“ The difficulties inherent in acquiring external finance in the United States
in the nineteenth century provide an explanation for the basis of the fortunes
of certain American entrepreneurs and suggest at least one reason why the
economy was characterized by increasing concentration in the growth sectors”
Lance Davis (1966).
1 Introduction
This paper presents the first model where entry deterrence takes place through
financial rather than product-market channels. This is a new form of entry
deterrence which has not previously been considered, but which is nonetheless
potentially important in countries and industries where funding opportunities
are relatively scarce. In standard models of the interaction between product
and financial markets, the focus has always been on how a firm’s use of financial
instruments affects its own product market behavior, and thus its rival’s optimal
response. By contrast, in this paper we show that even if financial contracts are
completely neutral in their impact on product market behavior, they have an
impact on the behavior of investors, and thus affect the funding opportunities
of potential entrants in this way.
One might think that with imperfectly competitive financial markets, the
problem of financial entry deterrence would be trivial: investors (who share in
the surplus generated by investment) should deny funding to entrants to limit
industrial competition. In fact, matters are not so simple, as the following
simple example demonstrates. Suppose a monopoly investor signs a contract
in which he agrees to supply the monopoly amount of capital to a single firm,
in return for safe debt in that firm. (Holding safe debt is of course desirable
since it maximizes the entrepreneur’s incentives to exert effort). A problem
arises because the investor is well-informed about the industry and his return
in the funded firm is safe and unaffected by changes in profitability - so the
investor will be tempted to fund another firm to enter the industry. Of course,
knowing that the investor will be tempted to supply a second firm ex-post,
the first firm will not accept the same terms ex-ante, so the investor’s profits
are reduced by his lack of commitment. This commitment problem is known
as the “Coase problem” in direct analogy to the problem of durable goods
monopoly (see Rey and Tirole, forthcoming).
The logic of our result is very straightforward. The form of the financial
contract between the incumbent firm and its investor will affect the investor’s
willingness to provide funds to entrant firms, by making his returns more or
less sensitive to the effect of product market competition. The solution to
the Coase problem is to make the investor’s claim sufficiently sensitive to the