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Liquidity Constraints, Production Costs and Output Decisions

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  • Povel, Paul
  • Raith, Michael

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.
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Suggested Citation

  • Povel, Paul & Raith, Michael, 1998. "Liquidity Constraints, Production Costs and Output Decisions," Papers 98-49, Sonderforschungsbreich 504.
    • Handle: RePEc:mnh:spaper:20051
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    Cited by:

    1. Murat Usman, 2004. "Optimal Debt Contracts with Renegotiation," Journal of Economics & Management Strategy, Wiley Blackwell, vol. 13(4), pages 755-776, December.
    2. Faure-Grimaud, Antoine, 2000. "Product market competition and optimal debt contracts: The limited liability effect revisited," European Economic Review, Elsevier, vol. 44(10), pages 1823-1840, December.
    3. Khanna, Naveen & Schroder, Mark, 2010. "Optimal debt contracts and product market competition with exit and entry," Journal of Economic Theory, Elsevier, vol. 145(1), pages 156-188, January.

    More about this item

    JEL classification:

    • G32 - Financial Economics - - Corporate Finance and Governance - - - Financing Policy; Financial Risk and Risk Management; Capital and Ownership Structure; Value of Firms; Goodwill
    • G33 - Financial Economics - - Corporate Finance and Governance - - - Bankruptcy; Liquidation
    • L13 - Industrial Organization - - Market Structure, Firm Strategy, and Market Performance - - - Oligopoly and Other Imperfect Markets

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