Does capital structure differently affect incumbents' responses to entry threat and actual entry?

• Date: 01 November 2019
• Published date: 01 November 2019
• Author: Chao Ma
• DOI: http://doi.org/10.1111/jems.12316

Received: 13 August 2017

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Revised: 29 January 2019

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Accepted: 3 April 2019

DOI: 10.1111/jems.12316

ORIGINAL ARTICLE

Does capital structure differently affect incumbents'

responses to entry threat and actual entry?*

Chao Ma

Wang Yanan Institute for Studies in

Economics, Department of Finance at

School of Economics, and MOE Key

Laboratory of Econometrics, Xiamen

University, Xiamen, Fujian, China

Correspondence

Chao Ma, Xiamen University, Economics

Building, 422 South Siming Road,

Xiamen, Fujian, 361005, China.

Email: ma.271@buckeyemail.osu.edu

Funding information

Fundamental Research Funds for Central

Universities, Grant/Award Number:

20720161085

Abstract

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.

KEYWORDS

airlines,capital structure,entry deterrence,entry threat, product‐market competition, responseto entry

JEL CLASSIFICATION

G3, L1

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INTRODUCTION

The effect of firms' capital structure on their competition behavior in product markets has been studied in both the

industrial organization and corporate finance literature. Some theories predict that firms with higher financial leverage

tend to compete more aggressively in product markets than firms with lower leverage, whereas other theories predict

that lower‐leverage firms tend to compete more aggressively than higher‐leverage firms. Moreover, some empirical

studies support the first prediction, whereas others support the second.

In this paper, I investigate how incumbent airline carriers' capital structure or financial leverage (measured by the

debt‐to‐asset ratio) affects their responses to Southwest Airlines' entry threat and actual entry. The results indicate that,

when responding to entry threat, incumbents with lower financial leverage cut their prices more aggressively, which is

in favor of the prediction by the second group of theories; in contrast, when responding to actual entry, incumbents

with higher leverage cut their prices more aggressively, which is in favor of the prediction by the first group of theories.

J Econ Manage Strat. 2019;28:585–613. wileyonlinelibrary.com/journal/jems © 2019 Wiley Periodicals, Inc.

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*I would like to thank the editor, two anonymous referees, Matthew Lewis, Michael Weisbach, Francesca Cornelli, Huanxing Yang, Donald Haurin,

Jason Blevins, Andrew Sweeting, Haiwei Jing, Sheridan Titman, Stephen Cosslett, Maryam Saeedi, Javier Donna, Zahn Bozanic, Daeho Kim, Mar

Reguant, Philip Gayle, Yizao Liu, Scott Thompson, Mark Chicu, Linda Allen, Mary‐Beth Deily, Jed DeVaro, Cheryl Long, Qiang Fu, Calos Llano, as

well as seminar participants at Ohio State University, Xiamen University, the Annual International Industrial Organization Conference, Midwest

Economics Association Annual Meeting, and Annual North American Meetings of the Regional Science Association International for their helpful

comments and suggestions. All errors are my own. This research is supported by the Fundamental Research Funds for Central Universities, No.

20720161085.

One major challenge facing the empirical studies in this area is inferring the causal effect of capital structure on

firms' product‐market behavior based on the empirical relation between the two, as firms' capital structure and product‐

market behavior may be jointly determined. One approach used in the literature to mitigate the endogeneity of the

relation between firms' financial conditions and product‐market behavior is to examine how firms with different

financial leverage differentially change their product‐market competition behavior in response to exogenous changes in

the product‐market environment. Campello (2003) and Chevalier (1995a) analyzed the responses of firms with different

leverage to unexpected macroeconomic shocks. Khanna and Tice (2000) studied incumbent discount department stores'

responses to Wal‐Mart's entry and found that incumbents with lower financial leverage fight more aggressively.

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This paper uses the event of entry threat (the change from an environment without threat or with much lower threat

to an environment with threat or with much higher threat) and the event of actual entry as two surrogates for

exogenous changes in the product‐market environment that would not significantly change incumbents' firm‐level

financial leverage, to examine how incumbents with different financial leverage respond differently to changes in the

product‐market environment.

To the best of my knowledge, this is the first paper that simultaneously studies the capital structure effect on both

incumbents' responses to entry threat and incumbents' responses to actual entry in the same industry. Notably, the

results show that the directions of the capital structure effects in these two scenarios are the opposite of each other.

Without distinguishing between Wal‐Mart's entry threat and its actual entry, Khanna and Tice (2000) studied how

changes in the competitive performance of incumbent discount department stores from 1 year before Wal‐Mart's entry

to 2 years after the entry are related to incumbents' capital structure and found that low‐leverage incumbents tend to

react more aggressively than high‐leverage incumbents. Using data from the casino industry, Cookson (2017) studied

the leverage effect on incumbents' responses to entry threat and found that low‐leverage incumbents expand physical

capacity after the potential entrants developed their entry plans.

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The results in this paper support those of Pichler, Stomper, and Zulehner (2008) from a different angle. Using data

on owner‐managed hotels at Austrian ski resorts, Pichler et al. (2008) constructed separate measures of two types of

leverage effects that theoretically can affect pricing in opposite directions. They included the two measures in the same

regression of hotel prices and found that both are significant. The first effect is the underinvestment effect: firms with

higher leverage tend to set higher prices (underinvest in market share). The second effect is the dynamic limited‐

liability effect: firms with higher leverage tend to set lower prices to shift risks from the recent period to the future.

Different from Pichler et al. (2008), I use two types of events to study the two competing effects of financial leverage.

For most industries, it is difficult to sequentially distinguish among the period without entry threat, the event of

entry threat, and the event of actual entry based on the available data, because researchers can typically observe when

actual entry occurs but cannot observe when the threat of entry occurs.

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However, the case of Southwest Airlines' entry

threat and actual entry, first studied by Goolsbee and Syverson (2008), has two important advantages.

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First, in this

case, the available data permit that the event of entry threat can be distinguished from the period without entry threat

and the event of actual entry. The event of entry threat to a route is defined as the time at which Southwest begins to

establish a presence at both endpoint airports of the route without flying the route,

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while the event of actual entry to a

route is defined as the time at which Southwest directly flies the route.

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The second advantage is that one type of the actual entry events studied by Goolsbee and Syverson (2008),

Southwest's preannounced and guaranteed entry, provides an excellent scenario in which the incumbents' responses to

actual entry can be isolated from their responses to entry threat. If the event of actual entry only occurs sequentially

after the event of entry threat, then incumbents' responses to actual entry can be correlated with their previous

responses to entry threat. Therefore, the empirical results in this paper (when responding to entry threat, low‐leverage

incumbents cut their prices more aggressively; when responding to actual entry, high‐leverage incumbents cut their

prices more aggressively) 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. Fortunately, there are some routes where Southwest simultaneously established a presence at

the second endpoint airport of the route and began direct service on the route. In this sample, there was no such case

that Southwest was finally deterred from entering these routes after its entry was preannounced. Therefore, the

incumbents should not be motivated to deter these preannounced and guaranteed entries. Moreover, Goolsbee and

Syverson (2008) found that in this case the incumbents only cut prices after the actual entry, not before it. Thus, their

price cuts are purely responses to Southwest's actual entry and are uncorrelated to their previous responses to

Southwest's entry threat, because in this case there is neither motive nor empirical evidence for them to respond to

Southwest's entry threat.

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