Product Market Competition and Real Activities Manipulations: Theory, Implications, and Applications

We investigate how a firm manipulates its real activities in production to meet the earnings target in product market competition against its product-market rivals. We show that the equilibratory way to reach the earnings target is to set a higher first-period output level, reaching a higher short-term profit level. However, once the expected level of demand uncertainty is high, a firm will exploit this effect on its output choice by taking a mixed strategy and raising its short-term output level. This result suggests that one should consider longer-horizon paths of variables to detect opportunistic real activities manipulation. Based on our results, we further argue that competitive strategy is an omitted variable in real activities manipulation estimation models and recommend that capacity utilization, which is related to a firm’s output competitive decisions, should be included in the first-stage models of normal investment levels in Roychowdhury (2006) and Gunny (2010).