Competition, Profitability, and Discount Rates

Joint with Yan Ji, Wei Wu

Journal of Financial Economics (2021) Vol. 140, No. 2, 582-620

We build an asset-pricing model with dynamic strategic competition to explain the strong joint fluctuations in aggregate discount rates, competition intensity, profitability, and asset prices. Product market competition endogenously intensifies as discount rates rise, because firms compete more aggressively for current cash flows by undercutting each other as the value of future cooperation decreases. In industries with a lower turnover rate of market leaders, firms' profit margins tend to be higher yet more exposed to discount-rate fluctuations, thereby generating the gross profitability premium. We exploit large tariff cuts to identify exogenous variation in market structure to test the model directly.