Finance sourcing in a supply chain

We examine the relative merits of bank versus trade credit in a supply chain consisting of a manufacturer and a capital constrained retailer. We show that trade credit is more effective than bank credit in mitigating double marginalization when production costs are relatively low, and that bank credit becomes more effective otherwise. Under bank financing, with limited liability the retailer carries the same inventory as if it faces no capital constraint. Under trade financing, the manufacturer shares the risk of low demand with the retailer, prompting the latter to stock a higher inventory than under bank financing. This higher inventory level mitigates (aggravates) double marginalization when the production costs are relatively low (high). This article thus provides a new explanation for trade credit, and also guides the manufacturer's decision as to when to offer such credit.