Trade Credit in Competition: A Horizontal Benefit

Forthcoming in Manufacturing & Service Operations Management

53 Pages Posted: 1 Mar 2015 Last revised: 12 Oct 2016

Heikki Peura

Imperial College Business School

S. Alex Yang

London Business School

Guoming Lai

University of Texas at Austin - Red McCombs School of Business

Date Written: October 7, 2016

Abstract

Trade credit is a widely adopted industry practice. Prior research has focused on how trade credit benefits firms by improving vertical supply chain relationships. This paper offers a novel perspective by examining whether trade credit benefits suppliers through a horizontal channel. Under the classic Bertrand competition framework, we analyze two competing firms' price decisions with and without trade credit. We find that when the firms are financially constrained, trade credit softens horizontal price competition. Specifically, with trade credit, the firms will behave less aggressively in setting their prices for fear of incurring additional financing costs, resulting in equilibrium prices above the marginal cost, even if the products are perfect substitutes. Equilibrium profits under trade credit may thus be strictly higher than those under cash contracts. Furthermore, we find that with trade credit, a financially stronger firm may be able to exclude its weaker competitor from the market. We also investigate the relationship between the firms' financial strength and their physical capacity in the competition with trade credit. We find that the horizontal benefit of trade credit over cash contracts increases as either the firms' physical capacities increase or their financial status weakens. Therefore, with trade credit, firms' financial constraints are a partial substitute for the role that physical capacity plays in price competition. Finally, we study the firms' choice between offering trade credit and cash contracts. We find that trade credit is the equilibrium contract form if customers value trade credit, suggesting that the horizontal benefit of trade credit may complement its vertical roles.

Keywords: trade credit, Bertrand competition, financial capacity, physical capacity, operations-finance interface

JEL Classification: D21, D24, D43, G30, G33, L14, L22, M11

Suggested Citation

Peura, Heikki and Yang, S. Alex and Lai, Guoming, Trade Credit in Competition: A Horizontal Benefit (October 7, 2016). Forthcoming in Manufacturing & Service Operations Management. Available at SSRN: https://ssrn.com/abstract=2571493 or http://dx.doi.org/10.2139/ssrn.2571493

Heikki Peura

Imperial College Business School ( email )

South Kensington Campus
Exhibition Road
London SW7 2AZ, SW7 2AZ
United Kingdom

S. Alex Yang (Contact Author)

London Business School ( email )

Sussex Place
Regent's Park
London, London NW1 4SA
United Kingdom

HOME PAGE: http://faculty.london.edu/sayang/

Guoming Lai

University of Texas at Austin - Red McCombs School of Business ( email )

Austin, TX 78712
United States

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