Vertical relational contracts and trade credit

Working paper

This paper uses a vertical relational contract between two firms to explore the implications of trade credit when the ability to repay is not observed by the supplier. Trade credit limits the supplier's possibilities to punish the cashless downstream firms and termination may be used in equilibrium. We find that the supplier always sells too little despite having enough instruments to fix the double marginalization problem. The downward distortion in the quantity results from the need to make the contract self-enforced and/or to tackle the asymmetric information problem. The distortion remains even as the firms become arbitrarily patient and a larger discount factor does not necessarily translate into a larger welfare. We show that the optimal contract resembles a simple debt contract: if the fixed repayment is met, the contract continues to the next period. Otherwise, the manufacturer asks for the highest possible repayment and terminates for a number of periods. The toughness of the termination policy decreases with the repayment.

Authors: Troya-Martinez, M

• Publication status: Published
• Publisher: University of Oxford
• Series: Department of Economics Discussion Paper Series
• Publication date: 2013-03-18
• Paper number: 648
• Keywords: trade credit; relational contracts; imperfect monitoring