The Strategic Effects of Long-Term Debt in Imperfect Competition

When rival firms issue long-term debt, their product market behavior is driven by strategic considerations that would not be present if the firms had no debt or if their debt was short term. It is shown that with limited liability, a firm’s behavior in product market competition can be strongly affected by its accumulated profits. In markets where firms choose output in every period, the higher is the firm’s profit in a given period, the less aggressive it will be in the subsequent periods. Thus, by issuing long-term debt rival firms may induce collusive behavior over some length of time. Furthermore, the path of equilibrium prices and the degree of price fluctuations may be entirely different depending on the structure of the firm’s debt. Journal of Economic Literature Classification Numbers: D43, G32.