Liquidity Constraints, Production Costs and Output Decisions

This paper analyses the effects of liquidity constraints on a firm's output decisions by emphasizing the role of production costs. We present a simple duopoly model in which firms have to produce goods and incur production costs before they can offer their products in the market. A financially constrained firm may choose to obtain external funds by agreeing on a financial contract with a bank, which we derive endogenously. After signing the contract, the firm chooses its level of production. Finally, its revenue, and hence the ability to repay the loan, depends on the firms' output levels and the realization of a stochastic demand function. We find that with endogenous debt contracts, existing debt has no effect on a firm's desired output level, as compared to a firm with a deep pocket. The requirement that production costs be debt-financed, however, places a constraint on the output level. As a result, in equilibrium, firms are forced to internalise the expected costs of possible bankruptcy, which leads firms to reduce output. This main result, and some other results we obtain, are consistent with empirical evidence.