Does product market competition discipline managers? Evidence from an exogenous trade shock and corporate acquisitions

• Published date: 01 March 2023
• Author: Azizjon Alimov
• Date: 01 March 2023
• DOI: http://doi.org/10.1111/corg.12463

ORIGINAL ARTICLE

Does product market competition discipline managers?

Evidence from an exogenous trade shock and corporate

acquisitions

Azizjon Alimov

IESEG School of Management, Univ. Lille,

CNRS, UMR 9221 - LEM - Lille Economie

Management, Lille, France

Correspondence

Azizjon Alimov, IESEG School of Management,

Univ. Lille, CNRS, UMR 9221 - LEM - Lille

Economie Management, F-59000, Lille,

France.

Email: a.alimov@ieseg.fr

Abstract

Research question/issue: This study uses the 1989 Canada-United States Free Trade

Agreement (FTA) to study the effect of increased foreign competition on the

efficiency of major corporate investment decisions. The analysis builds on the

disciplining theories of competition that suggest that managers facing greater

competition should make better investment decisions, resulting in more wealth

created for shareholders.

Research findings/insights: Using a sample of more than 2000 mergers and acquisi-

tions, the study finds that acquirers exposed to greater increases in foreign competi-

tion experience better acquisition performance. The positive impact of increased

competition is stronger in acquirers with relatively higher agency costs prior to the

FTA. Managers of acquirers exposed to greater foreign competition are more likely

to be terminated following value-destroying acquisitions.

Theoretical/academic implications: This study provides novel empirical evidence

showing that increased foreign competition results in better investment decisions

and that the result is likely due to the disciplining effects of competition. This

evidence adds to a growing body of work on the disciplining role of competition and

on the effects of increased foreign competition on corporate decision-making.

Practitioner/policy implications: This study is relevant to policymakers because the

extent of competition can be influenced by policy decisions. For regulators, it is

worth considering that reducing import tariffs and other entry barriers into product

markets may lower agency costs and increase the efficiency of corporate investment.

This is a topical issue due to the increase in globalization and ongoing debates about

further liberalization of trade relations.

KEYWORDS

corporate governance, competition, trade liberalization, mergers and acquisitions

Received: 19 February 2021 Revised: 3 May 2022 Accepted: 4 May 2022

DOI: 10.1111/corg.12463

370 © 2022 John Wiley & Sons Ltd. Corp Govern Int Rev. 2023;31:370–390.wileyonlinelibrary.com/journal/corg

“Monopoly is a great enemy to good management”

(Adam Smith, 1776).

1|INTRODUCTION

As the quote above illustrates, scholars have long argued that

competitive pressure from product markets plays an important role in

inducing managers to maximize shareholder wealth. One of the main

rationales for this argument is that tougher competition enforces dis-

cipline on managers to reduce inefficiency and increase productivity

or else be driven out of business (e.g., Alchian, 1950; Stigler, 1958).

The increased threat of bankruptcy and associated personal losses is

believed to provide particularly strong incentives for managers to

exert efforts that increase firm value (Grossman & Hart, 1983). In their

survey article, Shleifer and Vishny (1997: 738) state “we agree that

product market competition is probably the most powerful force

toward economic efficiency in the world.”Yet the argument that

greater competition unambiguously reduces agency costs is viewed

with skepticism by some economists. For example, Jensen and

Meckling (1976: 329) argue that managerial incentives to shirk exist

equally in both competitive and noncompetitive markets, and thus,

“the existence of competition …will not eliminate the agency costs

due to managerial control problems”. Schmidt (1997) theoretically

shows that a relation between a degree of competition and agency

costs can have an “inverted-U”shape: managerial incentives to maxi-

mize firm value increase initially with competition but may eventually

decrease when competition becomes too intense and the marginal

impact of managerial effort on expected value decreases. Thus, the

exact relation between the degree of competition and agency-driven

managerial behavior is ultimately an empirical question.

While scholars have written extensively on the disciplining effects

of competition, there is scarce direct evidence that competition actu-

ally plays a causal role in reducing agency costs. This paper attempts

to provide new evidence on this topic. Specifically, I examine whether

and how a plausibly exogenous increase in competitive pressure due

to a fall in trade barriers influences the amount of shareholder value

that managers create or destroy in mergers and acquisitions (M&A).

M&A is an attractive setting for studying the efficacy of competi-

tion as an external disciplining mechanism for three reasons. First,

M&A typically represent the largest investment decisions that

managers can make. M&A are largely unpredictable events with easily

identified announcement dates, which allow for relatively “clean”

empirical assessment of the quality of managerial decisions as

perceived by firm shareholders. A large body of literature in finance

holds that successful deals can create substantial value for share-

holders, while misguided ones can lead to significant long-lasting loss

of value. Second, M&A provide a setting in which conflicts of interests

between managers and shareholders are important. In fact, practi-

tioners and scholars often argue that self-serving managers make

acquisitions to derive personal benefits even if acquisitions hurt

shareholder value (e.g., Jensen, 1986; Morck et al., 1990). Accordingly,

the negative stock market response to a firm's acquisition decision is

often cited by researchers as evidence of bad quality acquisitions and

thus relatively more severe agency problems at the acquiring firm

(e.g., Masulis et al., 2007). Third, the M&A setting allows me to

complement my main analysis with a test of the ex-post disciplining

role of competition on the probability of disciplinary CEO replacement

following poor quality deals.

Giroud and Mueller (2010,2011) have shown that bad corporate

governance appears to be a problem that exists primarily in less com-

petitive industries, as measured by industry concentration ratio or

profit margin. These studies, however, do not necessarily establish a

causal link from the intensity of competition to the extent of agency-

driven behavior. The primary challenge facing any empirical attempt

to establish an impact of competition is the fundamental simultaneity

occurring between the structure of product markets, as measured by

industry concentration measures, and the efficiency of firms in those

markets. For example, Demsetz (1973) argues that industries with

greater variation in efficiency across firms become concentrated

because more efficient and profitable firms grow faster at the expense

of less efficient firms. Schmalensee (1989) notes that concentration

ratios do not reflect important competition parameters such as the

industry entry barriers, and Ali et al. (2009) show that industry

concentration measures calculated using only Compustat firms are

poor proxies for actual industry concentration.

This paper addresses these identification challenges by exploiting

a quasi-natural experiment based on a trade shock that materially

increased US firms' exposure to foreign competition. The experiment

is the Canada-United States Free Trade Agreement (FTA) of 1989,

which eliminated tariffs and other trade barriers between the two

countries and, as a consequence, reduced entry barriers into a large

number of product markets. A key advantage of using this setting is

that the FTA represented a clearly defined change in trade regime

which was exogenous to individual companies and was not driven by

changes in economic climate or accompanied by other reforms. This

experiment also allows me to exploit cross-sectional differences

across firms in their exposure to the competitive shock because

industries experiencing larger tariff cuts (and thus greater decline in

entry barriers) should be exposed to a greater increase in competition

from Canadian rivals. I verify that the FTA-mandated tariff cuts had a

significant impact on US firms' operating performance and the inten-

sity of competition they face from Canadian rivals.

Using a sample of more than 2000 deals announced between

1983 and 1997, I examine the effect of the trade liberalization's main

instrument—tariff cuts—on the quality of firms' M&A activity, as

perceived by the stock market. If an increase in competitive pressure

brought about by the fall in trade barriers indeed reduces agency

costs and promotes efficiency, we would expect managers exposed to

greater competition to make more value-increasing acquisitions

decisions, resulting, on average, in higher acquirer cumulative abnor-

mal returns (CARs) around the announcement day. The identification

strategy exploits the difference-in-differences model that isolates the

effect of the FTA (first margin) by studying its differential impact

across firms in industries, based on the degree to which industries

were protected by tariffs on Canadian imports prior to the agreement

ALIMOV 371