Adrian Shellard, for the Haskayne School of Business
Feb. 11, 2020
‘Collusion mechanism’ boosts prices paid by consumers
Study looks at trade credit financing used by wide range of retailers
Government regulators may need to take a closer look at a widespread form of business financing that a study has found reduces competition in potentially many industries, boosting prices paid by consumers, says a researcher.
“The key foundation of our capitalist system is that there is competition between firms,” says Dr. Alfred Lehar, PhD, an associate professor of finance at the University of Calgary’s Haskayne School of Business. “It is really important to keep that competition alive because only then does the system work for the average person by providing goods and services at the cheapest possible price.”
Lehar co-authored a study on the problem that was recently accepted for publication in The Review of Financial Studies. The other authors are Dr. Lasheng Yuan, PhD, an associate professor in the Department of Economics in the university’s Faculty of Arts, and Dr. Yang Song, PhD, a lecturer at Simon Fraser University’s Beedie School of Business.
Study finds 'collusion mechanism'
The study looked at trade credit financing, which is provided to a wide range of retailers in the U.S. and Canada by many different types of manufacturers and suppliers, says Lehar. Retailers use it to buy products to restock their inventories, accounting for a quarter of the total assets and nearly half of the short-term debt of a typical small American firm, he says.
The researchers found trade credit financing acts as a “collusion mechanism” among competing supply chains — such as rival automakers and their dealerships — diminishing competition and driving up prices for consumers, he says. Although it is one of the oldest forms of financing, “we are the first ones to really point at this potential problem,” says Lehar.
Regulators have been more aware of overtly illegal activities such as direct collusion where rival businesses secretly negotiate with each other to fix prices, he says. “I don’t think regulators have looked at how financial arrangements may potentially influence competitiveness in the product market,” he says.
Trade credit financing works differently than a loan, for example, that a consumer might get from a bank to buy a new car. It is provided to the actual dealership by the automaker, not a financial institution, to pay for the dealership’s supply of vehicles.
Unlike the fixed rate of interest of a bank loan, no interest is initially charged for a limited period, sometimes up to a year, after which the retailer must repay the financing on any remaining inventory at a rate that is much higher than a bank would charge, says Lehar. It means the size of the debt is determined by fluctuations in consumer demand, he says.
Difficult to answer
Consider two competing car dealerships. If customers buy fewer vehicles during the initial period of interest-free credit, each dealership will end up deeper in debt to their automaker. It creates a strong incentive for the dealerships to aggressively sell as many vehicles as soon as possible, resulting in very low prices, says Lehar.
Anticipating that things could get ugly, the rival dealerships will stock fewer cars and subsequently have fewer vehicles to sell if buyer demand is high, boosting prices and diluting competition, he says. The study found the overall effect of such consequences is to give both automakers and dealerships the ability to fine-tune inventory, creating higher profits than would have been the case if they’d used regular debt financing such as bank loans, he says.
The effect works best in situations where there are only a few rival manufacturers or suppliers, as is the case among automakers, says Lehar.
“A lot of production or manufacturing companies in the U.S. have opened up financial subsidiaries — for example, all the car companies have separate subsidiaries that provide financing to dealerships,” he says. “It is something that regulators should watch closely because there is a potential here for something that is not in the interest of consumers.”
But the study doesn’t answer the question of whether such manufacturers and suppliers are deliberately using it to fix prices, says Lehar. “I would think they do and that companies are consciously aware of it, but it’s hard to prove anything,” he says. “Nobody would likely be forthcoming and admit to anti-competitive behaviour because it is illegal.”