Two essays on product pricing and earnings characteristics

Abstract

My dissertation aims at understanding how product market frictions impact the nature of corporate earnings. It contains two essays. In Essay I, I study both theoretically and empirically how nominal price rigidity affects the time-series property of earnings. The friction in this essay is price adjustment cost that prevents firms from adjusting their prices immediately and completely in response to inflation shocks. In a menu-cost framework, I show that in an environment of expected production cost rises, firms react more slowly to unexpected cost decreases than to increases. One central prediction derived from this framework is that symmetrically distributed cost shocks are translated into asymmetrically distributed transitory earnings, with the implication that earnings are less persistent for firms receiving negative cost shocks than for those receiving positive cost shocks. Empirically, I employ a fuzzy regression discontinuity design that captures the spirit of the menu-cost framework to estimate the effect of downward price rigidity on earnings persistence. Particularity, I use a unique dataset and a structural approach to measure the extent to which prices are impacted by cost shocks. I find that firms whose long-run equilibrium prices are negatively impacted by cost shocks experience a sharp decline in earnings persistence relative to firms in opposite situations, and this result holds primarily for industries where costs are expected to rise. Further analysis shows that analysts and investors process earnings information less efficiently for firms delaying their downward price adjustments. In Essay II, I ask whether product market competition impacts firms' information quality through exacerbating adverse selection. The mechanism through which adverse selection endogenously arises is that firms' vigorous competition in price suppresses the revelation of their private information about production costs. Using a novel approach, I construct a measure of "markup distortion" calculated as the extent to which output prices are unfavorably impacted by industry-wide inflation shocks to production costs. I find the adjustment of output price in response to markup distortion is timely in concentrated industries but sluggish in competitive industries. I document the following results that are only observed in competitive industries but not in concentrated industries. First, markup distortion increases information asymmetry between firms and the public through reducing the usefulness of earnings. Second, markup distortion has a significant positive impact on both bond spread and borrowers' reliance on loan financing. Third, the relation between markup distortion and the design and renegotiation of loan contracts is consistent with theory predictions about debt contracting under information asymmetries.

Date of Award	2014
Original language	English
Awarding Institution	The Hong Kong University of Science and Technology