PolicyDesign

TUPD-2022-013

TITLE Excess Liquidity against Predation
AUTHOR Dai ZUSAI

Associate Professor, Graduate School of Economics and Management, Tohoku University

P D F
ABSTRUCT

To investigate why a firm may hold excess liquidity, we examine a duopoly competition in which a shallow-pocket entrant needs the financial support of an outside investor to pay for input costs and launch a business. We allow the investor to terminate the entry if they find the incumbent react too aggressively to the entry plan. However, such an exit option creates a threat of predation by a deep-pocket competitor. To avoid predation, the entrant must raise precautionary liquidity by taking out a loan both larger and further in advance than is actually needed. An entrant with little start-up capital will be less aggressive if the incumbent’s capacity size is unverifiable, because the need to raise precautionary liquidity restricts the entrant’s feasible capacity size.

KEYWORDS liquidity, predation, financial contract
ISSUED Augst 2022

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