Feedback and Contagion through Distressed Competition
The Rodney L. White Center Working Papers Series at the Wharton School
61 Pages Posted: 5 Feb 2020 Last revised: 10 Jan 2023
Date Written: December 31, 2022
Firms tend to compete more aggressively in financial distress; the intensified competition in turn reduces profit margins, pushing themselves further into distress and adversely affecting other firms. To study such feedback and contagion effects, we incorporate strategic competition into a dynamic model with long-term defaultable debt, which generates various peer interactions like predation and self-defense. The feedback effect imposes an additional source of financial distress costs incurred for raising leverage, which helps explain the negative profitability-leverage relation across industries. Owing to the contagion effect, in a decentralized equilibrium, leverage is excessively high from an industry perspective, compromising industry's financial stability.
Keywords: Competition-distress feedback loop, Distress spillover, Predatory price war, Profitability-leverage puzzle, Tacit collusion
JEL Classification: C73, D43, E31, G3, L13, O33
Suggested Citation: Suggested Citation