External Financing and Customer Capital: A Financial Theory of Markups

Joint with Yan Ji

Management Science (2021) Vol. 67, No. 9, 5569-5585

We develop an industry equilibrium model of dynamic games to understand how product markups are determined in the presence of external financing costs, customer capital, and imperfect competition. Firms optimally set markups to balance the tradeoff between profiting from their existing customer base and developing their future customer base. We analytically characterize the equilibrium markups. Firms exhibit strategic complementarity in setting markups, which increases the level of markups and decreases the positive response of markups to a rise in external financing costs. Moreover, the model predicts that greater product market threats lead to more conservative financial policies, which is supported by the data.