Financial frictions and market power accumulation

This paper examines the interplay between market power and financial frictions, highlighting the bidirectional relationship between firms' access to finance and competitive dynamics. We develop a theoretical model where firms invest in technology to enhance product quality, which increases their market power. In our model, firms with greater market power can invest more, thereby reinforcing and accumulating additional market power in subsequent periods. However, the general equilibrium effects of reducing financial frictions is not clear. Specifically, when financial frictions are relaxed, firms can invest more, enabling them to produce at higher margins. This results in an increase in aggregate average market power. On the other hand, a reduction in financial frictions could also facilitate the entry of new firms into the market, thereby increasing competitive pressure. Our results indicate that an increase in investment, driven by reduced financial frictions, does not necessarily enhance competition unless the entry of new firms accompanies it. Through empirical analysis, using data from publicly listed U.S. firms, we test that firms with more market power are subjected to less financial frictions pressures in the subsequential periods. Empirical evidence also suggests higher levels of market power in the earlier period are correlated with less financial constraints in later periods.