A Theoretical Analysis of Korea's Subcontracting Price Adjustment Scheme from an Economic Perspective

When a supplier agrees to deliver goods or services to a buyer under a fixed-price contract, fluctuations in raw material costs over the contract period influence the supplier’s profit. A sudden and unexpected increase in raw material costs (as seen in recent years following the Russian invasion of Ukraine and the disruptions to global supply chains caused by the COVID-19 pandemic) can be detrimental to suppliers, especially to small and medium-sized enterprises (SMEs). It is frequently argued that SMEs are prominent in South Korea. SMEs account for 99.9 percent (7.71 million) of all firms in South Korea. SMEs employ 80.9 percent of all workers (18.5 million), and annual sales generated by SMEs account for 46.8 percent of all sales nationwide (over KRW 3.07 quadrillion). In addition, a significant proportion of SMEs engage in subcontracting. A survey estimates that 50.6 percent of manufacturing SMEs participated in subcontracting in 2021. Despite the preponderance of SMEs in the economy, when SME suppliers request price adjustments in response to sudden increases in raw material costs they are (allegedly) not very successful. Given this, there had long been calls for the government to mandate price adjustments in subcontracting contracts to mitigate unexpected profit losses faced by suppliers when raw material costs suddenly increase. In October 2023, a mandatory price adjustment scheme for subcontracting contracts went into effect in South Korea. This article briefly explains how the policy works, introduces some discussions related to the adoption of the policy, and offers some economic perspectives on the policy.