Feedback and Contagion Through Distressed Competition

61 Pages Posted: 16 Jan 2023 Last revised: 14 Apr 2023

See all articles by Hui Chen

Hui Chen

Massachusetts Institute of Technology

Winston Wei Dou

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

Hongye Guo

The University of Hong Kong - University of Hong Kong

Yan Ji

Hong Kong University of Science & Technology (HKUST)

Multiple version iconThere are 2 versions of this paper

Date Written: January 2023

Abstract

Firms tend to compete more aggressively in financial distress; this intensified competition, in turn, reduces profit margins, pushing themselves further into distress and adversely affecting their industry peers. To study such feedback and contagion effects, we incorporate strategic competition into a dynamic model with long-term defaultable debt, exploring various peer interactions like predation and price war. The feedback effect represents a novel source of financial distress costs associated with leverage, which helps explain the negative profitability-leverage relation across industries. Owing to the contagion effect, firms’ optimal leverage is often excessively high from an industry perspective, undermining the industry's financial stability.

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Suggested Citation

Chen, Hui and Dou, Winston Wei and Guo, Hongye and Ji, Yan, Feedback and Contagion Through Distressed Competition (January 2023). NBER Working Paper No. w30841, Available at SSRN: https://ssrn.com/abstract=4325034

Hui Chen (Contact Author)

Massachusetts Institute of Technology ( email )

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Winston Wei Dou

University of Pennsylvania - The Wharton School ( email )

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National Bureau of Economic Research (NBER) ( email )

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Hongye Guo

The University of Hong Kong - University of Hong Kong ( email )

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China

Yan Ji

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

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Hong Kong

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