We show that in business groups with efficient internal capital markets, resources may be channelled to either more or less profitable units. Depending on the amount of internal resources, a group may exit a market in response to increased competition, or rather channel funds to the subsidiary operating in that market. This has important implications for the strategic impact of group membership. Affiliation to a monopolistic subsidiary can make a cash-rich stand-alone firm more vulnerable to entry deterrence. Conversely, a cash-poor firm becomes less sensitive to its financial constraints upon affiliation to a group, and thus less vulnerable to entry deterrence. Finally, resource flexibility within a group makes subsidiaries’ reaction functions flatter, thus discouraging rivals’ strategic commitments when entry is accommodated.

Business groups are a widespread organizational form in many countries. Groups often adopt a pyramidal structure, whereby individual subsidiaries are separate legal entities with limited liability and autonomous access to external capital markets. This marks a clear difference between business groups and multidivisional organizations.1 Yet, there is substantial evidence that groups establish internal capital markets just like multidivisional firms do.2 While many empirical studies of internal capital markets have looked at business groups, theoretical models have instead focussed on multidivisional firms. This paper is one of the first attempts to model the allocation of internal resources among group members.