Optimal Payment Contracts in Trade Relationships
Abstract: Trade credit is one of the most important sources of short-term finance in buyer-seller transactions. This paper studies a seller's trade credit provision decision in a situation of repeated contracting with incomplete information over the buyer's ability and willingness of payment compliance when the enforceability of formal contracts is uncertain. We show that selecting the payment terms of a transaction corresponds to managing an inter-temporal trade-off between improving the quality of information acquisition and mitigating relationship breakdown risks. The dynamically optimal sequence of payment contracts can be uniquely determined provided that the quality of contract enforcement institutions is sufficiently low.
