A Note on Bankruptcy Costs and the Theory of Oligopoly

Abstract

In an early paper examining the strategic consequence of a firm's financial structure, Brander and Lewis (1988) obtain the surprising result that 'With fixed bankruptcy costs, firms have an incentive to increase output levels if they take on more debt.' As the authors noted, this result is 'counter-intuitive at first glance,' since 'higher debt levels increase the likelihood of bankruptcy and would presumably tend to make firms more conservative in setting outputs.' Indeed, other papers, including Allen (1987), examining strategic and financial interactions in different settings obtain results at odds with those of Brander and Lewis and more in line with the intuition that debt makes the firm conservative. In this note I extend the Brander and Lewis analysis to incorporate a broader range of specifications. In contrast to the result of Brander and Lewis, I show that for some cases firms initially have an incentive to decrease output levels if they take on more debt. The comparative statics for the different cases are contrasted and discussed.