Optimal payment contracts in trade relationships

Trade credit is one of the most important sources of short-term finance in buyer-seller transactions.This paper studies a seller's trade credit provision decision in a situation of repeated contracting withincomplete information over the buyer's ability and willingness of payment compliance when theenforceability of formal contracts is uncertain. We show that selecting the payment terms of a trans-action corresponds to managing an inter-temporal trade-off between improving the quality of infor-mation acquisition and mitigating relationship breakdown risks. The dynamically optimal sequenceof payment contracts can be uniquely determined provided that the quality of contract enforcementinstitutions is sufficiently low.