Finance and Competition

Abstract

We investigate the role of financial constraints for product market competition in a general equilibrium model, where firms may differ in terms of own wealth and/or efficiency. We find that, in general, the amelioration of financial constraints increases competition (it lowers the Lerner index of markups) in financially dependent sectors even when other standard concentration indexes indicate otherwise. Our analysis implies that disruptions in financial markets – such as the recent financial crisis – may have adverse effects on competition in product markets, a cost that has not been identified before. Does the existence of financial constraints hinder product market competition in financially dependent sectors? Do such constraints matter for the number and size of firms as well as for concentration indexes and markups in these markets? There is a strong presumption, based on the notion that financial constraints act as a barrier to entry/expansion in financially dependent activities, that a more developed financial system is conducive to greater product market competition. Surprisingly, though, there is no theory linking asset market development to competition and things are not better on the empirical front. The empirical literature is quite meagre. Rajan and Zingales (2003) and Haber (2000) studied the effects of financial development and Cetorelli and Strahan (2006) and Bertrand et al. (2007) studied the effects of changes in the degree of ‘competition’ in the banking sector on various measures of market structure and performance. Rajan and Zingales find that financial development increases the number of firms, while it has an ambiguous effect on average firm size in financially dependent industries. Haber compares the cotton industries in Brazil and Mexico during 1880–1930, a period of financial liberalisation and argues that concentration indexes decreased, in particular in Brazil, the country that underwent the most effective financial market reform. Cetorelli and Strahan study how market structure in non-financial sectors was affected by the increase in ‘competition’ – lower bank concentration and looser statelevel restrictions – following deregulation in state banking in the US. They find that the number of firms increased, average size (number of employees per establishment) and concentration decreased, and the share of establishments in the smallest size group also increased. Similarly, Bertrand et al. examine the effects of lower state intervention (deregulation) in the French banking industry on performance and competition in financially dependent sectors. They find an increase in firm entry and exit rates and also a reduction in the level of product market concentration. The theoretical literature on finance and product market competition is quite extensive but, at the same time, quite narrow in scope. It has two key features. First, it is