Product Market Competition and Capital

Structure:

Empirical Evidence from the Newspaper Industry

Ernesto SchargrodskyUniversidad Torcuato Di Tella

Miñones 2159/77 – (1428) Capital FederalTE: 784-0080FAX: 783-3220

email: eschargr@utdt.edu.ar

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Abstract

This paper analyzes whether the extent of competition that a firm faces affects its capitalstructure, controlling for other determinants of leverage. We investigate this issuestudying the effect of competition on leverage for firms acting in the US newspaperindustry. The results show that debt ratios are reduced as the extent of competition falls.The effects are statistically and economically significant. We also study the effect ofcapital structure on newspaper advertising rates. For oligopolies, debt ratios show asignificant and positive effect on prices. The evidence is consistent with the view thatleveraging can act as a collusion-facilitating strategy in product market competition.

Este artículo analiza el efecto del grado de competencia que enfrenta una firma sobresu estructura de capital, controlando por el efecto de otros determinantes de estaestructura. Este efecto se investiga analizando el efecto del grado de competenciasobre el nivel de endeudamiento para firmas que actúan en la industria de periódicos delos Estados Unidos. Los resultados muestran que los niveles de endeudamiento sereducen cuando el grado de competencia se reduce. Los efectos son estadística yeconómicamente significativos. También se estudia el efecto del nivel deendeudamiento sobre las tarifas de espacios de publicidad que cobran los periódicos.Para los oligopolios, los niveles de endeudamiento tienen un efecto significativo ypositivo sobre los precios. Esta evidencia es consistente con la visión de que elendeudamiento puede actuar como una estrategia que facilita la colusión en lacompetencia en el mercado de productos.

Códigos de Campo (JEL): L1, L2, D4

Product Market Competition and Capital

Structure:

Empirical Evidence from the Newspaper Industry

Ernesto Schargrodsky*

Universidad Torcuato Di Tella

Agosto 29, 1998

AbstractThis paper analyzes whether the extent of competition that a firm faces affects its capitalstructure, controlling for other determinants of leverage. We investigate this issuestudying the effect of competition on leverage for firms acting in the US newspaperindustry. The results show that debt ratios are reduced as the extent of competition falls.The effects are statistically and economically significant. We also study the effect ofcapital structure on newspaper advertising rates. For oligopolies, debt ratios show asignificant and positive effect on prices. The evidence is consistent with the view thatleveraging can act as a collusion-facilitating strategy in product market competition.

* My special thanks to Michael Whinston for his guidance. Thanks also to RichardCaves, Aviv Nevo, Andrei Shleifer, Catherine Wolfram, and the participants at theHarvard University Industrial Organization seminar for helpful suggestions. All remainingerrors are mine. Comments welcome at eschargr@utdt.edu.ar.

1. IntroductionThe main purpose of this paper is to analyze whether the extent of competition faced byfirms affects their capital structures. We investigate this issue by studying the effect ofthe extent of competition on leverage for firms acting in the US newspaper industry. Theresults show that debt ratios are reduced as the extent of competition falls. We alsoanalyze the effect of capital structure on newspaper advertising rates. For monopolies,the results suggest that debt ratios have a negative and mainly non-significant effect onprices. For oligopolies, debt ratios show a significant and positive effect on prices.

An extensive body of research has identified stylized facts on the determinants ofleverage. Several firm characteristics -size, growth opportunities, profitability, non-debttax shields, or the proportion of fixed assets, for example- have been shown to affectcapital structure (i.e., the relative proportions of debt and equity financing). Intra-industrysimilarities in capital structure have also been repeatedly found. However, the empiricalevidence on the effect of product market conditions on firms’ capital structure issurprisingly small (Harris and Raviv, 1991). Titman and Wessels (1988)’s study on theeffect of product uniqueness on capital structure, and Kovenock and Philips (1995)’sanalysis on the effect of firm productivity, market concentration, and demand factors onrecapitalization decisions, represent scarce exceptions to the underexploration of theeffect of the conditions that firms face in the product markets on their capital structures.

The theoretical motivation for our study arises from recent models on the strategic useof debt. These models show that firms may have incentives to use their capitalstructures to commit to particular product market strategies. In some of these studies,debt financing commits firms to more aggressive output strategies (Brander and Lewis,1986, 1988). Other models find that leveraging helps to sustain higher equilibrium pricesin product market competition (Phillips, 1991; Showalter, 1995; Schargrodsky, 1997).Although these groups of models do not accord on the predicted effect of capitalstructure on prices, they agree that capital structure can be used as a value-increasingstrategy in product market competition. These incentives for taking on debt are onlypresent in situations of strategic interaction. As monopolistic or perfectly competitivefirms do not have similar incentives, these models predict that oligopolies have higherdebt levels than monopolistic or competitive firms.

We analyze the effect of competition on capital structures in the US newspaper industry.The newspaper industry is particularly appropriate for this study because there has beensignificant variation in the extent of competition that firms face. Moreover, the mainsource of this variation, a decline in the number of cities with competing newspapers, isassociated with an exogenous factor, the development of other mass media. We exploitthis exogeneity to address potential endogeneity concerns. In agreement with thepredictions of the strategic-use-of-debt models, our results show that debt ratios arereduced as the extent of competition (i.e., the degree of strategic interaction) falls. Theeffects are statistically and economically significant.

In addition, we explore the effect of capital structure on newspaper advertising rates. Ifnewspaper firms take on debt for strategic reasons, we would expect to observe aneffect of capital structure on prices. Chevalier (1995), Phillips (1995), and Chevalier andScharfstein (1996) have previously analyzed this effect comparing pricing by leveragedand non-leveraged firms. These studies only consider oligopolistic industries: Chevalier(1995) and Chevalier and Scharfstein (1996) analyze the supermarket industry, while

Phillips (1995) studies the fiberglass, tractor-trailer, polyethylene, and gypsumindustries. Our contribution to this previous research is to examine whether debt has adifferent effect on prices under oligopolistic than under monopolistic market conditions.We are able to perform this study because the newspaper industry is populated by firmsacting in monopolistic and oligopolistic markets. We exploit our results on thedeterminants on leverage to alleviate endogeneity concerns on the effect of capitalstructure on prices.

For monopolies, our results suggest that debt ratios have a negative and mainly non-significant effect on prices. For oligopolies, debt ratios show a significant and positiveeffect on prices. The oligopoly results coincide with previous findings. Chevalier (1995),Chevalier and Scharfstein (1996), and Phillips (1995) found that leveraged firms chargehigher prices than non-leveraged firms (although Phillips reports the opposite result forthe gypsum industry). These findings are consistent with the predictions of the modelsthat show that leveraging can allow firms to sustain higher product market prices(Phillips, 1991; Showalter, 1995; Schargrodsky, 1997), but inconsistent with the modelsthat predict more aggressive behavior by leveraged firms (Brander and Lewis, 1986,1988).

The evidence presented in this paper suggests that firms may undertake actions toaffect future market conditions. Although in recent years there has been significant workin the theory of industrial organization on the use of different variables (capacity,location, executive compensation schemes, learning by doing, etc.) as commitmentstrategies to affect market equilibria, there have been few attempts at finding empiricalevidence for these theories. This paper also represents a contribution in that direction.

Section 2 discusses the advantages of the newspaper industry for this study. Section 3analyzes the effect of the extent of product market competition on capital structure.Section 4 studies the effect of capital structure on product market prices. Section 5presents our conclusions, and discusses suggestions for future research. The Appendixprovides data definitions, sources, and summary statistics.

2. The Newspaper IndustryOur main purpose is to study the effect on firms’ capital structure of the extent ofproduct market competition (PMC) that they face. We investigate this issue analyzingthe determinants of leverage in the US newspaper industry. The intra-industry featureavoids the problem of cross-industry comparisons. This is important because significantintra-industry similarities in capital structure have been reported (Bowen, Daly, andHuber, 1982; Bradley, Jarrell, and Kim, 1984; Harris and Raviv, 1991).

For several reasons, the newspaper industry provides an appropriate setting for ourstudy. First, there is both cross-sectional and over-time variation in the extent ofcompetition that newspaper firms face. Cross-sectional variation arises because this is alocal-market industry with firms participating in markets with different degrees ofcompetition. Over-time variation arises from mergers and acquisitions amongnewspaper chains and, mainly, from a continuing decline in the number of cities withcompeting newspapers. The number of cities with competitive newspapers dramaticallydecreased from 502 in 1923, 109 in 1948, and 70 in 1958, to less than 20 in 1995.

Second, the reduction in the number of competing newspapers is associated with anexogenous factor, the development of other mass media. As it is plausible that shocksaffecting capital structure have an effect on the degree of competition that firms face,we will exploit the exogeneity of the media development to address endogeneityconcerns by instrumenting for the degree of competition that firms face.

Third, the two predominant market structure situations in this industry are monopoliesand duopolies. Out of hundreds of cities in which the firms in our sample publishnewspapers, New York, Chicago, and Washington are the only ones which, at somepoint in time during the period of observation, had more than two competingnewspapers. Monopolies and duopolies are sharply different market structures. In thisindustry, not only does there exist variation in the degree of competition that firms face,but this variation is significant and it is related to an exogenous factor.

The industry has the additional advantage of having a weak relationship betweencompetition and profitability. The literature on capital structure predicts that leveragelevels are negatively related to profitability (Myers and Majluf, 1984). If we comparemonopolistic and oligopolistic markets of similar size, we expect lower profitability for theoligopolies. Through the effect on profitability, we would then expect monopolies to havelower debt levels. This would not be the direct effect of competition on capital structurethat we try to capture. Although we will certainly control for profitability, it is preferable toconsider an industry where the relationship between PMC and profitability is weak inorder to identify this direct effect.

The newspaper industry has this advantage. In this industry the number of newspapersin each city is highly related to the city size. In 1978, the middle of our sample period,the mean population of cities with monopolistic newspapers was 47,159, and the meanpopulation of cities with competing newspapers was 725,369 (Rosse, 1978). Thisdifference has probably increased in recent years, as the number of cities withcompeting newspapers shrank. An oligopolistic newspaper competing with its rival indifferentiated products (the way that better describes newspaper competition) in a largemarket may be more profitable than a monopolistic newspaper in a smaller market. Thisis especially probable because fixed costs are significant in this industry.

We also study the effect of capital structure on prices and, in particular, whether thiseffect is different for oligopolies than for monopolies. The industry is appropriate forexploring this differential effect because, as already mentioned, newspapers arepublished in monopolistic or oligopolistic (mainly duopolistic) markets.

3. The Effect of Competition on Capital StructureWe start by considering all the US parent companies included in the COMPUSTATdatabase that have daily newspaper publication as their major line of business. Thisresults in a sample of 441 firm-year observations corresponding to 27 firms which wereactive at some point between 1957 and 1995. We lose one observation per firmbecause we will use lagged variables. We also lose 74 observations because of missinginformation in COMPUSTAT.

1 We drop 18 observations for which COMPUSTAT reports

1Most of these missing observations correspond to missing stock prices which are not

available because the firm’s stock was not publicly traded at that time.

a zero debt level. We interpret these values as missing information.2 As we will use firm-

fixed effects, we drop two observations for two firms which have only one observation.The final sample has 21 firms and 320 firm-year observations from 1964 to 1995.

To analyze the effect of the degree of competition on capital structure, we regress debtratios on a measure of the extent of product market competition and on variablescontrolling for size, profitability, growth opportunities, non-debt tax shields, and firms’fixed effects. This approach follows previous studies of the determinants of leverage(Bradley, Jarrell, and Kim, 1984; Titman and Wessels, 1988; Harris and Raviv, 1991;Rajan and Zingales, 1995).

Numerous papers on the theory of capital structure (for a survey, see Harris and Raviv,1991) predict that these control variables affect capital structure. It is also plausible toargue that current shocks to capital structure affect these controls. For example, thetheoretical models on the strategic use of debt predict that debt levels affect profitability.We alleviate these endogeneity concerns by lagging our control variables (Rajan andZingales, 1995). Our main regression is:

3

Debt ofitability GrowthOpportunities Sizeit it it itΖ Η Η

ϑ ϑ ϑ

ϒ ϒ ϒ1 1 2 1 3 1Pr

Η Η Η Ηϑ

ϒ ϒ4 1 5NonDebtTaxShield PMC Fixed u

it it i itδ

where for firm i in period t:Debtit = Total Debt/Total AssetsProfitabilityit is alternatively defined as:

Retained Earningsit = Retained Earnings/Total AssetsReturn on Assetsit = Operating Income/Total AssetsReturn on Salesit = Operating Income/Sales

Sizeit = ln(Sales in constant dollars)Growth Opportunitiesit = Market Value of Common Equity/Book Value of Common EquityNon Debt Tax Shieldit = Depreciation and Amortization/Total AssetsFixedi = Firm-fixed effectPMCit measures the extent of product market competition as:

PMC

pop d

popit

jtj

jit

jtj

Ζ

�

�

where: djit = 1 if firm i is the only firm publishing daily newspapers (of general interest and English language) in city j at time t.

4,5,6

2 Results are robust to including these zero-debt observations.

3 Sources and summary statistics are presented in the Appendix.

4 Newspapers published by the same firm in the same city (for example, morning and

evening editions) are not considered competing newspapers.5 Markets with joint operating agreements (JOA’s) are considered monopolistic

markets. JOA’s are agreements between publishing firms which allow two newspapersin the same city to pool their advertising, circulation, production and business operations

djit = 0 if firm i is not the only firm publishing daily newspapers (of general interest and English language) in city j at time t.

7

j = 1,...,J cities in which firm i publishes daily newspapers (of general interest and English language) at time t.popjt = population of city j at time t.

Our firms are parent companies that usually participate in more than one market. Thismeasure of competition is a weighted average of the degree of competition that firmsface in each of the markets in which they publish newspapers. The weights are given bythe size of the cities. The measure equals 0 for a pure oligopolist and 1 for a puremonopolist. Each city is considered an individual newspaper market.

8 Although

newspapers from different cities may compete for readers and national advertisers, theydo not compete for local advertisers, their main source of revenues.

9 Local retailers do

not usually buy advertising space in non-local newspapers. Daily newspapers also facecompetition from suburban newspapers, less-than-daily newspapers, shoppers andother media. However, our measure considers that there is a significant difference in thedegree of competition that a daily newspaper faces when there is another dailynewspaper published in the same city, in agreement with the literature on newspapercompetition and antitrust case law (Rosse, 1978; Busterna, 1988),

If firms’ profitability is related to market structure conditions, the degree of PMC that afirm faces can affect its capital structure not only directly but also indirectly through itseffect on profitability. Because we are interested in the direct effect of PMC on capitalstructure, we have to be particularly careful in controlling for profitability (although, asdiscussed above, the problem is mitigated because in this industry there is a weakrelationship between PMC and profitability). Myers and Majluf (1984) show thatprofitability affects leverage because firms prefer to raise capital from internal sourcesrather than from outside investors (the “pecking order” theory of financing). Leveragelevels are negatively related to the amount of retainable earnings. The accountingvariable that best represents this theoretical concept is Retained Earnings. We use this

while maintaining separate editorial departments. JOA’s are exempt from antitrust lawby the Newspaper Preservation Act of 1970.6 The national newspapers, Wall Street Journal and USAToday, are not considered.

7 No difference is made for oligopolies with different numbers of firms. As mentioned

above, in the sample there are very few cases of cities with more than two competingnewspapers.8 City boundaries are confused in some metropolitan areas. For competition in New York

City, newspapers in the five boroughs are considered competitors of each other (Rosse,1978). For competition in Los Angeles, the Daily News in San Fernando Valley is notconsidered a competitor of the central-city newspapers Times Mirror and Herald-Examiner (Tillinghast, 1988).9 Newspaper firms collect revenues from circulation and advertising. Advertising

revenues are obtained from three categories: local (or retail) display, national (orgeneral) display, and classified. Display advertising appears throughout the paper andoften involves illustrations. Classified advertising appears on special pages ordered byitem. Rosse (1978) calculates that in a typical newspaper in 1977, 75.4% of revenuescame from advertising (50.1% from local display, 6.9% from national display, and 18.4%from classified), and the other 24.6% from circulation. Thus, 70% of the revenuescorresponded to local advertising (local display and classified advertising).

variable to proxy for profitability (scaled by Total Assets). Alternatively, we also considerReturn on Assets (ROA) and Return on Sales (ROS) as measures of currentprofitability.

The results are presented in Table 1. Using any of the three profitability proxies(Columns A to C) or the three together (Column D),

10 the results show a negative and

significant coefficient for the PMC proxy. Controlling for size, profitability, non-debt taxshields and growth opportunities, as the extent of product market competition falls (asthe proxy increases), firms reduce their debt ratios. Moreover, the effect is economicallysignificant. A firm with the mean debt ratio of 0.2 that goes from being a pure oligopolyto being a pure monopoly, will experience a reduction in its debt ratio of 0.1 (roughlyaveraging the coefficients from the three regressions), i.e., a 50% reduction of its debtratio.

The control variables are significant and have the same sign as in previous empiricalstudies.

11 The results are robust to the use of different proxies for the controls and the

dependent variable,12

to the inclusion of a time trend,13

to a FGLS correction for thepresence of autocorrelation, to considering robust standard errors, and to restrictingattention to a balanced subpanel..We might be concerned about the possibility that firms’ financial situation affects thedegree of competition that they face. For example, we may speculate that financiallyhealthy firms could use their deeper pockets to prey on their rivals, and eventuallybecome local monopolists, or that monopolies maintain low debt level to dissuadepotential rivals from entering their market. We address this endogeneity concern byestimating a 2SLS regression instrumenting for PMC.

The declining trend in the number of cities with competing newspapers is associatedwith the development of other media, which has reduced newspapers’ share ofadvertiser and consumer demand. Rosse and Dertouzos (1978) report that a 1%increase in TV’s share of aggregate advertising expenditure reduces newspapers’advertising revenue by nearly 1%. The decline is also associated with the process ofsuburbanization, which has affected central-city newspaper demand; and to a greatersocial integration in American society, which has reduced the ability of newspaper firms

10 Similar results are obtained when the profitability proxies are included in pairs.

11 Harris and Raviv (1991) conclude that “leverage increases with fixed assets, non-debt

tax shields, growth opportunities, and firm size and decreases with volatility, advertisingexpenditures, research and development expenditures, bankruptcy probability,profitability and uniqueness of the product.”12

We have alternatively defined the debt ratio as Total Debt/Book Value of Equity, andTotal Debt/Book Value of the Firm. Results are robust to these alternativesspecifications. Debt ratios could also be calculated as a proportion of market value ofthe firm. However, using market value ratios could create spurious correlation betweenthe extent of competition and leverage. If its rival exits, we expect a firm’s stock price torise, reducing the debt ratio. Thus, we would spuriously observe that, as the extent ofPMC decreases, debt levels decrease, even without any direct effect being present.13

Because the extent of competition that newspaper firms face has been declining overtime, we may wonder whether PMC is spuriously capturing a general trend of decliningdebt ratios. The trend for US corporations is actually the opposite. There has been asecular increase in leverage since World War II (Taggart, 1985).

to offer products differentiated by, for example, political, social, or ethnic characteristics(Rosse, 1978).

We instrument for PMC using the total number of TV, AM and FM radio stations, andcable TV subscribers in the US to measure the development of these other mass media.The 2SLS results in Table 2 confirm our previous findings. Controlling for potentialendogeneity concerns by using the development of other media to instrument forchanges in the extent of competition, as the degree of competition falls, firms reducetheir debt ratios.

These results suggest that the extent of competition that firms face in the productmarkets has an effect on their capital structure. In particular, the evidence is consistentwith the predictions of the strategic use of debt models. If newspaper firms take on debtfor strategic reasons, as these models suggest, we would additionally expect to observean effect of capital structure on prices. We now turn to analyze this issue.

4. The Effect of Capital Structure on PricesWe start by considering all the newspapers included in the top 50 (according tocirculation levels as of September 30 of each year) in any year between 1984 and 1995.The analysis starts in 1984 because, since July 1, 1984, advertising prices for all thenewspapers are expressed in the same space units, the Standard Advertising Unit(SAU). We restrict our attention to newspapers published by US public parentcompanies, for which there is financial information available from COMPUSTAT.

From the initial sample, newspapers published for more than one market,14

andnewspapers published under Joint Operating Agreements are excluded.

15 We also

exclude newspapers published by firms that do not have newspaper publication as theirmajor line of business as we will use our intra-industry results from section 3 toinstrument for debt levels.

16 We drop one observation for a newspaper which has only

that observation as we will use newspaper-fixed effects.17

Two editions of the samenewspaper or two newspapers published by the same firm in the same city areconsidered one newspaper (and the combination advertising rate is used). Local andnational advertising rates for each newspaper are available biannually from 1985 to1993 (five observations per newspaper). The final sample has 26 newspapers and 108newspaper-year observations.

14 It is not possible to define market variables for these newspapers. This criterion

excludes the national newspapers, USA Today and Wall Street Journal, and New YorkNewsday, which was published for both the Long Island and New York City markets.15

This criterion excludes all the newspaper-year observations for Times, Seattle; Free-Press and News, Detroit; and Press, Pittsburgh; and some newspaper-yearobservations for Herald, Miami.16

This criterion excludes News, Buffalo, published by Berkshire Hathaway Inc.; andStar-Telegram, Forth Worth, and Star-Times, Kansas City, published by CapitalCities/ABC.17

This observation corresponds to Times Herald, Dallas.

Newspaper firms set four prices: circulation price, local display price, national displayprice, and classified price.

18 There is not enough variation in cover circulation prices,

19

and there are not homogeneous subscription and classified prices to analyze circulationand classified prices. Therefore, we concentrate on local and national displayadvertising prices. We analyze the effect of capital structure on prices, controlling fordemand and supply conditions, by running the following regression for both local andnational advertising prices:

20

Ε ΦRate Citypop Citypop Wage Paper Inkit it it it t tΖ Η Η Η Η↔ ↔ ↔ ↔ ↔

1 2

2

3 4 5

Ε ΦΗ Η Η Η Η↔ ↔ ↔ ⁄6 7 8Oligopoly Debt Oligopoly Debt Fixed

it it it it i it* δ

The equation states that advertising prices for newspaper i at time t are a function ofvariables affecting advertising space demand and supply: demographic variables (citypopulation, and city population squared),

21 cost variables (labor, paper, and ink), market

structure (oligopoly or monopoly), and capital structure. We include newspaper-fixedeffects.

22 Alternatively, we also include year-effects instead of the cost variables paper

and ink.23

It is not necessary to control for the degree of multimarket contact betweenthe newspaper chains in the sample because it is negligible (there are only 2 cases inwhich firms met in more than one market).

24

We explore whether firms use capital structure to affect market equilibria in situations ofstrategic interaction. As monopolies would not have such an incentive to take on debt,we allow the effect of debt on prices to be different for monopolies than for oligopoliesby including as explanatory variables both the debt ratio, and the interaction betweendebt ratio and market structure. Our interest is focused on the last two coefficients,which measure the effect of capital structure on prices under monopolistic andoligopolistic conditions.

18 Local rates are charged to local advertisers, and national rates are charged to

national advertisers. There is strong price discrimination by newspaper firms betweenlocal and national advertisers (see American Association of Advertising Agencies).Prices for national advertisers are about double those for local advertisers.19

In 1985, for example, 14 out of 17 newspapers in the sample cost $0.25. There seemto be significant “menu costs” in cover prices. Prices are only expressed in exact coinamounts, preferably quarters. For many newspapers, prices stayed at $0.25 for severalyears and then jumped to $0.50.20

Data definition, sources and summary statistics are presented in the Appendix.21

Results are robust to including other demographic variables (number of households,income, employment, and retail sales) besides population. All these variables show avery high degree of collinearity among them.22

We do not include other controls such as chain membership, or all-day, morning &evening, and tabloid dummies because these characteristics are captured by the fixedeffects. Results are robust to also controlling for these characteristics.23

These cost variables correspond to commodities priced at the national level. Therewould be perfect collinearity if year-effects and paper and ink cost variables wereincluded simultaneously.24

Chicago Tribune Co. and News America Pub. Co. (R. Murdoch) met in Chicago andNew York in 1985, and New York Times Co. and News America Pub. Co. (R. Murdoch)met in Boston and New York in 1993.

The results, presented in Table 3, show a negative coefficient for the Debt Ratio variable(although it is not significant for the national rates), and a positive and significantcoefficient for the interactive Debt Ratio*Oligopoly variable. We reject the hypothesisthat the sum of these two coefficients equals zero for both the local and the nationalrates. Thus, the results show that debt ratios have a negative effect (non-significant forthe national rates) on prices for monopolies, but a positive and significant effect foroligopolies. The control variables show that the cost variables have a positive effect onprices, and that monopolies charge higher rates than oligopolies.

Again, we have to deal here with endogeneity concerns. Just as firms’ debt levels mayaffect their prices, demand or supply shocks may affect their financial positions. Weaddress this problem by estimating our regression in 2SLS using our results from theprevious section to instrument for debt ratios. We use as instruments for debt thedegree of PMC, profitability,

25 size, non-debt tax shields, and growth opportunities. As

discussed before, these instruments could also be affected by current supply or demandshocks. We alleviate these problems by lagging all the instruments.

26 These

endogeneity concerns are further mitigated by the fact that our balance sheet data areat the parent company level, while our prices are at the newspaper level. For most of thenewspapers in our sample, each of these newspapers represent only a portion of thebusiness of the parent company, and therefore we expect that current shocks affectingthese prices only have a moderate effect on the parent company accounts.

In Table 4, we present the 2SLS results using lagged PMC, retained earnings, size,non-debt tax shields, and growth opportunities to instrument for debt ratios.

27 For

monopolies, debt ratios show a negative and non-significant effect on prices for both thelocal and national advertising rates. For oligopolies, debt ratios have a positive andsignificant effect on prices for both local and national advertising rates.

The negative effect of debt ratios on prices for monopolies is not a robust result. It isobtained for the local rates in our OLS regressions in Table 3, but it vanishes when weinstrument for debt ratios in Table 4. It might originate in changes in leverage associatedwith factors not captured by the strategic-use-of-debt models. In those models,monopolies would have no incentives to take on debt. The positive effect of debt ratioson prices for oligopolies suggests that leveraging can help firms to sustain higherequilibrium prices in situations of product market interaction. These results coincide withprevious findings for oligopolistic industries by Chevalier (1995), Chevalier andScharfstein (1996), and Phillips (1995), and with theoretical predictions by Phillips(1991), Showalter (1995), and Schargrodsky (1997).

5. ConclusionsThe main contribution of this paper is to analyze the effect of the extent of competitionthat firms face on their capital structure. In the US newspaper industry, debt ratios

25 We use Retained Earnings, rather than ROA or ROS, to proxy for profitability because

it reflects past profitability and, thus, is less likely to be affected by current shocks.26

For prices as of July 1 of year t, we use instruments as of December 31 of year t-2.27

We lose four observations because of missing information in COMPUSTAT (seefootnote 1).

decrease as the extent of product market competition falls. We also explore the effect ofcapital structure on advertising rates in the US newspaper industry. For monopolies,debt ratios show a negative and mainly non-significant effect on prices. For oligopolies,debt ratios have a significant and positive effect on prices. The oligopoly results coincidewith previous findings for oligopolistic industries (Chevalier, 1995; Chevalier andScharfstein, 1996; and Phillips, 1995). Our findings are consistent with the predictions ofthe models that show that firms engaged in situations of strategic interaction can usecapital structure as a collusion-facilitating device (Phillips, 1991; Showalter, 1995;Schargrodsky, 1997), but not with the predictions of the models that obtain that debtfinancing commits firms to more aggressive output strategies (Brander and Lewis, 1986,1988).

The newspaper industry is particularly appropriate for our study on the effect ofcompetition on capital structure because in this industry there were significant andexogenous changes in the extent of competition that firms face. For the study of theeffect of capital structure on prices, the variation in debt ratios in this industry cannot bedirectly associated to exogenous shocks, like the leveraged buyouts considered inChevalier (1995). However, by exploiting our results on the determinants of capitalstructure, and the fact that our newspapers represent only a fraction of the business oftheir parent companies, we have been able to obtain satisfying results. It is alsoreassuring that these price results coincide with previous findings in the literature. Ofcourse, it would be nice to find an industry with clearly identifiable exogenous shocksboth to competition and capital structure.

The strategic-use-of-debt models show that under imperfect competition firms may havestrategic incentives to take on debt. Monopolistic or perfectly competitive firms will nothave similar incentives. Graphically, these theories predict an inverted U-shapedrelationship between concentration and debt levels, i.e., that oligopolistic firms havehigher debt levels than monopolistic or perfectly competitive firms. We have exploredone part of this prediction by comparing debt ratios by monopolistic and oligopolisticfirms. It would be interesting to compare leverage levels for a sample consideringmonopolistic, oligopolistic, and competitive firms. As it is unlikely that there is an industrywith firms acting in this variety of market structures, this should probably be performedas an inter-industry study. This inverted U-shape would coincide with similar findings forthe relationship between concentration and other variables, such as advertising or R&Dexpenditure levels.

APPENDIX

Data Definition and Sources

Variable Definition Source

Debt Total Debt/Total Assets COMPUSTATPMC See text Editor & Publisher

International YearbookRetainedEarnings

Retained Earnings/Total Assets COMPUSTAT

ROA Operating Income/Total Assets COMPUSTATROS Operating Income/Sales COMPUSTATGrowthOpport.

Market Value of Common Equity/BookValue of Common Equity

COMPUSTAT

Size Ln(Sales in constant $) COMPUSTATNon-Debt TaxShield

Depreciation and Amortization/Total Assets COMPUSTAT

TV US television stations on air Television & Cable FactbookRadioAM

Licensed US radio AM stations Television & Cable Factbook

RadioFM

Licensed US radio FM stations Television & Cable Factbook

Cable Thousand of US cable TV subscribers Television & Cable FactbookRate(localandnational)

Rate per inch for a 1,000 inch-annual bulkcontract (most representative contractaccording to A.A.A.A.) for local or nationaladvertisers (combination rate for twoeditions of the same newspaper or twonewspapers published by same firm).

Newspaper Rate Differentials:A.A.A.A. Study of Generaland Retail Advertising Rates,American Association ofAdvertising Agencies

CityPop City population Editor & Publisher MarketGuide

Wage Publication industry (SIC 2711) wage at thestate level

Employment and Wages -Annual Averages-, andEmployment and Earnings,Bureau of Labor Statistics

Paper Newsprint price index Producer Price Indexes,Bureau of Labor Statistics

Ink Printing ink price index Producer Price Indexes,Bureau of Labor Statistics

Oligopoly Dummy=1 if newspaper is a central-cityoligopolist, =0 if newspaper is a central-citymonopolist

Editor & PublisherInternational Yearbook

Summary Statistics

Debt Study

Variable Mean Std. Deviation Min Max

Debt 0.20216 0.12857 0.00011 0.55727PMC 0.62873 0.40827 0 1Retained Earnings 0.48347 0.15413 0.09132 1.00170ROA 0.20681 0.06222 0.06353 0.50099ROS 0.20158 0.06095 0.05150 0.54983Growth 2.59260 1.71590 0.36009 16.07037Size 5.44263 1.00846 2.71621 7.07791Non-Debt TaxShield

0.04312 0.01265 0.01603 0.09745

TV 1197.453 241.5861 668 1533Radio AM 4750.6 205.7138 4126 4990Radio FM 5017.469 1274.956 1597 7240Cable 30996.47 19381.72 1275 60280

Price Study

Variable Mean Std. Deviation Min Max

Local Rate 75.80194 40.68343 24.87 197.85National Rate 154.9831 83.89403 55.89 412CityPop 1256166 1894348 129990 7635041Wage 455.1204 101.0188 260 858Paper 120.5981 6.28765 110.3 129.3Ink 106.438 6.45393 97.3 113.4Oligopoly 0.35185 0.47977 0 1Debt 0.25739 0.13059 0.00618 0.76502Retained Earnings 0.45378 0.14924 0.09132 0.92983Growth 2.94792 1.53600 1.47346 16.07037Size 6.20982 0.75145 4.62230 7.07791Non-Debt TaxShield

0.04752 0.01141 0.01961 0.09745

PMC 0.54268 0.38831 0 1

ReferencesAmerican Association of Advertising Agencies, Newspaper Rate Differentials: A.A.A.A.

Study of General and Retail Advertising Rates, several issues.Bowen, Robert M., Lane A. Daly and Charles C. Huber, Jr., 1982. “Evidence on the

Existence and Determinants of Inter-industry Differences in Leverage.” Financial Management, Vol. 11, pp. 10-20.

Bradley, Michael, Gregg Jarrell and E. Han Kim, 1984. “On the Existence of an Optimal Capital Structure: Theory and Evidence.” Journal of Finance, Vol. 39, No.3, pp. 857-877.

Brander, James A. and Tracy R. Lewis, 1986. “Oligopoly and Financial Structure.” American Economic Review, Vol.76, No. 5, pp. 956-970.

Brander, James A. and Tracy R. Lewis, 1988. “Bankruptcy Costs and the Theory of Oligopoly.” Canadian Journal of Economics, Vol.21, No. 2, pp. 221-243.

Busterna, John C., 1988. “Concentration and the Industrial Organization Model,” inPress Concentration and Monopoly: New Perspectives on NewspaperOwnership and Operation, Norwood, New Jersey.

Chevalier, Judith A., 1995. “Do LBO Supermarkets Charge More? An Empirical Analysis of the Effects of LBOs on Supermarket Pricing.” Journal of Finance, Vol. 50, No. 4, pp. 1095-1112.

Chevalier, Judith A. and David S. Scharfstein, 1996. “Capital-Market Imperfections and Countercyclical Markups: Theory and Evidence.” American Economic Review, Vol. 86, No. 4, pp. 703-725.

Harris, Milton and Artur Raviv, 1991. “The Theory of Capital Structure.” Journal of Finance, Vol. 46, No. 1, pp. 297-355.

Kovenock, Dan and Gordon Phillips, 1995. “Capital Structure and Product-Market Rivalry: How Do We Reconcile Theory and Evidence?.” American Economic Review, Vol. 85, No. 2, pp. 403-408.

Myers, Stewart and Nicholas Majluf, 1984. “Corporate Financing and Investment Decisions When Firms Have Information That Investors Do Not Have.” Journal ofFinancial Economics, Vol. 13, No. 2, pp. 187-221.

Phillips, Gordon M., 1991. “Financial Slack, Refinancing and Firm Interaction” in Capital Structure Decision: Firm Performance and Competition, Unpublished doctoral dissertation, Harvard University.

Phillips, Gordon M., 1995. “Increased Debt and Industry Product Markets. An Empirical Analysis.” Journal of Financial Economics, Vol. 37, pp. 189-238.

Rajan, Raghuram and Luigi Zingales, 1995. “What Do We Know about CapitalStructure? Some Evidence from International Data,” Journal of Finance, Vol. 50,No 5, pp. 1421-1460.

Rosse, James N., 1978. “An Economist’s Description of the Media Industry,” in Proceedings of the Symposium on Media Concentration, Washington, DC, FTC.

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Showalter, Dean M., 1995. “Oligopoly and Financial Structure: Comment.” American Economic Review, Vol. 85, No. 3, pp. 647-653.

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Tillinghast, Diana, 1988. “Limits of Competition,” in Press Concentration and Monopoly: New Perspectives on Newspaper Ownership and Operation, Norwood, New Jersey.

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Table 1

Dependent Variable: Total Debt/Total Assets

Variables (A) (B) (C) (D)

PMC -0.11965***(-3.982)

-0.08265**(-2.569)

-0.08162**(-2.462)

-0.11757***(-3.930)

RetainedEarnings

-0.36379***(-8.604)

-0.33519***(-7.275)

ROA -0.49905***(-4.498)

-0.31151**(-2.279)

ROS -0.20968(-1.312)

0.33344*(1.856)

GrowthOpportunities

0.01160***(3.887)

0.01953***(5.768)

0.01622***(4.613)

0.01238***(3.786)

Size 0.07758***(5.807)

0.08174***(5.659)

0.09086***(5.795)

0.06615***(4.543)

Non-Debt TaxShields

-0.02170(-0.039)

-0.67073(-1.118)

-0.64600(-1.044)

-0.05963(-0.107)

Firm-fixedeffects

YES YES YES YES

Observations 320 320 320 320R

20.6924 0.6397 0.6172 0.6982

Method OLS OLS OLS OLS

t-statistics are in parentheses. The controls Retained Earnings, ROA, ROS, GrowthOpportunities, Size, and Non-Debt Tax Shield are lagged.* Significant at the 10% level** Significant at the 5% level*** Significant at the 1% level

Table 2

Dependent Variable: Total Debt/Total Assets

Variables (A) (B) (C) (D)

PMC -0.24878***(-3.323)

-0.25460***(-3.044)

-0.23353***(-2.719)

-0.17762**(-2.577)

RetainedEarnings

-0.39034***(-8.525)

-0.34975***(-7.173)

ROA -0.50220***(-4.321)

-0.29971**(-2.169)

ROS -0.20537(-1.242)

0.33711*(1.863)

GrowthOpportunities

0.01018***(3.214)

0.01792***(4.955)

0.01475***(3.964)

0.01156***(3.400)

Size 0.08901***(5.919)

0.09795***(5.843)

0.10506***(5.895)

0.07135***(4.570)

Non-Debt TaxShields

0.16062(0.275)

-0.48243(-0.761)

-0.47884(-0.741)

0.03019(0.053)

Fixed effects YES YES YES YESObservations 320 320 320 320R

20.6731 0.6047 0.5898 0.6940

Method 2SLS 2SLS 2SLS 2SLS

t-statistics are in parentheses. The controls Retained Earnings, ROA, ROS, GrowthOpportunities, Size, and Non-Debt Tax Shield are lagged. The instruments are TV,Radio AM, Radio FM, and Cable.* Significant at the 10% level** Significant at the 5% level*** Significant at the 1% level

Table 3

Dependent variable: Advertising Rates

Variables Local Advertising Rate National Advertising RateCost Variables Year Effects Cost Variables Year Effects

City Population -0.0000307(-1.328)

-0.0000293(-1.263)

-0.0001011**(-2.069)

-0.000998**(-2.108)

(CityPopulation)

24.51e-12**

(2.419)4.70e-12**

(2.500)1.17e-11***

(2.959)1.26e-11***

(3.290)Wage 0.15883***

(5.350)0.13875***

(3.480)0.40250***

(6.405)0.26435***

(3.248)Paper 0.21731*

(1.765)0.15553(0.597)

Ink 0.42198*(1.762)

1.05588**(2.083)

Oligopoly -50.98568***(-6.486)

-50.08663***(-6.321)

-98.88034***(-5.943)

-95.83762***(-5.926)

Debt Ratio -16.91059*(-1.864)

-20.73652**(-2.146)

-10.52878(-0.548)

-10.96742(-0.556)

Debt Ratio*Oligopoly

52.83895***(3.258)

52.18699***(3.207)

74.03428**(2.157)

73.19883**(2.204)

Fixed-effects YES YES YES YESYear-effects NO YES NO YESF-stat.

†5.78** 4.14** 4.03** 3.90*

Observations 108 108 108 108R

20.9833 0.9837 0.9824 0.9840

Method OLS OLS OLS OLS

t-statistics are in parentheses† Null hypothesis: “Debt Ratio” coefficient + “Debt Ratio*Oligopoly” coefficient=0* Significant at the 10% level** Significant at the 5% level*** Significant at the 1% level

Table 4

Dependent variable: Advertising Rates

Variables Local Advertising Rate National Advertising RateCost Variables Year Effects Cost Variables Year Effects

City Population -0.0000303(-1.203)

-0.000029(-1.114)

-0.0000946(-1.661)

-0.000098(-1.619)

(CityPopulation)

24.33e-12**

(2.164)4.49e-12**

(2.134)1.11e-11**

(2.444)1.20e-11**

(2.449)Wage 0.17243***

(4.978)0.15753***

(3.277)0.44712***

(5.712)0.33811***

(3.029)Paper 0.22424

(1.201)-0.06704(-0.159)

Ink 0.36275(1.284)

0.79710(1.249)

Oligopoly -67.25085***(-3.774)

-70.70075***(-3.902)

-145.9529***(-3.624)

-163.9019***(-3.895)

Debt Ratio -33.38349(-1.420)

-35.40584(-1.314)

-29.13459(-0.548)

-39.94747(-0.638)

Debt Ratio*Oligopoly

102.2169**(2.058)

114.2487**(2.276)

218.423*(1.946)

276.9992**(2.376)

Fixed-effects YES YES YES YESYear-effects NO YES NO YESF-stat.

†2.70 3.19* 4.00** 5.35**

Observations 104 104 104 104R

20.9821 0.9813 0.9783 0.9760

Method 2SLS 2SLS 2SLS 2SLS

t-statistics are in parentheses. The lagged instruments are PMC, Retained Earnings,Growth Opportunities, Size, and Non-Debt Tax Shield.† Null hypothesis: “Debt Ratio” coefficient + “Debt Ratio*Oligopoly” coefficient=0* Significant at the 10% level** Significant at the 5% level*** Significant at the 1% level