The Impact of Switching Costs on Vendor Financing

Empirical studies point to trade credit as an important continuing source of short term financing for small and medium-sized enterprises. We show that vendor financing appears in equilibrium as the result of repeated trade interactions between a buyer and a supplier when changing supplier is costly. The supplier is then able to extract a periodic rent from the buyer. The presence of switching costs is not, however, detrimental to the buyer because competition between suppliers for this rent forces them to offer a rebate before the relationship is initiated. This sequence of a rebate followed by high prices is similar to a long term financing structure. The role of switching costs is similar to that of a precommitment device that allows the buyer to borrow a limited amount of capital from the supplier in the first period and to roll over the debt until the end of the relationship. In the case of small business owners who have difficulty accessing financial markets, our model suggests that switching costs allows them to smooth their dividend income, albeit inefficiently, by using vendor financing.