Capital Structure and Production Decisions under the Differentiated Duopoly : Price and Quantity

Abstract

It is shown that managers who act in the interests of corporate insiders behave more (less) aggressively if the firm has more debt, when firms compete with quantities (prices) in the product market. The equilibrium Quantities are larger than in the traditional Cournot duopoly if the products are (demand) substitutes and strategic substitutes. The equilibrium prices are higher than in the traditional Bertrand duopoly if they are (demand) substitutes and strategic complements. These' relationships between production and financial decisions explain why firms have relatively low leverage ratios irrespective of tax advantages of debt financing. Increases in debt payments have three effects on the firm's net present value: the negative own effect, the positive strategic effect and the tax advantage. The negative own effect increases as firm has more debt payment, while the positive strategic effect is irrelevant with debt payment. Therefore, according to the basic conditions of firms and their market structure, industry can have different capital structures and firms which are apparently similar in the same industry can have different capital structures.