northwest we merely admired the salmon for spending years feeding and growing in the bounty of the ocean only to return to their spawning grounds high up in the mountains. We did not realize that the runs were a principal nutrition stream for the Rocky Mountains. Nor did we realize the connection between salmon and sardines or tuna, or their connection to the once abundant beavers. Only gradually did we learn the complexity of natural ecosystems. The latter part of the 20th century highlighted those critical relationships in both the timber-chain and especially in the near-collapse of the mufti-billion dollar Salmon value-chain.

Regional ecosystems

Economics of the 20th century went through a similar bout. Local economies are complex: they usually have multiple value-chains that cross and intertwine, and evolve with new technologies and innovation. Mainstream economists staid away from regional (community) economics, since their mathematics simply could not capture that messy complexity. Not until the 1990s did economists even incorporate innovation and technology as drivers in economic growth and wealth generation^[4]Romer, Paul M. “Endogenous Technological Change.” Journal of Political Economy 98, no. 5 (1990): S71–S102.^[5]Krugman, Paul. Development, Geography, and Economic Theory. Cambridge, Massachusetts: The MIT Press, 1995..

Aware of the complexity of local economies, economic development professionals now talk about regions as “ecosystems”, where need, opportunity and local know-how mutually reinforce each other. Silicon Valley is the most famous example of such an ecosystem, and has sparked tremendous economic growth. Frederick Terman, provost, professor, and engineering dean at Stanford in the 1950s and 1960s, is credited as the father of Silicon Valley by creating the culture of cooperation and information exchange that still defines the region^[6]Vivek Wadhwa. “Silicon Valley Can’t Be Copied.” MIT TECHNOLOGY REVIEW 116, no. 5 (2013): 84–93..

Rural value-chains

There are examples in rural regions as well. When in 2012 yoghurt maker Chobani build a $450 million plant in Idaho, it purposefully leveraged the strong dairy sector around the City of Twin Falls. The city was willing to spend $6.5 million to upgrade its wastewater treatment facility. Twin Falls realized that the investment would not pay back not through direct economic impact. In stead, it saw the secondary economic ripples from growth of the regional economy. Lesser known, but perhaps equally important, was the quick response from the local Twin Falls College. In collaborating with Chobani, it created supportive job training. Additionally, University of Idaho’s research helped turn the dairy’s sizable waste-stream (manure) into an economic input.

A value-chain creates an ecosystem of companies, organizations and educational institutions, framed by local governance. It is the very ability of that network to recover from disruptions that allows for a durable economy. That ability of a regional economy to create and adapt will ultimately determine its prosperity ^[7]see also: Landes, David S. The Wealth and Poverty of Nations : Why Some Are so Rich and Some so Poor. New York: W.W. Norton, 1998..

Choosing your destiny

Understanding the regional value chain for a product or service is pertinent. It provides crucial insights into what businesses drive a local economy through jobs and spending. Value, after all, represents talent, know-how, skills and effort. The same infrastructure and local potential can follow different paths, however.

The grain-chain

Take the Grain Chain: the journey of grains from farm-to-mill-to-consumer^[8]The Western Rural Development Center works with its public and private sector partners to promote excellence in research, education and Extension for the prosperity of western rural communities. They published an interesting article: Rebuilding the Grain Chain.. If the grain is a generic “wheat flour”, the added value is small. Generic wheat flour trades on the commodity market. And, with competition everywhere and anywhere, the added value (and thus the profit for the farmers and mills) is squeezed to pennies on the dollar – if that much. A farmer will need to resort to large scale farming on large acreage to make a reasonable profit.

Artisan grains

Specialty wheat for artisan bakers, or specialty hops and barley for micro-breweries paint a totally different story. The quality and flavor of ingredients make or break a nutritious bread, a good malt or tasty beer. Craft bakers and brewers cater to a growing segment of the population that looks for taste and healthy nutrition. That segment is willing to pay a premium for those attributes^[9]Growth of the craft brewing industry in 2013 was 18% by volume and 20% by dollars compared to growth in 2012 of 15% by volume and 17% by dollars. Source: Brewers Association – Boulder, CO. A similar story can be told on artisan bread: SBDC. In turn, bakers,  brewers and distilleries are willing to pay a premium for their ingredients, allowing their suppliers to continue to invest. An investment that keeps the local economy humming.