Oligopoly and Financial Structure: The Limited Liability Effect

The authors argue that product market decisions and financial structure will normally be related. Assuming an oligopoly structure in which financial decisions and output decisions follow insequence, it is shown that limited liability may commit a leveraged firm to a more aggressive output stance, expanding its market share and profit at the expense of a fully equity-financed rival. Firms will therefore have incentives to use financial structure to influence the product market, leading normally, to an internal solution for the debt equity ratio even in the absence of bankruptcy costs and tax advantages of debt.

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