Working Paper: CEPR ID: DP2458
Authors: Paul Povel; Michael Raith
Abstract: This paper analyses the interaction of financing and output market decisions in an oligopolistic setting. We integrate two ideas that have been analysed separately in previous work: some authors argue that due to risk-shifting, debt (leverage) makes a firm 'aggressive' in its output market; others argue a firm with debts tends to be 'soft', in order to avoid bankruptcy. Our model allows for both effects. Given the key role that debt plays in this analysis, we derive debt as an optimal contract. We find that an indebted firm produces less than an unleveraged firm. The extent to which a firm is financially constrained is measured by its net worth, which determines by how much the firm will reduce its output. We find that output is a nonmonotonic function of net worth: while a moderately constrained firm reduces its output if its constraints become tighter, a more strongly constrained firm increases output. These results hold for a monopoly, but are more pronounced in a duopoly.
Keywords: liquidity constraints; debt contracts; product market competition
JEL Codes: G32; G33; L13
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| debt levels (H63) | output decisions (E23) |
| financial constraints (H60) | output decisions (E23) |
| net worth (G19) | output decisions (E23) |
| moderate constraints (D10) | output decisions (E23) |
| strong constraints (D10) | output decisions (E23) |