The impact of financial markets on firm behavior and industry evolution

The impact of financial markets on firms and industries has been relatively neglected in the field of management. This dissertation addresses this gap by developing theory and testing hypotheses with a case study of the retail brokerage industry and a large scale empirical analysis of a 40 year panel of US manufacturing firms. Additionally, a computer simulation explores dynamic implications of selected stock market effects. Empirical findings demonstrate the importance of stock prices in affecting firm behavior, specifically their investment strategies. Own share prices are important, but so are effects that high valuations of other firms have on a focal one. These effects are not uniform. Given high stock returns, small firms invest more into exploitation of existing product market positions, while large firms concentrate on exploring new positions. Similarly, high stock returns of other firms trigger further exploration in large firms, presumably by overcoming inertia. Moreover, these effects are more pronounced when executive compensation is strongly equity-based. The simulation formalizes relationships between stock markets and firms in a model in which Cournot duopolists play a multi-stage game involving investment and cost reduction. A related, ‘history friendly’ computer simulation explores learning dynamics in this context. Focusing on the case of misleading signals, the simulation analyzes interactions between financial markets that assign stock prices based on initial under- or overestimation of opportunities (demand), and firms that learn from the resulting stock price surprises at varying speeds. Findings include that financial markets, by initially underestimating demand, may enable an industry to reach a quasi-collusive equilibrium yielding higher firm values, and a surprising reversal in the effect of different learning speeds on realized firm values. Specifically, slow firm learning appears better when investors are pessimistic, while fast learning increases firm values when investors are overly optimistic. These results have implications for evolutionary theories by showing that stock markets play an important role in shaping interactions of entrepreneurial and incumbent firms in an industry. They further deliver insights into the behavioral impact of equity based compensation in interaction with stock market movements, and hence on effects that the corporate governance literature has failed to consider