Feedback and Contagion through Distressed Competition
The Rodney L. White Center Working Papers Series at the Wharton School
80 Pages Posted: 5 Feb 2020 Last revised: 8 Nov 2022
Date Written: November 5, 2022
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