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Product Market Competition and Corporate Risk-Taking

  • Ji Hye Lee
  • Hee Sub Byun
We examine how competitive threat in a product market, as an external environmental factor of the firm, influences corporate risk-taking behavior. Product market competition as a control mechanism is an issue of growing importance in the academic field of corporate finance (Giroud and Mueller, 2011; Kim and Lu, 2011). Firms in competitive industries have high investment and bankruptcy risks and low marginal profits, and thus need to lower their production costs to gain a competitive edge. Moreover, to decrease the cost of capital and signal the firm¡¯s reputation to the market, firms should reveal their inside information and alleviate information asymmetry. Competitive threat is also an important factor in agency theory, as it is related to managerial compensation (Karuna, 2007) and to management¡¯s pursuit of private benefits of control. In sum, competitive threat influences managerial decisions in various ways. Therefore, we investigate the relationship between competitive threat and firms¡¯ risk-taking behavior to better understand its role as an external control device. The relationship between product market competition and corporate risk-taking behavior is not yet theoretically defined; therefore, empirical evidence from this study will provide significant academic and practical implications. One strand of the literature argues that managers should be reluctant to pursue risk in a competitive environment, due to the high risk of bankruptcy (Griffith, 2001) and high turnover sensitivity based on performance. Managers are expected to build conservative investment portfolios to lower the cost of capital. A similar argument is that competitive threat mitigates the risk-pursuing behavior of management based on the overinvestment incentive (Alchian, 1950; Stigler, 1958). The other strand of the literature argues that firms in competitive industries pursue more risks to acquire market power and a competitive edge. Under strong competition, managers are endowed with greater discretion to make managerial decisions quickly (Hubbard and Palia, 1995; Christie, Joye, and Watts, 2003), and hence can take risks to make large profits. In addition, in a competitive environment with lower profits, managers might pursue higher risks to increase their monetary compensation (Hernalin, 1992; Raith, 2003), or pursue private benefits by overinvesting in risky projects. We empirically investigate which of these two competing theories is supported in the Korean economy. This is the first study to empirically examine the effect of product market competition on corporate risk-taking behavior in the Korean economy. External factors that influence risk-taking behavior are not actively discussed in the academic field, thus we aim to fill this academic gap. Moreover, we extend recent studies that analyze the effect of product market competition by investigating its effect on firms¡¯ risk-taking behavior. Under the agency theory, we test the disciplinary effect of competition in the Korean product market and explain how it disciplines managers or agency problems based on the risk-taking behavior of controlling shareholders. We use firms listed on the Korean Stock Exchange and run regressions while controlling for various firm characteristics and environmental factors. Measuring the level of product market competition, we use the Herfindahl-Hirschman index, which is commonly used in the field of corporate finance and industrial organization. To estimate corporate risk-taking behavior, we follow previous studies in using the standard deviation of the profit or net income over the past five years, standardized by total assets. Empirically, we find that competitive threat has a significantly negative effect on corporate risk-taking behavior. This means that managers burdened by high investment risks and bankruptcy costs in more competitive product markets do not want to form risky investment portfolios. It also implies that competitive threat can be considered as an external control device in the agency framework. The result is robust to control of the potential endogeneity problem, and to the use of alternative proxies for the level of product market competition and corporate risk-taking behavior. Furthermore, we find similar results when we perform an industry-level analysis. Our result is more strongly observed in firms with a low market share and those that do not belong to business groups. Meanwhile, examining the effect of the interaction between corporate governance and product market competition on corporate risk-taking behavior, we find that firms with good corporate governance are less likely to pursue risk. However, the negative effect of corporate governance on corporate risk-taking behavior exists only in less competitive product markets. We interpret this result as indicating that there is a substitution effect between internal corporate governance and competitive threat in product markets in determining corporate risk-taking behavior.
Product Market Competition,Corporate Risk-Taking,External Control Device,Market Power,Internal Corporate Governance