Diversion Risk, Markups, and the Financing Cost Advantage of Trade Credit
What this paper finds — and why it matters
This paper provides a theory and evidence for why firms with higher markups extend more trade credit, focusing on a financing cost channel that is distinct from existing competition-based explanations. In the model, diversion risk creates a wedge between the bank borrowing rate and the deposit rate. Under cash in advance, the buyer must borrow the full invoice amount (production cost times markup); under trade credit, the seller instead borrows only her production costs. Since higher markups amplify the difference in borrowing needs between these two payment forms, they make trade credit more attractive—and this advantage strengthens with the buyer’s borrowing rate, generating a unique interaction prediction. Empirical tests using detailed Chilean export transactions matched with firm-product markup estimates (De Loecker et al. 2016 methodology) find that a one standard deviation rise in upstream markups increases trade credit by 13 days, with the extensive and intensive margins contributing roughly equally; this effect strengthens with the destination country’s borrowing costs. Results are robust to instrumenting markups with plant-product level physical productivity and replicate in U.S. Compustat data with the real Effective Fed Funds Rate as the borrowing cost proxy.
Summary of a forthcoming paper, AI-assisted and human-reviewed. See the linked original for the authoritative claims and full conditions.
Q1. Why does a higher markup make trade credit more attractive?
Under cash in advance, the buyer must pre-pay the full invoice price (production cost times markup), requiring borrowing equal to the markup times production cost; under trade credit, the seller instead borrows only her production costs to finance production while the buyer pays later from sales revenues, requiring no pre-payment borrowing at all. Because diversion risk causes banks to charge more than the deposit rate for loans, a higher markup amplifies the savings in financing costs from using trade credit rather than cash in advance, making trade credit strictly preferred whenever the markup and interest rate spread are both positive. This mechanism is operative even if the seller and buyer face identical borrowing rates and even if goods are no harder to divert than cash (distinguishing it from Burkart and Ellingsen 2004, where trade credit dominates because goods are harder to divert).
Q2. What is the unique empirical prediction that distinguishes the financing cost channel?
The model uniquely predicts that the positive effect of upstream markups on trade credit should increase with the buyer’s borrowing rate: when borrowing is expensive, the relative financing cost advantage of trade credit (which reduces total borrowing) is larger, so higher markups generate even more trade credit use. This interaction prediction distinguishes the financing cost channel from competition-based theories (Demir and Javorcik 2018; Giannetti et al. 2021) which predict higher upstream bargaining power (lower markups) → more trade credit, and allows identification even with a rich set of fixed effects because the interaction term is residual to seller, buyer, and destination fixed effects.
Q3. What do the Chilean export data show?
A one standard deviation rise in upstream markups increases trade credit by 13 days on average, with the extensive margin (probability of using trade credit) and intensive margin (trade credit maturity conditional on use) contributing roughly equally; crucially, the effect of markups on trade credit strengthens with the destination country’s borrowing costs, consistent with the unique interaction prediction of the financing cost channel. Markup estimates are constructed at the firm-product level using the De Loecker, Eeckhout, and Unger (2016) methodology applied to Chilean manufacturing survey data, which requires quantity-based information on inputs and outputs to avoid revenue-based measurement confounds; the extensive fixed effects structure (seller × product, buyer-country × product, and seller × buyer-country-year fixed effects) addresses omitted variable concerns.
Q4. How does the paper handle endogeneity of markups?
The paper instruments for firm-product markups using plant-product level physical productivity, which is a supply-side technological variable that affects markups through the cost side (more productive firms have lower marginal costs and thus higher markups for a given price) but is unlikely to directly affect payment choice; the IV results are quantitatively similar to OLS, supporting the causal interpretation of the markup effect on trade credit. Because markups estimated with revenue data can conflate productivity with demand shocks (the ‘De Loecker critique’), the Chilean quantity-based data are particularly valuable: firm-product quantities and input prices are directly observed in the manufacturing survey, enabling markup estimates that are free of revenue confounds.
Key concepts
financing cost channel of trade credit : the mechanism by which trade credit reduces the total bank borrowing needed for a transaction—because the seller borrows only production costs rather than the buyer borrowing the full invoice price—thereby lowering financing costs when diversion risk creates a borrowing-deposit rate wedge; the paper’s central contribution, distinct from competition-based explanations of trade credit provision. diversion risk and borrowing-deposit rate wedge : the risk that borrowers divert borrowed funds, which causes banks to charge a borrowing rate above the deposit rate; the spread between these rates determines the per-dollar financing cost saved by switching from cash in advance to trade credit, amplifying the role of markups in payment choice. De Loecker et al. (2016) markup estimation : a methodology for estimating markups at the firm-product level using quantity-based production data (physical inputs and outputs) rather than revenue data, avoiding the confound between productivity and demand shocks; used here to obtain the Chilean firm-product markup estimates.