Delayed payment (trade credit) and prepayment are widely observed forms of interfirm credit. We propose a simple theory to account for the prevalence of such credit. A downstream firm trades off inventory holding costs against lost sales. Lost final sales impose a negative externality on the upstream firm. The solution requires a subsidy limited by the value of inputs. Allowing the downstream firm to pay with a delay, an arrangement known as “trade credit,” is precisely such a solution. Further, solving a reverse externality accounts for the use of prepayment\ud for inputs, even in the absence of any risk of default by the downstreamfirm. We clarify howinput prices vary with such policies as well as when such instruments are more efficient than pure input price adjustments. Thus we account for inter-firm credit as an optimal instrument delivering a targeted inventory subsidy designed to prevent lost sales. The theory offers an explanation for the\ud widespread use of net terms, and the fact that prepayment always carries a zero interest rate. Our results are also consistent with non-responsiveness of trade credit charges to fluctuations in the bank rate as well as market demand, and the fact that trade credit is negatively related to supplier profit level and inventory, but positively related to supplier profit margin
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