Impact of loss aversion on financing mechanism preference under consignment: Direct vs. Guarantee

Abstract

This study examines the impact of loss aversion on the retailer’s financing mechanism preference under the consignment contract in a supply chain consisting of a retailer and a capital-constrained supplier. Both the retailer and the supplier could be loss averse. To help the supplier overcome financial distress, two financing mechanisms are available for the retailer as follows. (1) direct financing (DF): the retailer directly provides loans to the supplier; (2) guarantee financing (GF): the retailer guarantees to repay a certain percentage of the supplier’s outstanding loan to the bank, and thereby the supplier can obtain a loan from the bank. By comparing different financing mechanisms, we show that the retailer always prefers GF over DF once his loss aversion level exceeds a threshold. We find that the differences in cash flows (i.e., losses and gains per period) between mechanisms are the driving force behind the impact of loss aversion in determining the relative preference of the financing mechanisms. More specifically, even when the sum of the losses and gains under DF is greater than that under GF, the absolute magnitude of losses under DF can be significantly greater than that under GF. In equilibrium, we have Furthermore, numerical studies show that the attractiveness of GF for the loss-averse retailer increases with the consignment rate and the production cost, and decreases with the supplier’s working capital. The results provide an explanation for the adoption of GF in practice business and can help managers map financing options to environments where they perform best.