by Chao Ma
Some theories predict that firms with higher financial leverage compete more aggressively in product markets than firms with lower financial leverage, whereas others predict that lower-leverage firms compete more aggressively than higher-leverage firms. This paper studies how incumbent airlines’ capital structure affects their responses to Southwest Airlines’ entry threat and actual entry. The results indicate that, when responding to entry threat, lower-leverage incumbents cut prices more aggressively than higher-leverage incumbents; in contrast, when responding to actual entry, higher-leverage incumbents cut prices more aggressively than lower-leverage incumbents.
The following section is a Q&A with Dr. Ma
- Please briefly describe the main results of your paper.
When responding to entry threat, incumbents with low financial leverage cut their prices more aggressively than incumbents with high financial leverage. This result is consistent with the “long purse” theory that a firm with low financial leverage has a greater ability to fight against competitors in the product market.
In contrast, when responding to actual entry, incumbents with high financial leverage cut their prices more aggressively than incumbents with low financial leverage. This result is consistent with a group of theories that a firm with high financial leverage is more likely to take actions that boost its short-run cash flows in order to survive at the expense of hurting overall or long-run profits, because of facing more pressure (financial distress) and having a stronger incentive (discrepancy between managers and shareholders’ interests and firms’ profit-maximizing objectives) to do so.
- How does your focus differ from previous explorations of incumbents’ responses to entry threat and actual entry?
Previous research mainly studied incumbents’ responses to entry threat and actual entry in terms of prices, capacities, qualities, and strategic alliances. In contrast, I study how incumbents’ financial leverage affects their responses.
- Why is the airline industry ideal for examining this topic?
First, competing effects (with opposite directions) of financial leverage on firms’ product market behavior may coexist in an industry, but are difficult to separately identify. Some empirical studies find that the overall effect is positive in some industries, which is consistent with a group of theories, whereas other empirical studies find that the overall effect is negative in other industries, which is consistent with the other group of theories.
The threat of entry and actual entry by Southwest Airlines provide two ideal scenarios to separately identify the two competing effects in the same industry because the dominant status of the two competing effects can alternate between the two scenarios. When responding to entry threat, on the one hand, incumbents with low leverage have a greater ability to cut prices to deter potential entry by Southwest. On the other hand, unlike Southwest’s actual entry, the threat of entry itself does not actually take away incumbents’ market shares or reduce their cash flows in the threatened markets; thus, incumbents with high leverage do not face much more pressure to boost their current cash flows by cutting prices in order to fulfill their debt obligations.
When responding to actual entry, on the one hand, incumbents with high leverage face much more pressure to boost their current cash flows by cutting prices in order to fulfill their debt obligations and survive because Southwest’s actual entry would take away part of the incumbents’ market shares and reduce their current cash flows from the market. On the other hand, although incumbents with low leverage have a greater ability to cut prices in order to force the new entrant to exit the market, they do not have a greater incentive to do so because it is almost impossible to force Southwest (the strongest low-cost carrier) to exit a market it has already entered.
Second, if the event of actual entry only occurs sequentially after the event of entry threat, incumbents’ responses to actual entry can be correlated with their previous responses to entry threat. Therefore, the empirical result for responses to actual entry, which is the opposite to that for responses to entry threat, could simply be driven by the fact that incumbents with low financial leverage have less space to cut their prices further in response to actual entry, as they have already cut their prices more aggressively in previous responses to entry threat.
However, there exists one type of entry, Southwest’s preannounced and guaranteed entry. For this type of entry, theoretically incumbents should not be motivated to deter entry and empirically they cut prices only after the actual entry, not before it (see Goolsbee and Syverson, 2008). Thus, their price cuts are purely responses to Southwest’s actual entry and are uncorrelated to their previous responses to Southwest’s entry threat.
- What are the most important managerial and public policy implications of this work?
When firms decide whether to enter a certain market and predict how aggressively incumbents will respond after entry, besides market conditions (e.g., market demand, market concentration, entry barrier, competitor’s market power, and product differentiation), incumbents’ financial leverage is an important factor to be considered. Potential entrants should not be misled by how incumbents behave in response to entry threat, as the market condition and incumbents’ incentive after entry can be fundamentally different from those under threat, causing the direction of the financial leverage effect to be different.
When regulators make decisions regarding the deregulation of a certain industry to reduce the entry barriers of local markets to domestic firms or to reduce the entry barriers of domestic markets to foreign firms, in order to predict the market price changes and the impact to incumbents, besides market structure and demand elasticity, incumbents’ financial leverage is an important factor to be considered. More importantly, once the entry barrier is removed, the financial leverage effect in markets under entry threat can be fundamentally different from that in markets with new entries.
- What directions might you suggest for further research?
Traditional IO literature focuses on firms’ product-market strategies. However, firms’ financial-side conditions and decisions can affect their product-market-side behavior. Recently, the interaction between firms’ financial side and their product-market competition has attracted increasing attention in both the IO and corporate finance areas. Taking firms’ financial side into account and reexamining their product-market decisions (e.g., decisions on prices, qualities, product differentiation, responses to mergers, R&D, entry and exit, tacit collusions, and dumping) and the corresponding regulation implications (e.g., antitrust) will significantly enrich the IO literature in the future.