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

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  • Leach, J. Chris

    ()
    (Leeds School of Business, University of Colorado at Boulder)

  • Moyen, Nathalie

    (Leeds School of Business, University of Colorado at Boulder)

  • Yang, Jing

    (California State University, Fullerton)

Abstract

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.

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Bibliographic Info

Paper provided by Institute for Financial Research in its series SIFR Research Report Series with number 33.

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Length: 52 pages
Date of creation: 15 Mar 2004
Date of revision:
Handle: RePEc:hhs:sifrwp:0033

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Keywords: Industrial organization; Deregulation; Deterrence; Capital structure; Capacity; Telecommunications;

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  1. Chevalier, Judith A, 1995. "Capital Structure and Product-Market Competition: Empirical Evidence from the Supermarket Industry," American Economic Review, American Economic Association, vol. 85(3), pages 415-35, June.
  2. Junsen Zhang, 1993. "Holding Excess Capacity to Deter Entry in a Labour-Managed Industry," Canadian Journal of Economics, Canadian Economics Association, vol. 26(1), pages 222-34, February.
  3. Phillips, Gordon M., 1995. "Increased debt and industry product markets An empirical analysis," Journal of Financial Economics, Elsevier, vol. 37(2), pages 189-238, February.
  4. Cabral, Luis, 1995. "Sunk Costs, Firm Size and Firm Growth," Journal of Industrial Economics, Wiley Blackwell, vol. 43(2), pages 161-72, June.
  5. Dan Kovenock & Gordon M Phillips, 1995. "Capital Structure and Product Market Behavior: An Examination of Plant Exit and Investment Decisions," Working Papers 95-4, Center for Economic Studies, U.S. Census Bureau.
  6. A. Michael Spence, 1977. "Entry, Capacity, Investment and Oligopolistic Pricing," Bell Journal of Economics, The RAND Corporation, vol. 8(2), pages 534-544, Autumn.
  7. Dean Showalter, 1999. "Debt as an Entry Deterrent Under Bertrand Price Competition," Canadian Journal of Economics, Canadian Economics Association, vol. 32(4), pages 1069-1081, August.
  8. Kirman, William I. & Masson, Robert T., 1986. "Capacity signals and entry deterrence," International Journal of Industrial Organization, Elsevier, vol. 4(1), pages 25-42, March.
  9. Rotemberg, Julio J & Scharfstein, David S, 1990. "Shareholder-Value Maximization and Product-Market Competition," Review of Financial Studies, Society for Financial Studies, vol. 3(3), pages 367-91.
  10. Williams, Joseph T, 1995. "Financial and Industrial Structure with Agency," Review of Financial Studies, Society for Financial Studies, vol. 8(2), pages 431-74.
  11. Bolton, Patrick & Scharfstein, David S, 1990. "A Theory of Predation Based on Agency Problems in Financial Contracting," American Economic Review, American Economic Association, vol. 80(1), pages 93-106, March.
  12. Reynolds, Stanley S., 1991. "Dynamic oligopoly with capacity adjustment costs," Journal of Economic Dynamics and Control, Elsevier, vol. 15(3), pages 491-514, July.
  13. Dixit, Avinash, 1979. "The Role of Investment in Entry-Deterrence," The Warwick Economics Research Paper Series (TWERPS) 140, University of Warwick, Department of Economics.
  14. Jensen, Michael C. & Meckling, William H., 1976. "Theory of the firm: Managerial behavior, agency costs and ownership structure," Journal of Financial Economics, Elsevier, vol. 3(4), pages 305-360, October.
  15. Fulghieri, P. & Nagarajan, S., 1992. "On the Strategic Role of High Leverage in Entry Deterrence," Papers 92-10, Columbia - Graduate School of Business.
  16. Vojislav Maksimovic, 1988. "Capital Structure in Repeated Oligopolies," RAND Journal of Economics, The RAND Corporation, vol. 19(3), pages 389-407, Autumn.
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