A Contest of Payment Contracts: A Structural Approach on How Chinese Firms Coped with Default Risk of Trade Credit

Abstract During the transition period from a planned economy to a market economy in the 1990s of China, there was a considerable accrual of deferred payment, and default due to inferior enforcement institutions. This is a very common phenomenon in the transition economies at that time. The Chinese government attempted in vain to deal with this problem by legislation of related institutions and administrative control. Interviews with home electronics appliance firms revealed that firms were able to cope with this problem by adjusting their sales mechanisms (found four types), and the benefit of institutions was limited. A theoretical analysis here found that spot and integration are inferior to the two contract mechanisms in terms of cost and price: a contract with a rebate on volume and prepayment against an exclusive agent can realize the lowest cost and price, and maximize social welfare. Hence, through Bertrand price competition, any of two contract mechanisms is selected to dominate the supply behavior. The empirical part showed that sales contract mechanisms employed by the brand gradually converged into the one with a rebate on volume an against exclusive agent, as it realized the lowest cost. A firm who initiated this mechanism gained the largest share in the market. The competition is the driving force of the convergence of mechanisms and improvement risk management capacity.