Predation and Self-Defense: Feedback and Contagion through Distressed Competition

Winston (Wei) Dou, Finance, The Wharton School; Hongye Guo, Finance, The Wharton School; Hui Chen, MIT Sloan; and Yan Ji, Hong Kong University of Science and Technology

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 them further into distress. Competitors’ aggressive pricing reactions could be attributed to both predatory and self-defensive incentives. To quantify the effects of competition-distress feedback and financial contagion, as well as disentangle the predation from self-defense, we incorporate supergames of price competition into a model of long-term debt and strategic default. Incorporating distressed competition into asset pricing models can explain various market phenomena that otherwise seem puzzling. 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.

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