The Effect of Trade Credit on Price and Price Level Comparisons

Abstract

THE comparison of prices and price levels is an important ingredient in many economic forecasts, policy prescriptions and empirical academic studies. For example, prices charged by a firm for domestic sales are compared with those charged on exports to substantiate charges of dumping. Differences in national price levels are also used in place of real foreign exchange rates as more stable and appropriate translators for international comparisons of such macroeconomic indicators as gross national product or per capita income. On the domestic side, temporal comparisons of individual prices and their contributions to a high and volatile inflation rate have been cited by advocates of wage and price controls and an oil consumption tax, and comparisons of prices, price levels, and exchange rates are at the center of academic controversies over the validity of the law of one price and the purchasing power parity theory. The fundamental assumption underlying these investigations is that the goods or services under comparison are identical. This assumption has proven troublesome because differences in product characteristics such as quality, service support, and delivery availability are difficult to identify and value; they are also generally specific, in size and character, to a product or industry. Further, it may be difficult to see the relationship between these qualitative characteristics and macroeconomic variables, a relationship that, once established, might simplify the identification and measurement of product differences. As a result, the effect of differences in product quality on comparisons of prices is commonly ignored or assumed random or stable. However, one product quality-extended trade credit-can be measured easily because it is neither random nor stable. It also has the desirable trait of being systematically related to several macroeconomic variables: the cost of extending trade credit is a function of interest rates and expected inflation-a correlation that allows us to recognize the importance of trade credit in some price comparison applications. It is possible to use this relationship to adjust prices and price levels for the extension of trade credit. More importantly, some price comparisons may be substantially affected by the adjustment. This paper describes a model linking transactions prices and trade credit. It demonstrates that the prices of identical goods will differ, even in perfectly efficient markets for goods and capital, if credit terms differ. As a result, apparent arbitrage profits may disappear when prices are adjusted for the value of trade credit extended to finance the goods. One major component is the length of time for which trade credit is extended. Within a single economy different explicit or implied credit maturities translate into different credit costs. In turn, these costs are reflected in price differences. A good example is the recent use of merchant discounts for cash payments as a disincentive against credit card payment. The amount of the discount is directly related to the merchants' cost of funds. When prices are compared internationally, another element is added. Variations in the cost of credit extended in different currencies may reflect differences in interest rates and expected inflation. When compared at the current exchange rate the national prices of goods sold on credit should differ by the variation in the cost of providing that credit. The reflection of trade credit in the relationship between prices, exchange rates, and interest rates has several interesting implications. For example, the increased rate of inflation normally expected after a devaluation may not present itself if it has been reflected in transactions prices prior to devaluation; when devaluation occurs the domestic inflationary response may seem unReceived for publication June 12, 1980. Revision accepted for publication February 18, 1981. * Duke University. I am grateful for helpful comments from Jacob Frenkel, John Hekman, Richard Levich, Stephen Magee, David Mullins, Rachel McCulloch, Aris Protopapadakis, and William White. I received additional suggestions from the International Trade Workshop of the Harvard Economics Department. Support for this work from the Associates of the Harvard Business School is gratefully acknowledged.