ANTI-COMPETITIVE FINANCIAL CONTRACTING: THE DESIGN OF FINANCIAL CLAIMS.



ever, it greatly simplifies the analysis and the drawing of parallels to the Coase
problem in input supply markets. No important insights are lost in simplifying
from imperfect competition to monopoly in the market for funds, apart from
the impact of the level of financial competition on the design of claims. We
address this briefly in section 5.3.

We assume that the single investor has cost of funds r= 1 and makes take-
it-or-leave-it offers to the firm(s).5

Project:

Once started, each firm’s project is subject to moral hazard. After the
project is financed, entrepreneur i chooses a level of effort e
i [∆, 1], which
is not observed by the investor. We assume ∆
1/2. Entrepreneurial effort
raises the probability of success, which also depends on whether the firm enjoys
a monopoly position or it competes with the other firm.

Under monopoly, if effort ei is exerted then the project yields RH (success)
with probability e
i and RL (failure) with probability (1 - ei), where RH >I>
R
L > 0.6

Competition reduces the probability of success by ∆.7 That is, under
duopoly, effort e
i induces a probability of success of just (ei - ∆) for firm
i.Moreover,firm j ’s effort does not affect i’s probability of success and vice
versa.8 This is the simplest possible way of capturing the idea that competition
in section 6.

5 The results would be even stronger if we instead allowed firms to make take-it-or-leave-it
offers to the investor. But given the investor’s monopoly position, it seems reasonable to
give him the bargaining power.

6In a sample of 49 venture capitalists, Gorman and Sahlman (1989) report that most
venture-backed companies that have failed to meet expectations still manage to ”squeeze
out a stable, independent existence”, which supports our assumption that R
L > 0. The
interest of the assumption R
L > 0 is that it becomes possible to distinguish between debt
and equity, which are equivalent if there are no returns to divide in the failure state.

7In Gorman and Sahlman (1989), 34% of the venture capitalist respondents cited com-
petition as a factor contributing to financed companies’ failure. For more general evidence
that competition reduces the probability of survival, see Hannan and Freeman (1989), or
Carroll and Hannan (1989). See also the next footnote. Similar results can be obtained
when competition reduces revenues in case of success; but the analysis is considerably more
cumbersome, so we use this simpler set-up.

8 See Cestone and White (2000) for some stylized examples as to when such an assumption
might be taken literally. Here we make it mainly for modelling purposes. It has several
advantages, including allowing us to be agnostic on whether competition increases or reduces
optimal effort by managers (on which the literature is inconclusive - see Hart (1983), Martin
(1993)). A probably more realistic alternative would be to assume that firm i’s probability
of success is reduced by firm j ’s effort (although this is not obvious since some efforts,
such as advertising, may be mutually beneficial). In this case, a different type of entry
deterrence becomes possible. If Firm 1 commits to a high effort, Firm 2’s entry becomes
more and more unprofitable per se. This is the standard form of entry deterrence, just like
accumulation of capital à la Spence (1977) and Dixit (1979, 1980). Rather than repeating



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