Strategic debt in a mixed duopoly: The limited liability effect

We study the impact of the private firm's debt on the equilibrium of a mixed duopoly by focusing on the effect of limited liability. The debt, combined with the limited liability clause, encourages the private firm to take into account only those states of the nature where demand is high. Debt therefore drives the private firm to increase its production. In response, the public firm reduces its production. Total production is increasing, causing the equilibrium price to fall and the consumer surplus to rise. The social welfare increases thanks to a more efficient allocation of total production between the two firms.