Bolton and Scharfstein (1990)
 Consider the interplay between (financial) agency problem within a firm
and its competitiveness in product market.
 In order to better control the manager, the investors need to commit
terminating funding if performance is bad. On the other hand, this
increases the incentives of product market competitors to predate.
 The optimal contract for the manager balances the two considerations
above.
Model
 Two firms: A, B.
 Two periods: 1, 2.
 Both pay a fixed cost F at beginning of each period.
 A pays for F with internal funds.
 B obtains funds from an investor who offers a take-it-or-leave-it contract,
which B accepts if contract provides non-negative expected payoff.
 B’s profit can be either  1 or  2 , with  2  1 and F  1 .
 The probability that  1 realizes is  in each period.
     (1   ) 2  F .
 No discount.
 Assume it is impossible to have financial contract contingent on realized
outputs
 1 or  2 .
 However, investor can force the firm to pay out at least  1 .
 The investor will not fund investment if there is only one period: The firm
will only report   1  F , and the investors always lose money.
 In a two-period relationship, the investor can decide whether to fund the
firm in the 2nd based in the first period report. The threat to terminate
funding in the second period can force the firm to report profit honestly.
Contracting without Predation
 Suppose investor gives the firm F at date 0 to fund first-period production.
 R1 is the transfer from firm to investor at date 1 if reported profit is  i ;
i=1, 2.
  i  [0, 1] is the probability that the investor will fund the 2nd period
investment if  i is reported in period 1.
 The 2nd period transfer cannot be contingent on 2nd period report
because the firm always reports  2 .
 The 2nd period transfer, R i , can thus be contingent only on first period
report  i .
i
 Limited liability requires that Ri   i , R   i  Ri   1 , i=1, 2.
 The optimal contract is to maximize investor’s expected profit
1
2
Maximize

F


[
R


(
R

F
)]

(
1


)[
R


(
R
 F )],
1
1
2
2
i
{  i , Ri , R }
subject to
(1)
 2  R2   2 (  R 2 )   2  R1  1 (  R1 ) ;
(2)
 i  Ri ,
i
(2’)  i  Ri   1  R , i  1, 2;
(3)
 [ 1  R1  1 (  R1 )]  (1   )[ 2  R2   2 (  R 2 )]  0.
 (1) is the incentive compatibility constraint of the firm.
 (2) and (2’) are limited liability constraints.
 (3) is the individually rational constraint.
 (2) and (2’) imply that (3) is not binding.
 At the equilibrium, (1) is binding.
1
2
 There exists an optimal constraint in which R  R   1 .
 The optimal contract: The investor will invest at date 0 if
F    (   1 ) /( 2   ) . In this case, R1*   , 1*  0 , R2*   ,  2*  1 . The firm
operates at date 2 if 1st period profit is  2 .
 There is ex post inefficiency: The firm is not funded if 1st period profit is
 1 , even if   F .
 Summary: A firm’s performance affects its financing cost and its access to
capital.
Optimal Contract with Predation
 If firm A knows of B’s contract, it has incentives to prey in order to drive
out B, and becomes monopolist in the 2nd period.
 Assume with cost c>0, A can increase  to  .
m
 Assume if A is monopolist, profit is  ; if it is duopolist, profit is  d .
m
d
 Given (1 ,  2 )  (0, 1) the expected benefits of predation is (   )(   ) .
m
d
Thus it pays to prey if   c /[(    )(   )]  1 .
 The investor’s expected profit when A preys is  1  F  (1   )(  F ) .
 In general (for any value of  1 ,  2 ), firm A preys if (2  1 )   .
 The benefit of predation thus depends on firm B’s financial contract.
 The optimal contract derived earlier (  2  1 , 1  0 ) has largest value of
 2  1 , and thus maximizes firm A’s incentive to prey.
 Two further assumptions: (i) Court cannot observe predation, so firm B’s
contract cannot be contingent on whether there is predation. (ii) A can
observe the contract for B. Thus investor can redesign the contract to deter
predation.
 The non-predation constraint: ( 2  1 )   .
 The optimal contract solve
max  F   [ R1  1 ( 1  F )]  (1   )[ R2   2 ( 1  F )] ,
{1 , R1 , R2 }
subject to (1), (2), and non-predation constraint.
 Substituting R1   1 and R2    (1  ) 1 into target function, we have
max  F  1 ( 1  F )  (1   )(  F ) .
*
*
 1  0,  2   .
 The investor deters predation by lowering the probability that the firm is
refinanced when profit is high.
 Intuition: Increasing  1 is costly since it increases chance of predation.
 The expected profit of the investor is  1  F  (1   )(  F ) .
 Thus, conditional on entering, firm B chooses to deter predation if
(1   )  1   . Moreover, if  1  F  max {(1   ), 1  }(  F )  0 , it is profitable to
enter.
 Results above critically depend on  1  F .
 If  1  F :
(1)
Without threat of predation, (1 ,  2 )  (0, 1) , provided  1 is not too
large.
(2)
With threat of predation, rather than reducing  2 , 1 should be
increased. This increases probability that investor earns  1  F in the 2nd
period. “Deep pocket” is thus the optimal response to predation.
 In contrast to Brander and Lewis (’86) and Maksimovic (’86), leverage
tends to soften product market competition.