Safety First, Bankruptcy, and the Pricing and Investment Decisions of the Firm

S Abraham Ravid

Economic Inquiry, 1987, vol. 25, issue 4, 695-706

Abstract: This paper analyzes the impact of imposing a constraint on the probability of bankruptcy for the pricing and investment choices of firms. Two models are presented in which a firm faces stochastic demand; in one costs are known with certainty, and in the other costs of production are probabilistic. In both cases the constraint induces a reduction in optimal price if demand is elastic. For less elastic demand, price reductions may be indicated. With constant costs, the constraint lowers optimal investment. The results are applicable to the analysis of rating agencies' behavior or to the design of bond covenants, especially for public utilities. Copyright 1987 by Oxford University Press.

Date: 1987
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