Penalties, Manipulation, and Investment Efficiency

Lin Nan () and Xiaoyan Wen ()
Additional contact information
Lin Nan: Krannert School of Management, Purdue University, West Lafayette, Indiana 47906
Xiaoyan Wen: Neeley School of Business, Texas Christian University, Fort Worth, Texas 76129

Management Science, 2019, vol. 65, issue 10, 4878-4900

Abstract: In this study, we examine whether imposing a penalty based on an earlier positive signal and a bad realized outcome can be welfare-improving. We find that imposing a penalty helps to improve investment efficiency, but it also brings a deadweight cost of potential penalty for entrepreneurs with good projects. We show that when a good project has a much larger chance to achieve a good outcome than a bad project or when a large proportion of the penalty can be reimbursed to the investor, it is optimal to impose a penalty to deter entrepreneurs with bad projects from reporting positive signals to the greatest degree, as the benefit from reducing the investment inefficiency outweighs the expected deadweight cost. Otherwise, it is optimal not to impose any penalty. We also find that a larger penalty may induce more manipulation by a good entrepreneur. This is because, although a larger penalty directly discourages manipulation for both good and bad types by increasing the expected penalty cost, it also encourages upward manipulation by lowering the implicit financing cost upon a high signal. The encouraging effect is mostly pronounced for the good entrepreneur when the good entrepreneur has a much larger chance of success than the bad entrepreneur or when the reimbursement proportion is very high.

Keywords: optimal penalty; manipulation; investment efficiency (search for similar items in EconPapers)
Date: 2019
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (1)

Downloads: (external link)
https://doi.org/10.1287/mnsc.2018.3149 (application/pdf)

Related works:
This item may be available elsewhere in EconPapers: Search for items with the same title.

Export reference: BibTeX RIS (EndNote, ProCite, RefMan) HTML/Text

Persistent link: https://EconPapers.repec.org/RePEc:inm:ormnsc:v:65:y:2019:i:10:p:4878-4900

Access Statistics for this article

More articles in Management Science from INFORMS Contact information at EDIRC.
Bibliographic data for series maintained by Chris Asher ().