Debt and Product Market Fragility

Stefan Arping

Cahiers de Recherches Economiques du Département d'économie from Université de Lausanne, Faculté des HEC, Département d’économie

Abstract: This paper studies the interplay between corporate leverage and product pricing when liquidation is costly for customers. I develop a model which illustrates that highly leveraged firms can enter a vicious circle in which financial distress and sales drops are re--enforcing. There is a "good'' equilibrium in which the firm is in good financial shape. However, when leverage is excessive there is also "bad'' equilibrium in which consumers' pessimistic perceptions about the firm's financial health become self-fulfilling. Moreover, whenever the "bad'' equilibrium exists the "good'' equilibrium is highly fragile in that a small shock can trigger a spiral of sales drops. I show that the firm can avoid the "bad'' equilibrium by not fully exercising market power (i.e. cutting prices) and reducing leverage. The model sheds light on why highly leveraged companies often face severe sales drops and how price cuts and debt restructurings can help to restore customer confidence.

Keywords: debt; liquidation costs; business policy and financing decisions; market fragility (search for similar items in EconPapers)
JEL-codes: G32 G33 L1 (search for similar items in EconPapers)
Pages: 22 pages
Date: 2000-07
References: Add references at CitEc
Citations: View citations in EconPapers (1)

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http://www.hec.unil.ch/deep/textes/00.21.pdf (application/pdf)

Related works:
Working Paper: Debt and Product Market Fragility (2000)
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Persistent link: https://EconPapers.repec.org/RePEc:lau:crdeep:00.21

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