Trade Credit and Informational Asymmetry

Abstract

Commonly used trade credit terms implicitly define a high interest rate that operates as an efficient screening device where information about buyer default risk is asymmetrically held. By offering trade credit, a seller can identify prospective defaults more quickly than if financial institutions were the sole providers of short-term financing. The information is valuable in cases where the seller has made nonsalvageable investments in buyers since it enables the seller to take actions to protect svch investments.TRADITIONAL EXPLANATIONS FOR THE widespread use of trade credit fall into two categories. The financing motive holds that capital market imperfections enable sellers to finance buyer purchases at lower cost than financial institutions. Ferris [4] argues that trade credit provides payment flexibility and thus reduces the overall need for buyers and sellers to maintain precautionary balances. Emery [3] contends that noncompetitive rents of financial institutions can be circumvented by sellers and buyers through provision of trade credit. However, the financing motive is not sufficient to explain why small suppliers offer trade credit, the wide cross-sectional variation in terms, or why large buyers often take the "prompt payment discount" late.A second set of explanations is best described as pricing motivations for trade credit provision. Nadiri [ 101 argues that availability of alternative payment terms can increase product demand but does not indicate why the offered terms could not be duplicated by financial institutions. Schwartz and Whitcomb [ 141 argue that trade credit is used to circumvent Robinson-Patman and similar prohibitions on price discrimination. The correctness of this position depends on the charge to users of trade credit exceeding the cost of provision by the seller.' Although the explanation is possible in principle, an empirical question remains as to why variations in actual credit terms appear to be based on product market, rather than buyer, characteristics.The literature also contains analyses of the impact of changing macroeconomic conditions on trade credit terms and aggregate credit flows. Schwartz [13], for example, employs a financing motive for trade credit to conclude that restrictive monetary policy can be partly mitigated by liberalization of trade credit terms by firms with relatively easy access to capital markets. However, a microeconomic for comments on earlier drafts. I also benefited from discussion by participants of the Sloan Workshop, UCLA, and from comments of an anonymous referee. Financial support was provided by the Center for Financial System Research, A.S.U. ' Cost-based price differences are legal under the Robinson-Patman Act (1936). 863 * Textbooks routinely point out the high expense of using trade credit. See, for example, Brealey and Myers 121, p. 640; Van Horne [16], p. 438; Weston and Brigham [17], p. 225. 'The notion that aspects of financial contracts and institutional arrangements can be explained by problems arising from informational asymmetr...

Trade Credit: Suppliers as Debt Collectors and Insurance Providers

“…The disadvantage of this alternative model is that the cash holdings of the supplier have to be explicitly modelled. 23 We opted for this version with equal discount rates to keep the exposition simple.…”

“…If this specificity is lost in a bad production period, suppliers will not be able to extract any tion technology that yielded more than 1 β units of non verifiable returns per period, per unit invested, where they could invest their "spare" funds. 22 Without going into the details of this alternative model; we can infer from the final expressions for p and d that if, for example, suppliers had also discount rate δ, the cost advantage of supplier insurance would be (β − δ)(1 + ∆)υL in the case of d and (β − δ)(1 + ∆ (i−g) (1+g) )υL in the case of p. 23 For example, the structure of the model has to preclude that the supplier could strategically consume all her funds to commit credibly not to bail out the customer. surplus from the relationship again.…”

“…See also Emery (1984) and Schwartz (1974) for models in which suppliers have superior access to financial markets. 5 Brennan, Maksimovic and Zechner (1988) and Smith (1987) link the asymmetric information and the price discrimination literature by showing that suppliers can use credit terms to screen their customers in the presence of asymmetric information. The idea of price discrimination through trade credit stresses the fact that from an economist's point of view it is sometimes impossible to differentiate between prices paid for intermediate goods and interest rates.…”

On the Ethics of Trade Credit: Understanding Good Payment Practice in the Supply Chain

“…There are many economic studies that explain and test, theoretically and empirically, what influences how much 1 The SSBF provides the most comprehensive information on the patterns of credit use by small businesses and their providers for 1987for , 1998for and 2003for . The 2003 survey is the last to have been conducted.…”

“…Studies also examine the use of trade credit as a substitute for bank credit, particularly when the latter is difficult to come by (Gertler and Gilchrist 1994;Jaffee 1969;Nilsen 2002;Schwartz 1974). As in previous downturns (Smith 1987;Walker 1991), the current economic recession engendered by the banking crisis will be putting pressure on trade credit, tempting companies to take longer to pay their suppliers-to the detriment of these businesses (suppliers) that are not always included in the list of a firm's stakeholders, ''but deserve to be'' (Sorell and Hendry 1994 p. 138). Part of the reason for this effect is that, in addition to the direct impact of recession upon their operating cash flow, firms are usually affected by difficulties in securing funds from credit institutions during times of economic crisis (see, for example, Demirgüç-Kunt et al 2006;Eichengreen and Rose 1998;Kaminsky and Reinhart 1999), which encourages or tempts them to delay paying their trade debts.…”