Abstract
We examine whether corporate rivals react to industry-specific competition-shocks by increasing product differentiation or, alternatively, by lowering differentiation to capture scale-economies. As rival reactions affect intraindustry cash-flow correlations, these two hypotheses imply differential changes in extra-factor, within-industry stock return comovement. Consistent with the cost-reduction hypothesis, idiosyncratic return comovement increases significantly on average, and more so for industry laggards. Industries where competition-shocks significantly affect return comovement also develop higher cost-efficiency measures. Finally, greater return comovement increases the likelihood that two rival firms will merge and raises subsequent industry average return comovement.
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