Financial Constraints and Product Market Competition: Ex-Ante vs. Ex-Post Incentives
42 Pages Posted: 20 Jul 2004
Date Written: April 2003
This paper analyzes the interaction of financing and output market decisions in a duopoly in which one firm is financially constrained and can borrow funds to finance production costs. Two ideas have been analyzed separately in previous work: some authors argue that debt strategically affects a firm's output market decisions, typically making it more aggressive; others argue that the threat of bankruptcy makes debt financing costly, typically making a firm less aggressive. Our model integrates both ideas; moreover, unlike most previous work we derive debt as an optimal contract. Compared with a situation in which both firms are unconstrained, the constrained firm produces less, while its unconstrained rival produces more; prices are higher for both firms. Both firms' outputs depend on the constrained firm's internal funds; the relationship is U-shaped for the constrained firm and inversely U-shaped for its unconstrained rival. The unconstrained rival has a higher market share, not because of predation but because of the cost disadvantage of the financially constrained firm.
Keywords: Financial constraints, debt, product market competition
JEL Classification: G32, G33, L13
Suggested Citation: Suggested Citation