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James A. Brander, professor of Asia-Pacific International Trade, University of British Columbia is co-author of a seminal 1986 article in The American Economic Review, with Tracy R. Lewis, on “Oligopoly and Financial Structure: The Limited Liability Effect.”

Brander and Lewis proposed a model in which it might be rational for the managers of a corporation to load up on debt, to a degree that would be socially disfunctional.

The argument depends on a central feature of corporations, the limited liability of shareholders. From their point of view, liquidation is the end of matters. A share of common stock never becomes a liability – its value doesn’t drop below $0. So in certain situations in which management might be tempted to take a risky gamble with borrowed money, stockholders will go along, since the question whether the firm ought to take this gamble might be a choice between the certainty of owning nothing and the possibility of owning $0.20 – not a difficult choice. (The spirit of Blaise Pascal hangs over this portion of the argument.)

Bondholders, on the other hand, would have something to lose beyond liquidation. The value of their bonds in the context of an eventual corporate liquidation or re-organization will be lessened if the corporation makes this gamble and fails at it, because there will be a new round of debtors with whom they'd then have to split the remnant assets.

Brander and Lewis, writing for the sake of simplicity about a hypothetical duopoly, suggested that management on one side might deliberately incur debts in order to wed its interests to those of the shareholders and pursue with their support a risky low-margin, high-output strategy that in turn may gain market share. This gamble has a chance of success if the other duopolist is low-risk, and would rather leave the market than engage in a price-cutting war. On the other hand, if both duopolists adopt the same approach, though, the result is that they are both worse off than if neither had. Furthermore, that result will have negative social utility -- the affected market will resemble the recent airline industry in North America.