Sustaining Production Chains through Financial Linkages

Abstract

The technological constraints on sustaining production chains have been discussed extensively by development economists, but the role of financial linkages has received less attention. In a model of recursive moral hazard for a manufacturing supply chain, we show that the structure of interlocking receivables and payables serve as the glue for the production chain that sustains complex manufacturing output. The inefficiency associated with recursive moral hazard can be mitigated through optimal delays in payments along the chain. However, efficiency requires large stocks of working capital, and invoice prices are high due to implicit amortization costs of inter-firm credit.