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Institute for Financial Research SIFR Research Report Series, Institute for Financial Research

No 33:
On the Strategic Use of Debt and Capacity in Imperfectly Competitive Product Markets

J. Chris Leach (), Nathalie Moyen and Jing Yang

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.

Keywords: Industrial organization; Deregulation; Deterrence; Capital structure; Capacity; Telecommunications; (follow links to similar papers)

JEL-Codes: D43; G32; L13; L96; (follow links to similar papers)

52 pages, March 15, 2004

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