19 Jul 2011Working Paper Summaries

Signaling to Partially Informed Investors in the Newsvendor Model

by Vishal Gaur, Richard Lai, Ananth Raman and William Schmidt

Why might firms make operational decisions that purposefully do not maximize expected profits? This model looks at the question by developing scenarios using the example of inventory management in the face of an external investor. The research was conducted by Vishal Gaur of Cornell University, Richard Lai of the University of Pennsylvania, and Ananth Raman and William Schmidt of Harvard Business School. Key concepts include:

Companies face pressure from external investors that leads them to make suboptimal operations decisions. This pressure arises from three forces: a strong prior belief that firms are of a "low" type (one with a low quality investment opportunity), an inability for firms to mitigate the information asymmetry regarding their actual type, and an emphasis on short-term valuation.
Surprisingly, this scenario includes instances in which a firm with a high quality investment opportunity finds it attractive to underinvest.
There have been relatively few applications of signaling games in the operations management literature and this model provides an important application of signaling game theory to the problem of inventory management in the face of an external investor.
The researchers find several real-life examples in which firms faced pressure to underinvest, and how the firms chose to deal with those situations. One example is the decision by French upscale beauty brand Clarins Group to go private in 2008. The move relieved management of shareholder pressure for short-term profits and allowed them to pursue longer-term opportunities that eventually paid off.
The model can be effectively applied regardless of whether the decision is about inventory or some other type of capacity investment, including plant expansions, capital expenditures, and contracting for production inputs.

Author Abstract

We investigate a puzzling phenomenon in which firms make investment decisions that purposefully do not maximize expected profits. Using an extension to the newsvendor model, we focus on a relatively common scenario in which the firm's investor has imperfect information concerning the quality of the firm's investment opportunities. We apply Perfect Bayesian equilibrium solution concepts and confirm that over a range of reasonable model parameters the firm's investment decision does not maximize expected profits. Surprisingly, this includes instances in which a firm with a higher quality investment opportunity finds it attractive to underinvest, thereby behaving as if the investor faces a lower quality investment opportunity. This is particularly interesting, as prior research in finance literature has shown that firms will overinvest in high quality projects when investors have imperfect information about the quality of the firm's opportunities. While we conduct our analysis in the context of an inventory stocking decision, our model is generalizable to other types of capacity investment decisions.