Self-Enforcing Trade Credit
35 Pages Posted: 29 Aug 2012 Last revised: 10 Mar 2017
Date Written: February 28, 2017
Trade credit plays a very important role in inter-firm transactions. Because formal contracts are often unavailable, it is granted within an ongoing relationship. We characterize the optimal self-enforcing contract, when the ability to repay is unknown to the supplier and the threat of trade suspension is used to discipline the buyer. The optimal contract resembles a debt contract: if the fixed repayment is met, the contract is renewed. Otherwise, the supplier demands the highest feasible repayment and suspends trade for some time. The length of the trade suspension is contingent on the repayment. We provide a novel explanation for why the quantity is undersupplied, even when a repayment is met.
Keywords: Relational contracts, trade credit, imperfect monitoring, debt contract
JEL Classification: C73, D82, L14
Suggested Citation: Suggested Citation