Trade Credit, Relationship-specific Investment, and Product Market Power*

Abstract

We rely on a model with incomplete contracts and bargaining power to argue that trade credit (TC) can serve as a commitment device for making relationship-specific investments (RSIs). Unlike existing theories, we explain within a single theoretical framework why TC is affected by firms’ bargaining power and by the specialized nature of transacted goods. Using a large panel of publicly listed firms and innovation-based proxies for RSI, we find strong support for the model’s predictions: TC increases in upstream firm’s RSI and downstream firm’s market power. Endogeneity concerns are addressed by using the passage of innovation-increasing state laws to instrument for RSI and import penetration to instrument for bargaining power.