7 Conclusion
In this paper we have drawn attention to a new channel through which entry
deterrence can operate. Previous work has focused firstly on the product mar-
ket moves a firm can make to discourage entry (Spence (1977) and Dixit(1980))
and then on how financial commitments can be used to induce such product
market behavior (Brander and Lewis (1986)). We show that when capital mar-
kets are imperfectly competitive, there is an alternative way to prevent entry
which has nothing to do with altering product market behavior. Instead it
relies on altering investors’ incentives in order that they are unwilling to fund
entrant firms.
To simplify matters, we have considered the case of a monopoly investor.
We showed that even in the monopoly case, when financial entry deterrence
should in principle be easiest, ensuring that the investor does not fund compet-
ing firms is not a trivial matter. Although the investor would like to commit
ex ante to avoiding competition (since this reduces industry surplus), ex post
he will face a commitment problem in doing so. Once the contract with the
first firm is signed, the investor can appropriate some of that firm’s returns by
funding a second entrant to the industry. Of course, anticipating this, the first
firm will not agree to the same terms, so the investor must find a way to com-
mit to deterring entry. The solution is to make sure that the investor’s stake
in the first firm is sufficiently sensitive to the first firm’s ex post performance
that he no longer gains from introducing competition. In other words, to deter
entry, the first firm must be funded by equity, even at the cost of reducing
the entrepreneur’s incentives to exert effort. The whole problem of financial
entry deterrence is analogous to that of foreclosure in the vertical integration
literature; the investor’s commitment problem is a variant of the well known
Coase problem of oversupply of inputs, with the input in this case being money.
Equity finance plays the role of vertical integration in our context.
Applying the logic of foreclosure to financial markets provides several new
insights. Firstly, previous generalities are shown to no longer hold true. In
particular, it is equity that is the entry deterring claim, whereas in previous
analyses relying on product market incentives, it was always debt finance that
constituted aggressive behavior.30
30 This was true no matter whether competition was in strategic substitutes (Brander and
Lewis, 1986), or complements (Showalter 1995), or potential collusion (Maskimovic 1988).
The exception is Poitevin (1989), where an equity-financed incumbent has an advantage over
the debt-financed entrant in predatory price wars. But there the focus is on the design of
the entrant’s claim, which (because of asymmetric information) gives him “short pockets”;
the incumbent deters entry by threatening a price war. Here instead, we emphasize how the
design of the incumbent’s claim deters entry by making it difficult for entrant to get finance.
The design of the entrant’s claim and the behavior of the incumbent in the event of entry -
central to the Poitevin result - are largely irrelevant here.
28