Financial Constraints and Product Market Competition: Ex-Ante vs. Ex-Post Incentives

Posted: 25 May 2004

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

Multiple version iconThere are 2 versions of this paper

Abstract

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

Povel, Paul and Raith, Michael, Financial Constraints and Product Market Competition: Ex-Ante vs. Ex-Post Incentives. Available at SSRN: https://ssrn.com/abstract=550184

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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