Feedback and Contagion through Distressed Competition

The Rodney L. White Center Working Papers Series at the Wharton School

Jacobs Levy Equity Management Center for Quantitative Financial Research Paper

80 Pages Posted: 5 Feb 2020 Last revised: 8 Nov 2022

See all articles by Hui Chen

Hui Chen

Massachusetts Institute of Technology

Winston Wei Dou

The Wharton School, University of Pennsylvania; National Bureau of Economic Research (NBER)

Hongye Guo

University of Pennsylvania

Yan Ji

Hong Kong University of Science & Technology (HKUST)

Date Written: November 5, 2022

Abstract

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

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

Hui Chen

Massachusetts Institute of Technology ( email )

50 Memorial Drive
Cambridge, MA 02142
United States
+1 (617) 324-3896 (Phone)

Winston Wei Dou (Contact Author)

The Wharton School, University of Pennsylvania ( email )

2318 Steinberg Hall - Dietrich Hall
3620 Locust Walk
Philadelphia, PA 19104
United States

HOME PAGE: http://finance-faculty.wharton.upenn.edu/wdou/

National Bureau of Economic Research (NBER) ( email )

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

HOME PAGE: http://www.nber.org/people/winston_wei_dou?page=1&perPage=50

Hongye Guo

University of Pennsylvania ( email )

Yan Ji

Hong Kong University of Science & Technology (HKUST) ( email )

Clearwater Bay
Kowloon, 999999
Hong Kong

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