Vertical Relations under Credit Constraints

We analyze the impact credit constraints have on how firms structure their dealings with their partners in the supply chain; and hence how imperfect capital markets can alter short run prices and long run investment levels. Credit constrained firms are shown to become endogenously risk averse and so seek to push some risk onto suppliers. Our predictions reflect risk sharing contracts in general, slotting fees (prevalent in groceries), and current evidence from trade credit. We demonstrate that the optimal contract has the effect of raising marginal costs and so credit constraints raise retail prices in the short run. We show that this is exacerbated by tight money; poor corporate governance; negative technology shocks and lack of diversification. Finally we show that credit constraints and market risk cause outsourcing to dominate in house provision.