Three essays on the strategic interaction between production and financial decisions

This thesis consists of three essays in the theory of Industrial Organization. More specifically, the thesis focuses on the interaction of financial structure and market structure. The intellectual starting point of this thesis is the Modigliani-Miller theorem. Modigliani & Miller (1958) show that in the presence of perfect financial and output markets, financial structure has no effect on the value of the firm. This thesis departs from a Modigliani-Miller economic environment by assuming that firms have more information about their projects than financiers have. In imperfect output markets, this departure from Modigliani-Miller world implies that there may exist important strategic interactions between production and financial decisions. In the three essays of this thesis, we derive theoretical links between financial structure and output market competition. We show that in the presence of asymmetric information in output and financial markets, firms may affect the outcome of various oligopolistic and entry games by choosing an appropriate financial policy. We explicitly introduce financial variables in these types of games to show that they may have an important role to play in the resolution of the output competition. The presence of asymmetric information is usually a sufficient condition for financial structure relevance to the firm's market value. However, this is not necessary. It is shown elsewhere that taxes or bankruptcy costs may also affect financial decisions. Throughout this thesis, we abstract from these important determinants of financial structure to focus on asymmetric information in output and financial markets to show that a firm's financial policy may be used strategically in oligopolies. The three essays may be united under the common theme of asymmetric information and strategic financial decisions. In the first essay, the choice of a lender in a debt contract becomes a determinant of the extent of competition in downstream industries. We show that in the presence of imperfect output markets and asymmetric information in financial markets, members of an industry may achieve a partial collusion in the output market by borrowing from the same bank. In an oligopoly, debt is pro-competitive as it gives incentives to the borrowing firm to undertake an aggressive output strategy. This aggressiveness is translated into an increased output. As both firms borrow, the industry becomes more competitive. The industry also becomes riskier and firms' debt value is decreased. A common lender can better control these incentive effects and hence, limit the extent of competition in the output market. This model finds a natural interpretation in an international trade context. In this framework, the result shows that freeing financial markets from trade barriers may decrease the competitiveness of international oligopolies by allowing firms to borrow from the same lender. In the second essay, we develop a theoretical link between firms' financial structure and their output market structure. In the presence of asymmetric information about the incumbent's cost level, an incumbent's financial structure may constitute a signal of its efficiency and prevent potential entrants from coming into the market. A market, threatened by entry, is occupied by one of two possible types of incumbent. The firm's type is completely characterized by its cost level. Only the own firm knows with certainty its true type while the entrant and financiers are uncertain of it. Entry is profitable for the entrant if and only if the market is occupied by the high cost type incumbent. The low cost firm chooses a financial structure that credibly distinguishes itself from the high cost incumbent. From the observation of the incumbent's financial policy, the entrant can correctly infer the incumbent's type. If it observes a financial structure consistent with the low cost incumbent's financial strategy, it stays out of the market. Otherwise, it enters. In equilibrium, financial structure allows credible revelation of all private information and entry occurs in the same circumstances as with perfect information. In the third essay, we give a formal representation of Telser (1966)'s 'deep pocket' argument. We propose that entrants are financially vulnerable because they must signal their value to financiers before entering the market. We assume that there are two possible types of entrant threatening to enter a monopoly market. The entrant's type is parametrized by its cost level. This information is private to each entrant as other players are uncertain of the entrant's true type. Entry is profitable only for the low cost entrant. But if the high cost type can misrepresent as a low cost firm, there exist financial structures which yield positive equity value. The low cost firm must avoid these structures to credibly reveal its type to financiers, secure sufficient funds and finance its entry. In equilibrium, the low cost entrant must issue debt to signal its quality to investors. It enters the market heavily leveraged. This provides incentives for the incumbent to engage in a price war to financially exhaust the entrant and cause its bankruptcy. The price war may be interpreted as the incumbent's predatory response to the entrant's leveraged entry. We argue that a diversified pool of undistinguishable entrants is sufficient to justify the 'deep pocket' argument put forward by Telser (1966). We base our explanation on the presence of asymmetric information in financial and output markets.Arts, Faculty ofVancouver School of EconomicsGraduat