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Subsidizing Inventory: A Theory of Trade Credit and Prepayment

Author

Listed:
  • Arup Daripa

    (Department of Economics, Mathematics & Statistics, Birkbeck)

  • Jeffrey Nilsen

Abstract

We propose a simple theory of trade credit and prepayment. A downstream firm trades off inventory holding costs against lost sales. Lost final sales impose a negative externality on the upstream firm. We show that allowing the downstream firm to pay with a delay, an arrangement known as “trade credit,” is precisely the solution to the problem. Solving a reverse externality accounts for the use of prepayment for inputs, even in the absence of any risk of default by the downstream firm. We clarify previously unexplained facts including the universal presence of a zerointerest component in trade credit terms, and the non-responsiveness of interest charges to fluctuations in the bank rate as well as market demand. We explain why trade credit is short term credit and why the level of provision is negatively related to sales and profit and inventory, but positively related to the profit margin. Finally, we show that under trade credit, inventory investment is invariant to the real interest rate for a wide range of parameters, explaining the puzzle posed by Blinder and Maccini (1991). This implies that standard empirical inventory models would gain explanatory power by including the subsidy effect of accounts payable.

Suggested Citation

  • Arup Daripa & Jeffrey Nilsen, 2005. "Subsidizing Inventory: A Theory of Trade Credit and Prepayment," Birkbeck Working Papers in Economics and Finance 0522, Birkbeck, Department of Economics, Mathematics & Statistics.
  • Handle: RePEc:bbk:bbkefp:0522
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    File URL: http://www.bbk.ac.uk/ems/research/wp/PDF/BWPEF0522.pdf
    File Function: First version, 2005
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    Citations

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    Cited by:

    1. repec:bas:econth:y:2012:i:6:p:47-64 is not listed on IDEAS
    2. Liu, Qigui & Luo, Jinbo & Tian, Gary Gang, 2016. "Managerial professional connections versus political connections: Evidence from firms' access to informal financing resources," Journal of Corporate Finance, Elsevier, vol. 41(C), pages 179-200.
    3. Galia Taseva, 2012. "Trade Credit Terms between the Firms in Bulgaria," Economic Studies journal, Bulgarian Academy of Sciences - Economic Research Institute, issue 4, pages 110-136.
    4. Bougheas, Spiros & Mateut, Simona & Mizen, Paul, 2009. "Corporate trade credit and inventories: New evidence of a trade-off from accounts payable and receivable," Journal of Banking & Finance, Elsevier, vol. 33(2), pages 300-307, February.
    5. Galya Taseva, 2012. "Overdue Intercorporate Debts in Bulgaria," Economic Thought journal, Bulgarian Academy of Sciences - Economic Research Institute, issue 3, pages 76-94.
    6. repec:bas:econth:y:2012:i:6:p:26-46 is not listed on IDEAS
    7. Cristina Martínez-Sola & Pedro García-Teruel & Pedro Martínez-Solano, 2014. "Trade credit and SME profitability," Small Business Economics, Springer, vol. 42(3), pages 561-577, March.

    More about this item

    Keywords

    Trade credit; prepayment; externality; subsidy; the Burkart-Ellingsen critique; inventory investment;

    JEL classification:

    • D2 - Microeconomics - - Production and Organizations
    • E5 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit

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