Credit constraints have been known to be a part of corporate reality for decades (Hubbard, 1998, and references therein). Massively reduced access to credit has been a feature of the major financial crisis of recent years. It is also well known that firms are subject to substantial market risk – whether on the demand side or supply side. Incorporating corporate finance aspects into an industrial organization model of the vertical supply chain, we study the interaction between credit constraints and market risk, and their effects on short-run retail pricing, long-run investment, and welfare. We show that credit constraints and market risk impact optimal vertical contracting, creating scope for double marginalization, slotting fees, finance arms, and outsourcing. Further, we identify a new monetary transmission mechanism from interest rates to the real economy which acts via firms which are at risk of becoming credit constrained. Finally, the model gives rise to a novel theory of countervailing power based on credit constraints.
Consider a vertical supply chain consisting of a single upstream firm (“he”) supplying a single downstream firm (“she”), and exposed to demand-side risk. The joint-profit maximizing supply contract would involve per unit input prices at the upstream firm’s marginal cost, irrespective of any demand-side risk. But now suppose the downstream firm has some future investment opportunities. The size of the loan she is able to raise to fund the investment, and therefore the actual investment level, depend on the size of the pledgable assets the firm owns. Under the standard assumption that investment is subject to diminishing marginal returns, we show that the profit maximizing firm becomes endogenously risk averse when accumulating pledgable assets. When pledgable assets are low, the induced investment level is low as well. This implies that the return on a marginal dollar of investment would be high, and so an extra marginal dollar of pledgable assets can be greatly levered through the banking sector.
As a result, the optimal contract between the downstream firm and its upstream supplier involves risk sharing and, we show, double marginalization. The endogenously risk-averse downstream firm wants to insure her level of pledgable income. So she demands a risk-sharing contract in which the supplier bears some loss for poor demand realizations. But for the supplier to recoup these potential losses, he requires payments in high demand states to grow at a rate faster than cost. Hence, double marginalization is introduced, causing the retail price of the downstream firm to rise. The cost of the insurance made necessary by the credit constraints is in this sense partly paid for by final consumers.
The optimal supply contract can be thought of as involving a fixed payment from the upstream to the downstream firm and demand-dependent repayments. This may help explain the increasingly common use of “slotting fees” in the grocery market as well as in other industries such as software and publishing. These fees are fixed payments many retailers require of manufacturers in return for stocking their products. Empirical evidence suggests that an important part of the story is the sharing of risk (Sudhir and Rao, 2006; White et al. 2000), which accords with our model.
It is standard to see the input suppliers and the banking sector as two completely separate industries. However, if the input supplier also provides pledgable income insurance, as in our model, it is no longer clear whether such a separation is indeed optimal. In fact, we demonstrate that there exists an intrinsic complementarity between the provision of insurance and lending. An input supplier with access to funds at the same rate as the banking sector could actually lend on rates that the independent banking sector would find unprofitable. This result may offer an original insight into the existence and profitability of finance arms of major companies such as GE and Cisco. As financial companies lend almost $1 for every $2 lent by a mainstream bank, gaining an insight into what makes financial companies effective competitors to banks therefore seems a first-order issue.
