Optimal Payment Contracts in Trade Relationships

Abstract

In buyer-seller trade relationships, long-term collaboration and payment contract selection are mutually dependent: While the provision of trade credit to buyers increases the stability of trade relationships, its availability varies systematically as relationships evolve. To explain this reciprocity, we model the optimal provision dynamics of trade credit when the information of sellers about buyers is incomplete and parties can sign contracts with limited enforceability. We investigate how self-enforcing relational contracts and formal contracts complement each other and show how their interaction determines optimal payment contract choice. We find that payment contracts can be interpreted as screening technologies and imply distinct learning opportunities for the seller about the buyer's reliability. When buyers are liquidity-constrained and sellers can verify occurring liquidity problems the screening properties of payment contracts are sufficient to predict that all transitions that occur between payment terms lead to the provision of seller trade credit in the long run.