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Limited Liability and Market Power

  • Teresa John


  • Lemma Senbet
  • Anant Sundaram
  • Peter Woodward
Registered author(s):

    This paper evaluates the welfare effects of limited liability on firm behavior when market power is present. A risk-neutral monopolist facing uncertain demand (with constant returns to scale technology) produces higher output, yielding higher expected profits when costless exit is induced by limited liability. The higher output may increase social welfare (monopolist profit plus consumer surplus) even though the monopolist may overproduce relative to the quantity that maximizes social welfare. When no market power is present, the overproduction resulting from the provision of limited liability results in loss of social welfare. Appropriate use of liability limitation laws can thus provide policy makers an additional policy instrument with which to mitigate the effects of market power. Copyright Springer Science + Business Media, Inc. 2005

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    Article provided by Springer in its journal Review of Quantitative Finance and Accounting.

    Volume (Year): 25 (2005)
    Issue (Month): 3 (November)
    Pages: 215-231

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    Handle: RePEc:kap:rqfnac:v:25:y:2005:i:3:p:215-231
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    1. Sappington, David, 1983. "Limited liability contracts between principal and agent," Journal of Economic Theory, Elsevier, vol. 29(1), pages 1-21, February.
    2. Gilson, Stuart C. & John, Kose & Lang, Larry H. P., 1990. "Troubled debt restructurings*1: An empirical study of private reorganization of firms in default," Journal of Financial Economics, Elsevier, vol. 27(2), pages 315-353, October.
    3. Dotan, Amihud & Ravid, S Abraham, 1985. " On the Interaction of Real and Financial Decisions of the Firm under Uncertainty," Journal of Finance, American Finance Association, vol. 40(2), pages 501-17, June.
    4. Kose John, 1993. "Managing Financial Distress and Valuing Distressed Securities: A Survey and a Research Agenda," Financial Management, Financial Management Association, vol. 22(3), Fall.
    5. Klemperer, Paul D & Meyer, Margaret A, 1989. "Supply Function Equilibria in Oligopoly under Uncertainty," Econometrica, Econometric Society, vol. 57(6), pages 1243-77, November.
    6. Chevalier, Judith A, 1995. " Do LBO Supermarkets Charge More? An Empirical Analysis of the Effects of LBOs on Supermarket Pricing," Journal of Finance, American Finance Association, vol. 50(4), pages 1095-1112, September.
    7. Kahn, Charles & Scheinkman, Jose, 1985. "Optimal employment contracts with bankruptcy constraints," Journal of Economic Theory, Elsevier, vol. 35(2), pages 343-365, August.
    8. A. Mitchell Polinsky & William P. Rogerson, 1983. "Products Liability, Consumer Misperceptions, and Market Power," Bell Journal of Economics, The RAND Corporation, vol. 14(2), pages 581-589, Autumn.
    9. Black, Fischer & Scholes, Myron S, 1973. "The Pricing of Options and Corporate Liabilities," Journal of Political Economy, University of Chicago Press, vol. 81(3), pages 637-54, May-June.
    10. DeAngelo, Harry & Masulis, Ronald W., 1980. "Optimal capital structure under corporate and personal taxation," Journal of Financial Economics, Elsevier, vol. 8(1), pages 3-29, March.
    11. Kose John & Lemma W. Senbet & Anant K. Sundaram, 1991. "Cross-Border Liability of Multinational Enterprises, Border Taxes, and Capital Structure," Financial Management, Financial Management Association, vol. 20(4), Winter.
    12. 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.
    13. Brander, James A & Spencer, Barbara J, 1989. "Moral Hazard and Limited Liability: Implications for the Theory of the Firm," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 30(4), pages 833-49, November.
    14. John, Teresa A & John, Kose, 1993. " Top-Management Compensation and Capital Structure," Journal of Finance, American Finance Association, vol. 48(3), pages 949-74, July.
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