On the Strategic Use of Debt and Capacity in Imperfectly Competitive Product Markets

In capital intensive industries, firms face complicated multi-stage financing, investment, and production decisions under the watchful eye of existing and potential industry rivals. We consider a two-stage simplification of this environment. In the first stage, an incumbent firm benefits from two first-mover advantages by precommiting to a debt financing policy and a capacity investment policy. In the second stage, the incumbent and a single-stage rival simultaneously choose production levels and realize stochastic profits. We characterize the incumbent's first-stage debt and capacity choices as factors in the production of an intermediate good we call "output deterrence." In our two-factor deterrence model, we show that the incumbent chooses a unique capacity policy and a threshold debt policy to achieve the optimal level of deterrence coinciding with full Stackelberg leadership. When we remove the incumbent's first-mover advantage in capacity, the full Stackelberg level of deterrence is still achievable, albeit with a higher level of debt than the threshold. In contrast, when we remove the incumbent's first-mover advantage in debt, the Stackelberg level of deterrence may no longer be achievable and the incumbent may suffer a dead-weight loss. Evidence on the telecommunications industry shows that firms have increased their leverage in a manner consistent with deterring potential rivals following the 1996 deregulation.