In July 2021, President Biden issued an executive order aimed at promoting competition in the American economy. This development has renewed researchers’ interest in the impact of competition on firm behavior and economic activity. While prior research focused on how competitive pressure from the product market influences firms’ investment and financial decisions (Haushalter et al., 2007; Frésard, 2010; Hoberg et al., 2014; Frésard and Valta, 2016), stock valuation (Li and Zhan, 2019; Giroud and Mueller, 2011), and internal governance (Giroud and Mueller, 2010; Chhaochharia et al., 2017), our study investigates the role of competition in disciplining a company’s socially undesirable behavior. Specifically, we examine whether product market competition deters corporate misconduct that significantly threatens sustainability and imposes considerable costs on firms and society.
There are two main arguments for how market competition affects a firm’s propensity to commit misconduct. One argument is that it has a positive effect, with competition and the resulting pressure for short-term performance exacerbating managers’ myopia and leading to a higher propensity for misconduct. In contrast, an alternative view suggests that it has a negative effect, with competition disciplining lax managers and creating incentives for managers to act in the best interests of the firm and its stakeholders.
Our empirical investigation uses a measure of competition called fluidity, which is a firm-level measure of competitive threats based on product descriptions and rivals’ moves, with a higher fluidity indicating a more competitive product market. We find a negative relation between product market fluidity and a firm’s propensity to commit misconduct, even after controlling for other firm characteristics. The finding is robust to alternative variable constructions, alternative model specifications, and different subsamples.
To address concerns about endogeneity, we employ a quasi-natural experiment design based on large tariff reductions as a plausibly exogenous shock that radically increases foreign competition. The results show a significant decrease in firm misconduct in industries with a large tariff reduction shock, suggesting that firms respond to unexpected increases in competitive pressure by reducing misconduct.
We then examine the nature and potential causes of the disciplining effect of product market competition. The results are threefold. First, we show that competitive pressure matters more when managers have greater incentives to shirk their duties. This observation is in line with the notion that competition reduces managers’ incentives to avoid combating misconduct. Second, we analyze the interaction between product market competition and firm governance and find that market competition and governance act as substitutes in reducing firm misbehavior, which again indicates competition has a governance role in the context of corporate misconduct. Third, consistent with competition’s reinforcing punishment for wrongdoing, we find that firms that engage in misconduct later perform worse in the product market, but this effect is significant only when the firms face competitive pressure.
To shed light on how competition affects misconduct, we explore the policies firms adopt under competitive pressure that could plausibly lead to less misconduct. Our results suggest that firms under competitive pressure tend to have environmental-, social-, and governance (ESG)-related incentives in executive compensation contracts, higher expenditures on safety, and lower injury rates. These findings are in line with the view that competitive threats from the product market prompt firms to adopt practices that strengthen their commitments to stakeholders.
Our study provides evidence that product market competition is an effective deterrent to corporate misconduct. This finding has important implications for policymakers, suggesting that promoting competition can be a policy tool to improve corporate accountability and reduce the social costs of corporate misconduct.
Chhaochharia, V., Grinstein, Y., Grullon, G., Michealy, R., 2017. Product market competition and internal governance: evidence from the Sarbanes Oxley Act. Management Science 63, 1405–1424.
Frésard, L., 2010. Financial strength and product market behavior: the real effects of corporate cash holdings. Journal of Finance 65, 1097–1122.
Frésard, L., Valta, P., 2016. How does corporate investment respond to increased entry threat? Review of Corporate Finance Studies 5, 1–35.
Giroud, X., Mueller, H.M., 2010. Does corporate governance matter in competitive industries? Journal of Financial Economics 95, 312–331.
Giroud, X., Mueller, H.M., 2011. Corporate governance, product market competition and equity prices. Journal of Finance 66, 563–600.
Haushalter, D., Klasa, S., Maxwell, W.F., 2007. The influence of product market dynamics on a firm’s cash holdings and hedging behavior. Journal of Financial Economics 84, 797–825.
Hoberg, G., Phillips, G., Prabhala, N., 2014. Product market threats, payouts, and financial flexibility. Journal of Finance 69, 293–324.
Li, S., Zhan, X., 2019. Product market threats and stock crash risk. Management Science 65, 4011–4031.
This post comes to us from Jie Chen at the University of Leeds, Xuan Tian at Tsinghua University’s PBC School of Finance, Bin Xu at the University of Leeds, and Xiaoyu Zhang at VU University Amsterdam. It is based on their recent article, “Do Product Market Threats Discipline Corporate Misconduct?” available here.