How Do Firm Financial Conditions Affect Product Quality and Pricing?

We analyze the interaction of firm product quality and pricing decisions with financial distress and bankruptcy in the airline industry. We consider an airline’s choices of quality and price as dynamic decisions that trade off current cash flows for future revenue. We examine how airline mishandled baggage, on-time performance and pricing are related to financial distress and bankruptcy, controlling for the endogeneity of financial distress and bankruptcy. We find that an airline’s quality decisions are differentially affected by financial distress and bankruptcy. Product quality decreases when airlines are in financial distress, consistent with financial distress reducing a firm’s incentive to invest in quality. In contrast, in bankruptcy product quality increases relative to financial distress. In addition, we find that firms price more aggressively when in financial distress consistent with firms trying to increase short-term market share and revenues. ∗University of Southern California and NBER, **University of Houston. Phillips can be reached at [email protected]. Sertios can be reached at [email protected]. We wish to thank Sheri Tice, our discussant at the 2011 American Finance Association meetings and also Roger Betancourt, Eyal Dvir, Ginger Jin, Ivan Marinovic, John Shea and seminar participants at London Business School and the Norwegian School of Management for helpful comments.