Predation or Self-Defense? Endogenous Competition and Financial Distress

Abstract

Firms tend to compete on prices more aggressively when they are in financial distress. The intensified competition in turn reduces firms' profit margins, pushing firms further into distress. To quantify the feedback effect between industry competition and financial distress and the predatory incentives, we incorporate supergames of price competition into a model of long-term debt and strategic default. We show that this feedback mechanism has important implications on asset prices and financial contagion. Depending on the heterogeneity in customer bases and financial conditions across firms in an industry as well as between incumbents and new entrants, firms can exhibit a rich variety of strategic interactions, including predation, self-defense, and collaboration. Finally, we provide empirical support for our model's predictions.

Keywords: Competition-Distress Feedback, Financial Contagion, Industrial Organization, Gross Profitability Premium, Financial Distress Premium

JEL Classification: G12, L13, O33, C73