Product Market Competition and Optimal Debt Contracts: The Limited Liability Effect Revisited

This paper shows that asymmetric information between lenders and borrowers plays a crucial role in the existence of interactions between financial decisions and output market strategies. Lenders offer an optimal, renegotiation-proof financial contract which resembles a standard debt contract. Computing Cournot equilibria, debt causes firms to compete less aggressively: the usual (positive) limited liability effect on quantities is offset by a negative one due to (endogenous) financial costs.

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