Feedback and Contagion through Distressed Competition

Firms tend to compete more aggressively in financial distress; the intensified competition, in turn, reduces profit margins, pushing firms further into severe distress. To study such feedback and contagion effects, we incorporate dynamic strategic competition into an industry equilibrium with long-term defaultable debt, generating various peer interactions like predation and self-defense. The feedback effect imposes an additional source of financial distress costs incurred for raising leverage, which reconciles the tradeoff theory and the negative profitability-leverage relation across industries. Owing to the contagion effect, leverage ratios in a decentralized equilibrium are excessively high from an industry perspective, compromising industry’s financial stability.

Keywords: Customer base, Predatory price war, Collective entry prevention, Tacit collusion, Profitability-leverage puzzle

JEL Classification: G12, L13, O33, C73

Suggested Citation: Suggested Citation

Chen, Hui and Dou, Winston Wei and Guo, Hongye and Ji, Yan, Feedback and Contagion through Distressed Competition (November 5, 2022). The Rodney L. White Center Working Papers Series at the Wharton School, Jacobs Levy Equity Management Center for Quantitative Financial Research Paper, Available at SSRN: https://ssrn.com/abstract=3513296 or http://dx.doi.org/10.2139/ssrn.3513296