Skip to main content
Article
Financial Constraints and Product Market Competition: Ex-ante vs. Ex-post Incentives
International Journal of Industrial Organization (2004)
  • Michael Raith, University of Rochester
  • Paul Povel, University of Houston
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 separately analyzed 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
Publication Date
2004
Citation Information
Michael Raith and Paul Povel. "Financial Constraints and Product Market Competition: Ex-ante vs. Ex-post Incentives" International Journal of Industrial Organization Vol. 22 (2004)
Available at: http://works.bepress.com/michael_raith/5/