Commitment Role of Trade Credit in a Supply Chain With Buyer Competition

Abstract

In practice, trade credit (TC) is often offered in a contract that stipulates a single interest rather than an interest menu contingent on the loan amount. This paper offers a new explanation for the provision and use of TC by financially resourceful firms by accounting for special the form of TC contract and buyer competition in the supply chain. We solve a dynamic game between a supplier and two buyers who have access to a perfect capital market and compete in a Cournot game in the downstream market. We show that the TC contract incentivizes the buyer to order more than the first-best order quantity. Thus, the buyers use TC for purely strategic purposes: to commit to competing aggressively. The supplier offers TC this way to induce the buyers to over-order and increase demand. Surprisingly, despite its deadweight agency cost, strategic TC may create value for the buyers and the entire supply chain. This finding is opposite to the well-known result that strategic debt always destroys value and make the borrowers worse off. It is made possible by the effect of TC on the supplier-to-buyer interaction that is unique to a supply chain. Specifically, strategic TC may allow the buyers to enjoy a lower wholesale price, thus making them better off by reducing the purchasing cost. The over-ordering distortion of TC mitigates the under-ordering problem caused by double marginalization, thus improving the total welfare of the supply chain. Our results imply that the supplier should enhance its production cost reduction effort to take advantage of TC and unlock substantial profit increase. The buyers should also leverage the benefit of TC when improving the consumers' willingness-to-pay (WTP). Their payoffs may be maximized at a moderate consumers' WTP that leads to TC usage.