Optimal payment contracts in trade relationships

In buyer-seller trade relationships, long-term collaboration and payment contract selection are mutually dependent: While the provision of trade credit to buyers increases the stability of trade relationships, its availability varies systematically as relationships evolve. To explain this reciprocity, we model the optimal provision dynamics of trade credit when the seller's information about the buyer's type is incomplete and parties can sign contracts with limited enforceability. We investigate how self-enforcing relational contracts and formal contracts complement each other and show how their interaction determines optimal payment contract choice. We find that payment contracts can be interpreted as screening technologies and imply distinct learning opportunities for the seller about the buyer's type. When buyers are stochastically liquidity-constrained and sellers can observe their liquidity status, in line with empirical evidence the model predicts that all transitions between payment terms lead to the provision of seller trade credit in the long run