DP3182 | Anti-Competitive Financial Contracting: The Design of Financial Claims

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This Paper presents the first model where entry deterrence takes place through financial rather than product-market channels. In standard models of the interaction between product and financial markets, a firm's use of financial instruments deters entry by affecting product market behaviour, whereas in our model entry deterrence occurs by affecting the credit market behaviour of investors towards entrant firms. We find that in order to deter entry, the claims held on incumbent firms should be sufficiently risky, ie equity, in contrast to the standard Brander-Lewis (1986) result that debt deters entry. We show that this effect is more marked, the less competitive is the credit market, implying that more credit market competition spurs more product market competition. The model can be used to shed light on the mode of financing of start-up industries and the policy debate on the separation of banking as to whether banks should be permitted to hold equity in firms.