Strategic Trade Credit in a Supply Chain With Buyer Competition

Abstract

Problem definition: In practice, trade credit (TC) is often offered in a contract that stipulates a single, fixed interest, rather than an interest menu contingent on the loan amount. We examine why a supplier uses such a single-interest contract and why a buyer who can access perfect external capital (EC) with contingent interest may use TC, when the supplier does not share the buyer’s demand risk. Methodology/results: We solve a dynamic game between a supplier and two buyers, who have access to EC and compete in a Cournot game in the product market. We show that the single-interest contract incentivizes a buyer to order more. Thus, such a contract benefits the supplier and makes TC a strategic device for buyers to commit to competing aggressively. Opposite to well-known results, we show that buyers may benefit from using strategic TC, because their access to EC gives them strong pricing power that yields sufficiently low wholesale price. The entire supply chain also benefits because the over-ordering distortion under TC mitigates the under-ordering problem caused by double marginalization. Managerial implications: Our analysis implies that, to weaken buyers’ pricing power and improve profit, the supplier should offer cheap TC—for example, in net terms to—financially resourceful buyers and expensive TC—for example, with early payment discount—to financially constrained buyers, as observed in practice. We find strategic TC to yield increasingly more benefit for the supplier as its production cost decreases and may allow the buyer to maximize its payoff at an intermediate consumers’ willingness-to-pay that leads to strong pricing power and low wholesale price.