Delayed Payments in Supply Chains: The Role of Moral Hazard vs. Bankruptcy

We consider a large buyer who uses delayed payments as a mechanism to mitigate supplier moral hazard. Moral hazard in the supply chain arises because the buyer prefers shorter lead times that require the supplier to exert costly effort that is unobservable. For a cash-constrained supplier, a delayed payment raises the possibility of bankruptcy due to default and therefore incentivizes the supplier to exert effort. Bankruptcy has negative long term consequences for both the supplier and the buyer. While the supplier ceases operations and may incur a bankruptcy cost, the buyer incurs the cost involved with choosing another supplier. Thus, the optimal payment structure from the buyer's viewpoint (principal) has to manage the tradeoff between supplier moral hazard and bankruptcy. The supplier (agent) chooses the effort level for timely delivery while factoring in the probability of bankruptcy. We model this as an infinite-horizon principal-agent game. We show that suppliers with high cost of effort are able to use the threat of bankruptcy to extract better payment terms (less or no delay) from the buyer and also exert less or no effort than what would be optimal for a supply chain as a whole. We show that a payment structure that involves a bonus payment for timely delivery combined with a delayed payment coordinates the supply chain. This payment structure effectively implies buyer cost-sharing in the supplier's effort, contingent on adequate supplier performance. Our results provide managers with a roadmap on when and how to implement delayed payments as a function of different supplier parameters such as the cost of operational effort and the wholesale price.