Liquidity Constraints, Production Costs and Output Decisions

CEPR Discussion Paper No. 2458

Posted: 27 Jun 2000

See all articles by Paul Povel

Paul Povel

University of Houston - Department of Finance, C.T. Bauer College of Business

Michael Raith

University of Rochester - Simon Business School

Date Written: May 2000

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.

JEL Classification: G32, G33, L13

Suggested Citation

Povel, Paul and Raith, Michael, Liquidity Constraints, Production Costs and Output Decisions (May 2000). CEPR Discussion Paper No. 2458, Available at SSRN: https://ssrn.com/abstract=231960

Paul Povel (Contact Author)

University of Houston - Department of Finance, C.T. Bauer College of Business ( email )

University of Houston
334 Melcher Hall
Houston, TX 77204
United States
713-743-4759 (Phone)

HOME PAGE: http://www.bauer.uh.edu/povel

Michael Raith

University of Rochester - Simon Business School ( email )

Rochester, NY 14627
United States
585-275-8380 (Phone)
585-273-1140 (Fax)

HOME PAGE: http://works.bepress.com/michael_raith/

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