DP7636 Vertical Relations under Credit Constraints

Author(s): Volker Nocke, John Thanassoulis
Publication Date: January 2010
Keyword(s): countervailing power, double marginalization, finance arms, financial companies, market risk, monetary transmission mechanism, outsourcing, price puzzle, risk aversion, risk sharing, vertical contracting
JEL(s): G32, L14, L16
Programme Areas: Industrial Organization
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=7636

We model the impact credit constraints and market risk have on the vertical relationships between firms in the supply chain. Firms which might face credit constraints in future investments become endogenously risk averse when accumulating pledgable income. In the short run, the optimal supply contract therefore involves risk sharing, thereby inducing double marginalization. Credit constraints thus result in higher retail prices. The model offers a concise explanation for several empirical regularities of firm behavior. We demonstrate an intrinsic complementarity between supply and lending providing a theory of finance arms of major suppliers; a monetary transmission mechanism linking the cost of borrowing with short-run retail prices that can help explain the price puzzle in macroeconomics; a theory of countervailing power based on credit constraints; and a motive for outsourcing supply (or distribution) in the face of market risk.