Does Product Market Competition Reduce Agency Costs

Abstract

The folk wisdom is that competition reduces agency costs. We provide indirect empirical support for this view. We argue that the temptation to retain cash and engage in less productive activities is more severe for firms in less competitive industries. Hence an unanticipated increase in cashflow due to higher past returns is more likely to lead to a reduction in leverage as well as a lowering of future returns for firms in less competitive environments. Current leverage will therefore be negatively related to past returns and positively related to future returns for such firms. In contrast, for firms in more competitive industries, the negative relation between past returns and current leverage will be attenuated. Theory suggests that the relation between current leverage and future returns for such firms will be zero or negative. Using a proxy to distinguish firms in less competitive industries, and data for 165 single business firms in the U.S.A., we provide empirical support for our arguments.