The Impact of Capital Market Imperfections on the Relationship Between Competition and Corporate Performance

Abstract

This paper explores the relationship between product market competition and firm performance under different levels of information-related capital market imperfections. We show empirically, on a sample of listed as well as unlisted firms, that for companies suffering from financing constraints, increasing competition leads to a decrease in both productivity and profitability while the opposite holds for non (less) constrained firms. This result is robust to alternative measures of competition and can be explained by differences in access to external financing and its impact on investment behavior. Combining the logic of option theory with the literature on competition, we argue that the value of postponing investment is influenced by both the intensity and the type of competitive interaction. Intense and aggressive competition pressures firms to exercise investment options early. For firms with limited access to external financing this pressure to invest exacerbates financing constraints, forcing them to leave valuable investment options unexercised. Overall, our results suggest that competition is not necessarily beneficial for firm performance and that the positive relation that is usually found in the recent corporate governance literature, can be due to restricting the sample to listed firms, i.e., companies that suffer least from capital market imperfections.

Keywords: Firm performance, Financing constraints, Product market competition, Stocklisting, Productivity, Profitability

JEL Classification: L1, D2, G3