Credit Rationing and Pass-Through in Supply Chains: Theory and Evidence from Bangladesh

The standard model of pass-through in imperfectly competitive markets focuses on double marginalization of rents and highlights the importance of the curvature of demand curve. We develop a model of equilibrium prices in a supply chain with financing intermediaries to incorporate credit rationing faced by wholesale traders. The financing intermediaries help relax the quantitative credit limits faced by the wholesalers by reducing moral hazard through informal enforcement mechanisms not available to formal banks. To discriminate between models with and without credit rationing, we exploit a policy experiment in Bangladesh in 2011 which banned financing intermediaries called Delivery Order Traders (DOTs) from edible oils market. The elimination of DOTs from the market leads to higher pass-through rate and a lower intercept of the wholesale price equation in the standard double marginalization model. A model of financing intermediaries where DOTs provide low-interest credit, and the wholesalers do not face quantity constraints also yields the same conclusions. In contrast, a model with quantitative credit rationing yields sharply different predictions: the ban on DOTs raises the intercept and reduces the pass-through rate. The pass-through rate falls as the elimination of DOTs tightens the credit constraints faced by the wholesalers and the effective wholesale demand curve becomes a rectangular hyperbola with a lower (unit) elasticity. We test the predictions using a difference-in-difference design with wheat as the comparison commodity, and provide evidence on the credibility of the research design using a placebo reform date and a placebo treatment commodity (lentil). Contrary to the expectations of the policy-makers, prices were higher in post-reform period when world prices of crude oils were declining, because the ban resulted in lower pass-through rate but a higher intercept in the wholesale price equation. The evidence contradicts the standard models, and is consistent with the model of quantitative credit rationing.