Does Capital Structure Have Opposite Effects on Incumbents’ Responses to Entry Threat and Actual Entry?

Some theories predict that firms with higher financial leverage compete more aggressively in product markets than firms with lower leverage, whereas others predict that lower-leverage firms compete more aggressively than higher-leverage ones. This paper studies how incumbent airlines’ capital structure affects their responses to Southwest Airlines’ entry threat and actual entry. The results indicate that, when responding to entry threat, lower-leverage incumbents cut prices more aggressively, which is consistent with the “long purse” story; by contrast, when responding to actual entry, higher-leverage incumbents cut prices more aggressively, which is consistent with the “bagging the bondholder” story, the “gambling” story, the “limited liability” story, and the “collusion deviation” story.