Supply Chain Debt Financing in Competition

Abstract

The seminal paper of Brander and Lewis (1986) concludes that debt financing causes two firms that engage in a Cournot game to behave more aggressively in the product market. However, both firms are worse off than if they are purely equity financed, resulting in the so-called prisoner’s dilemma. Incorporating two supply chain structures, distributional and parallel, we explore the effect of supply chain upstream structure on the downstream retailers’ strategic use of debt. We find that this prisoner dilemma persists because the upstream benefits from the intensified downstream competition. Moreover, the supply expansion effect is more pronounced in the parallel structure than in the distributional one, because each dedicated supplier in the parallel structure abets its retailer to compete more aggressively against the competitor by lowering its wholesale price. Therefore, the strategic effect of debt financing not only deters the competitor but also “squeezes†its supplier. In contrast, the common supplier in the distributional structure adopts an inertia strategy, keeping the same price regardless of the downstream’s debt levels because overheated downstream competition may be detrimental to it.