Supply Chain Due Diligence Regulation's Impact on Firm Profitability and Social Value

Abstract

Supply chain due diligence (SCDD) regulation is spreading rapidly, raising concerns about its effectiveness in achieving societal goals and whether mandatory compliance inevitably burdens firms. These concerns, however, often fail to recognize that SCDD activities also generate business value (such as efficiency gains, greater supply chain visibility, and operational resilience) in addition to societal value (e.g., improved labor standards, elimination of child labor), especially when supply networks of buying firms in the same sector overlap. In this paper, we analyze how such overlap creates spillover effects of firms’ SCDD efforts across the supply network and how it shapes the effectiveness of output-based SCDD regulation for both firm profitability and social welfare. We develop a game-theoretic model of two firms sourcing from overlapping supply networks, where firms’ SCDD efforts generate both social benefits and business value. A regulator sets a minimum level of SCDD effort required for compliance and penalties for non-compliance. We show that penalties induce greater SCDD effort from firms, up to compliance with regulation. More importantly, when the penalties exceed a critical threshold, stricter enforcement can generate a 'win-win' situation, improving sustainability outcomes as well as firm profitability. When the degree of spillovers is high, however, potential free-riding benefits dominate and reduce the effectiveness of penalties in inducing SCDD effort. Furthermore, in asymmetric networks, where firms differ in size or in their exposure to spillovers, the firm that benefits more from the other’s efforts invests less but may capture higher profits, thereby shifting the compliance burden to its competitor. Our analysis demonstrates that, contrary to common belief, well-calibrated SCDD regulation can turn from a regulatory burden into a source of value generation, aligning firm incentives with broader societal goals. We identify under which conditions such “business-friendly” SCDD regulation is more likely to occur.