Debt financing in a duopoly with asymmetric costs

Abstract

This paper examines the strategic use of debt financing in a quantity-setting duopoly with asymmetric costs. Before output competition (Cournot or Stackelberg) with demand uncertainty takes place, both firms can strategically choose to issue debt to commit to an aggressive output stance. We find that the strategic use of debt, serving as a commitment device, can help the disadvantaged firm (i.e., the high-cost firm in Cournot competition or the follower firm in Stackelberg competition) to leapfrog its superior rival in product market competition. Moreover, in light of the substitution between first-mover advantage and the commitment advantage of debt financing, when the order of firms’ moves in output is endogenously determined, in a sizable parameter region, there exists a Pareto-dominant equilibrium that the high-cost firm acts as the Stackelberg leader.