Financing Overconfident Retailers: Bank Loan or Trade Credit?

ABSTRACT Overconfidence is a cognitive bias of believing an uncertain event to be more certain than it is. This bias is prevalent in small retailers whose operations (e.g., product ordering) rely on financing such as bank financing (where banks finance retailers' product ordering) or trade‐credit financing (where retailers order products from their upstream manufacturers without immediate payments). We study which one of the two financing modes should be used to finance an overconfident retailer. Our findings reveal that a higher level of overconfidence harms the retailer under bank financing but does not harm the retailer under trade‐credit financing. Under either financing mode, a higher overconfidence level can benefit the supply chain. We further uncover that the manufacturer should offer trade‐credit financing when the retailer exhibits low levels of overconfidence and should not offer it when the retailer's overconfidence level is high. When the retailer's overconfidence level is high, trade‐credit financing will yield a higher expected profit for the retailer and the supply chain than bank financing. We show that our main findings are robust in a variety of model extensions. Our paper explores the complex interplay between a prevalent psychological factor (overconfidence) in retailers' financing strategies, enriching the literature on supply chain finance and providing insights into the operations of overconfident retailer supply chains.