Working Paper | HBS Working Paper Series | 2011

Signaling to Partially Informed Investors in the Newsvendor Model

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

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 she faces a lower quality investment opportunity. This is particularly interesting as prior research in the 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.

Keywords: Decision Choices and Conditions; Investment; Profit; Logistics; Performance Capacity; Game Theory; Valuation;

Citation:

Schmidt, William, Vishal Gaur, Richard Lai, and Ananth Raman. "Signaling to Partially Informed Investors in the Newsvendor Model." Harvard Business School Working Paper, No. 11-105, April 2011. (Revised March 2012.)