Oligopoly and financial structure: the limited liability effect

Abstract

We argue that product markets and financial markets have important linkages. Assuming an oligopoly in which financial and output decisions follow in sequence, we show that limited liability may commit a leveraged firm to a more aggressive output stance. Because firms will have incentives to use financial structure to influence the output market, this demonstrates a new determinant of the debt-equity ratio. The literature on financial structure and the literature on oligopoly have at least one common feature: they both place relatively little emphasis on the strategic relationships between financial decisions and output market decisions. In financial theory, the product market is typically assumed to offer an exogenous random return which is unaffected by the debt-equity positions of the firms in the market. Correspondingly, in the economic analysis of oligopoly, the firm's obligations to debt holders and the possibility of financial distress are usually ignored in modeling the strategic interaction between producers in the output market. This approach of focusing separately on financial and output decisions is clearly useful in understanding certain aspects of both financial structure and strategic output market behavior. It seems equally clear, however, that there are important linkages between financial and output decisions. The choice of financial structure can affect output markets in the following way, which we refer to as the limited liability effect of debt financing. As firms take on more debt, they will have an incentive to pursue output strategies that raise returns in good states and lower returns in bad states.