profits of the incumbent firm that he has a financial incentive not to fund the
second firm. In effect, recognizing the possibility that a knowledgeable investor
could fund several firms in an industry changes financial contract design from
a one-sided to a two-sided moral hazard problem, where the entrepreneur’s
incentives must be traded off against those of the investor.
We show that the entry-deterring claim is in fact equity (or, equivalently,
risky debt), in contrast to the Brander-Lewis result that debt induces tougher
behavior in the product market, and so deters entry. The difference in re-
sults comes from the different channels through which entry deterrence occurs.
Brander and Lewis (1986) - and the literature on the interaction between prod-
uct and financial markets which has followed them1 - abstract from any finan-
cial market effects of the design of claims, and concentrate on product market
effects. We do the reverse. Our model is in some ways a new formulation of
the “deep pocket” argument. An incumbent can shorten an entrant’s pocket
by borrowing money which would otherwise be invested in his rival. Which
approach is the most relevant in practice is largely an empirical question. We
believe that there are some situations where difficulty in obtaining funding
per se, rather than fear of aggressive behavior by an incumbent, is the factor
which prevents firms from entering the market. This is certainly the case in
some Eastern European countries, and countries such as in Italy, where com-
petition in financial markets is very limited and has never been encouraged.
Moreover, historical evidence suggests that our model can be readily applied
to the nineteenth century United States.2
The model also sheds light on the debate as to whether banks should be
permitted to hold equity in firms. In situations where there are ample alter-
1 The literature on the interaction between product and financial markets is becoming
extensive, here we just mention a few papers. The impact of capital structure on incumbent
product market behavior has been analyzed by Showalter (1995), who extends the Brander-
Lewis model to price competition, Maskimovic (1988) who looks at the impact of debt on
collusive outcomes; and Aghion, Dewatripont and Rey (1998) who show how the extent of
outside finance can affect whether firms compete in strategic substitutes or complements.
Fudenberg and Tirole (1986), Poitevin (1989a) and Bolton and Scharfstein (1990) are instead
mainly concerned with the design of claims on the entrant; they show how agency problems
in financial markets can leave entrant firms vulnerable to predation. Gertner, Gibbons and
Scharfstein (1988) analyze the conflicts that arise when capital structure is used to signal
to more than one receiver. Poitevin (1989b) and Battacharya-Chiesa (1995) depart from
the norm in considering lenders’ rather than product market incentives. They show that
coordination on a common lender can help coordinate on mutually desirable outcomes for
the industry, but do not consider the design of claims. Empirical evidence of financial market
effects on product markets is provided by Chevalier (1995), Chevalier-Scharfstein (1996) and
Zingales (1998).
2 For a theoretical discussion of why financial markets are often uncompetitive, and a
review of anti-trust cases in financial markets, see Bruzzone and Polo (1998). In section 6.1
we present a more detailed discussion of case studies.