An Optimal Financial Response to Variable Demand

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Abstract
This paper develops a positive theory of trade credit based on its use as a financial response to deterministic variations in demand. The operating alternatives to trade credit, which include the use of storage or additional capacity, are modeled using results from the peak-load pricing literature. The paper shows that the extension of credit partitions the buyer's inventory cost and permits specialization at incurring the components of this cost. This specialization is economical when the seller has an advantage at incurring the financial cost and does not have an advantage at incurring the operating cost of accommodating variable demand. Conditions that provide these necessary and sufficient cost relationships are described. The paper also shows that a reduction in costs rather than an increase in revenues is the source of both the buyer's and seller's increase in wealth.

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