Trade Credit, Relationship-Specific Investment, and Product-Market Power
60 Pages Posted: 16 Aug 2010 Last revised: 26 Oct 2015
Date Written: June 27, 2011
The extant literature on trade credit emphasizes its financing role wherein financially sound firms provide trade credit to ease the credit constraints of weaker trading partners. We offer an alternative, though not mutually exclusive, perspective in which trade credit serves as a commitment device. We develop a simple model to argue that an upstream firm commits to making the appropriate level of relationship-specific investment (RSI) by offering trade credit to the downstream firm. Our model predicts that trade credit will increase in (i) the level of the upstream firm's RSI, (ii) the relative bargaining power of downstream firms, (iii) the economic importance of the vertical relationship, and (iv) the cost and difficulty of verifying RSI. Using firm R&D, innovation activity, and production of differentiated goods and services to proxy for RSI, we find strong support for these predictions in a large panel of publicly listed firms. We show that trade credit is increasing in RSI proxies and decreasing in the market power of upstream firms. Further, these relationships are stronger when information frictions are greater: for example, when the upstream firm has had a shorter relationship with its downstream customer, the upstream firm is further away, is younger, or not NYSE-listed.
Keywords: Trade Credit, Relationship Specific Investment, Vertically Related Industries, Market Power, Incomplete Contracts
JEL Classification: G10, G30, G32
Suggested Citation: Suggested Citation