Capital Structure and Product Market Strategy

The effect of company capital structure on product market competition did not get economists' extensive concern until the 80's of the last century. There are two completely different conclusions in theory on this subject. One reckons that the increase of a firm's debt will make itself tougher in the product market competition and then strengthen its competition ability. The other is just on the opposite. Based on these theories, this paper tries to set up a more general analysis framework in theory and provide a new direction for the future studies in this field.In order to analyze comprehensively the effects of the firms' capital structures on their product market competition, we must consider the following two aspects. First, the effects of the firms' capital structures on their product market competition are influenced by many factors including the nature of uncertainty (whether demands or costs are uncertain), the nature of the competition (Cournot competition versus Bertrand competition, Nash game versus Stackelberg game) and the characteristics of the product (whether the product is substitute or complement, whether or not the quality of the product is observable pre-purchase). Secondly, the firms' capital structures have two different effects on their product market competition, agency effect and strategy effect. Any neglect of these two aspects may lead to unilateral conclusions.Because of the separation between ownership and operation, the conflicts of their utility function will bring about certain agency costs. Firms' capital structure has a great influence on these agency costs. This is the agency effect. Moreover, a firm's financial decision will significantly influence its product market competition through its effect on the product market rivals' strategy. This is the indirect strategy effect. It is the tradeoff between these two different effects that determines the firms' optimal capital structure. The interaction between firms' capital structure and their product market competition depends on the nature of agency problem, the source of uncertainty, the characteristic of the product market, etc. 