Evidence on the Importance of Market Competition in Distress Propagation

Joint with S. Johnson, Wei Wu

July 2023

Using local natural disasters as a quasi-experimental setting, we show that heightened distress risk in shocked firms drives both these firms and their unshocked competitors to cut profit margins by about $0.8$ percentage points. These reductions stem from predatory pricing, inventory liquidation, and weakened tacit collusion in product markets. Distress propagates horizontally as unshocked competitors rationally respond almost 1-for-1 with profit-margin cuts, significantly increasing their distress risk. Spillovers are more pronounced in tradable industries or those with higher barriers to leadership, larger inventories, greater price flexibility, or tighter financial constraints, revealing a novel channel for distress propagation across the economy.