The degree of industry competition influences a firm’s performance. According to Nickell (1996), most people believe that competition is a good thing. However, theory and empirical evidence are not conclusive about the relationship between firm performance and product market competition.
Many studies have investigated the effects of industry competition and corporate governance on firm performance; however, the theoretical predictions are ambiguous, and there are divergent views on competition. Some papers show that firm performance and industry competition are negatively related (Hill and Hansen, 1991; Schmidt, 1997; Ghosal, 2002; Slade, 2004; Peress, 2010; Stefan, Markus, and Gabrielle, 2011). Previous studies show that lack of competition induces higher returns because of the power of monopoly; in addition, firms in such concentrated industries have better methods of enforcing discipline on each other, and as such, monopoly firms are less likely to suffer profit losses in periods when demand is falling because they could pass them on to their customers (Hill and Hansen, 1991; Ghosal, 2002; Slade, 2004; Peress, 2010). Schmidt (1997) indicates that increasing competition lowers each firm’s profits; thus the owner of the firm may not be interested in paying the manager the high rent necessary to achieve cost reduction although this reduces the manager’s incentives for the latter to exert effort. In the same vein, Stefan, Markus, and Gabrielle (2009) propose that the relation between product market competition and managerial incentive is convex. Thus, above a certain level of intensity in product market competition, the negative effect of lower economic rents seems to outweigh the positive effect of reducing managerial slack resulting from additional monitoring and the threat of liquidation.
Although imperfect convergence exists in theoretical studies, most of the empirical evidence suggest a positive impact of industry competition on firm performance (Nickell,
1996; Nickel et al., 1997; Jagannathan and Srinivasan, 1999; Griffith, 2001; Januszewski et al., 2002; Mitton, 2004; Bozec, 2005; Gaspar and Massa, 2005; Irvine and Pontiff, 2005;
Hou and Robinson, 2006; Baggs and Bettignies, 2007; Grullon and Michaelly, 2007;
Karuna, 2007; Bartram et al., 2008; Stefan et al., 2009; Giroud and Mueller, 2010).
According to these studies, competition can produce better managerial incentives and monitoring quality. Therefore, it could alleviate management inefficiency and improve company performance. In a highly competitive environment, the space of profit may be compressed or plundered by other companies in the same industry and only efficient companies can survive. Managers must focus on increasing product quality or reducing costs of production in order to avoid bankruptcy or lose their jobs (Griffith, 2001; Bozec, 2005; Baggs and Bettignies, 2007; Giroud and Mueller, 2010). Meanwhile, other studies show that firms in highly competitive industries are easily influenced by aggregate shocks because each firm has less power to dominate the market. This, in turn, increases the probability of bankruptcy, providing incentives for managers to avoid this outcome through hard work and less free cash flow (FCF) waste; thus, product market competition can reduce FCF problems resulting from conflict of interest between shareholders and managers (Nickell, 1996; Nickel et al., 1997; Jagannathan and Srinivasan, 1999; Januszewski et al., 2002; Karuna, 2007). Such firms in competitive industries are also more likely to distribute cash to shareholders (Mitton, 2004; Grullon and Michaelly, 2007; Bartram et al., 2008).
There are three possible reasons for them to do distribute cash to shareholders. First, a highly competitive industry overinvesting in projects of negative net present value can make the firm less competitive and more likely to be driven out of the market. Second, intense competition makes it easier for outside investors to benchmark managers’ performance to the performance of their competitors. This increases the risk of making investors discover overinvesting moves, improves monitoring quality, and reduces agency problems between the shareholders and the manager. Third, trying to avoid bankruptcy and the loss of their
jobs, managers in more competitive industries tend to avoid overinvesting and distribute excess cash to shareholders as dividends. In the secondary market, these companies in highly competitive industries have higher average of stock returns not only on account of their risk due to the influence of aggregate shock, but also because these firms have a certain efficiency, lower price distortions, greater accountability, and transparency in business decisions (Gaspar and Massa, 2005; Irvine and Pontiff, 2005; Hou and Robinson, 2006).
Due to the growing interest in corporate governance, the link between agency issues and competition situation has attracted an increasing amount of attention. Agency conflicts strongly impact on managerial decision making (Januszewski et al. 2002; Rogers 2004). In an effort to find out the common rule in the relationship between industry competition and firm performance, we added one factor into consideration when investigating the topic:
agency problem. Managerial slack is a source of agency problems; it breeds inefficiency, inhibits risk taking, and hurts performance (Jensen and Meckling, 1976; Jensen, 1986; Fama, 1980; Brush, Bromiley and Hendrickx, 2000). Agency problems also exist when firms have substantial free cash flows (Jensen, 1986; Chi and Lee, 2005). Since the product market competition is an effective instrument for solving agency problems and improving corporate governance (Fama 1980; Giroud and Mueller 2010), we expect a stronger positive correlation between industry competition levels and operating performance among firms with severe agency costs of free cash flows. Our empirical results prove our expectation that the positive relation between product competition and firm performance is more profound for firms with higher free cash flow, thus presenting a severe agency problem.
Different countries have different objectives in their corporation and ranking in their corporate governance (Allen and Gale, 2000; Gompers, Ishii and Meyrick, 2003).
Particularly, poor shareholder protection is penalized with lower valuation (La Porta et al., 2002; Chua, Eun et al., 2007; Gompers, Ishii and Meyrick, 2003). In the USA and the UK,
the threat of takeover ensures that managers act in line with the shareholders' interests. In Germany and France, the system of co-determination on the supervisory board formalizes this balance of interests, and both the shareholders and the employees emphasize their mission of protecting stakeholders (Allen and Gale, 2000). Aside from the firm’s mission to shareholders’ rights, different legal protections for outside investors tend to provide much higher levels of protection than civil law countries such as Germany and France, although these matter in the firm performance in different countries with common laws, such as the USA and the UK (La Porta et al. 1998). In our paper, we used four country samples, including the USA, UK, Germany, and France. Our aim is to examine whether different company missions and legal protection affect the relationship between competition and performance. Another consideration is that few studies have examined the relationship between competition and performance in different countries.
Our study focuses on the relationship between industry competition and firm performance while considering agency problem conditions. In the sample selection, we used the top four economic markets, including the USA, UK, Germany and France, to help us to investigate the relation between industry competition and firm performance under different levels of national corporate governance.
The rest of this paper is organized into sections. Section 2 describes the definitions of variables, sample selection, and descriptive statistics; Section 3 discusses our research design and hypotheses; Section 4 presents the results; and Section 5 provides a summary of our main results and the conclusion.