Entry deterrence through credit denial

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Abstract

Firms in oligopoly can use debt to commit to a strategic position that negatively affects rival firms and improves profitability. In this paper, I show that an incumbent firm can deter entry by using debt to commit to such a low price that an entrant's lender will not finance entry, even if the entrant's expected profit from entry is positive. Empirical evidence shows that concentration and debt are positively related in several industries, indicating that debt may be used to reduce competition.

Section snippets

The model

A monopoly is threatened by entry. I assume that entry requires payment to a fixed cost of production (patent license, capital) that must be financed by debt. The demand for debt is therefore fixed.1 Financing an entry fee through debt may be necessary if, for instance, retained earnings is limited and the costs of issuing equity are prohibitive. The incumbent monopolist chooses a debt level in the first stage

Equilibrium prices — stage three

Because debt and the interest rate are fixed in the third stage, equityholders of firms no longer have the incentive to consider the fortunes of debtholders in choosing a price for their product.2 As such, the firm's objective in the third stage is to choose price to maximize the value of equity once the

Equilibrium interest rate — stage two

In the second stage, the entrant's lender observes the debt choice of the incumbent and chooses whether or not to lend the fixed amount of funds to the entrant at the optimal interest rate. The entrant's lender at this stage anticipates pricing reactions by firms to a change in the interest rate on entry funds. The bank's expected return is the firm's operating profit under default [z̲, ẑi] plus debt and interest under solvency [ẑi, z̅], minus the direct cost of debt:ρ=zzˆeRe(pe(D,r),pm(D,

Equilibrium incumbent debt — stage one

In the first stage, the incumbent monopolist chooses its debt level, given that its own lender will lend the necessary funds. Since the focus here is on the ability of the incumbent to cause a denial of credit to the entrant, I assume that the incumbent can always get the debt it needs to do so at a fixed interest rate. That is, I assume that incumbent's debt value under a monopoly is higher than its debt value under any case of duopoly, thus its lender will always lend enough to deter entry.

A numerical example

Suppose that duopolists, an entrant (firm e) and incumbent (firm m), compete in differentiated products Bertrand price competition. Each firm faces demand pi = 100  qi + .5pj for i, j = m, e. Marginal costs for the incumbent and entrant are (for simplicity) uniformly distributed on the interval [0, 40]. Both firms are risk-neutral. No fixed costs exist for the incumbent, but the entrant faces fixed entry costs of $100. I will first outline the case for zero debt, then consider cases where the entrant

Empirical results

An emprical implication from the above model is that if firms in an industry use at least some debt to deter entry, then ceteris paribus, debt ratios of incumbent firms should increase as concentration in an industry increases. If concentration (and thus the level of interdependence) is low, one firm's debt will have a negligible effect on the lender of an entrant and thus the cost of strategic debt will likely outweigh the benefit. However, if concentration is high, a firm's debt can have a

Summary

The contribution of this paper is to show that when an entrant must borrow a fixed amount to finance entry, an incumbent is able to block entry through its own debt choice. Using a three-stage game to show that under cost-uncertain price competition, the incumbent, by taking on large debt levels, is able to commit to a low future price. The lender, who must compete for depositors to gain funds, realizes that a low price commitment makes the entrant's prospects poor. At some large incumbent debt

Acknowledgements

I wish to thank Richard Jensen and participants at the Southern Economic Association meeting for helpful comments.

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