Vertical Relational Contracts and Trade Credit

This paper explores the consequences of using supplier trade credit within a vertical relational contract. The downstream firm operates in an environment where shocks may make it unable to repay. The shocks are unobservable to the supplier, which creates an asymmetric information problem. Trade credit limits the supplier’s possibilities to punish the downstream firm and termination is used in equilibrium. Surprisingly, we find that the supplier always sells too little despite having enough instruments to fix the double marginalization problem. The downward distortion in the quantity results from the need to make the contract self-enforced and/or to tackle the asymmetric information problem. Furthermore, we show that the optimal contract resembles a simple debt contract: if the fixed repayment is met, the contract continues to the next period. Otherwise, the manufacturer asks for the highest possible repayment and terminates for a number of periods. The toughness of the termination policy decreases with the repayment. JEL Classification: C73, D82, L14.