Information Acquisition and Resource Allocation Decisions

Ramji Balakrishnan

Firms' investment practices often seem to be suboptimal; for example, they may ration capital or underinvest in risky projects. Recent research (e.g., Antle and Eppen 1985, Antle and Fellingham 1990, Harris et al. 1982) argues that these practices might be optimal responses to contracting frictions that arise from information asymmetry among the members of the firm. Analyzing a two-person firm, these studies endow the manager with pre-decision information about the returns from a given project and examine the owner's optimal response to the information asymmetry. This article expands the problem in two ways. First, it considers the choice between two competing projects. Second, it explicates the source of the manager's information superiority: proximity to the firm's operations advantage the manager in both acquiring and knowing the cost-benefit of additional information pertinent to project choice. Because of the manager's advantage, the owner cannot infer why the project was selected. The owner's response to the information asymmetry must optimize over both the information-acquisition and resource-allocation decisions. This article considers a model in which the manager must choose between a risk-free and a risky project. The owner delegates project selection because of the manager's pre-contract information superiority and because only the manager can obtain post-contract additional, costly information. Delegating project choice, however, creates a coordination problem because of the owner's inability to observe whether the manager expended effort on information search and because the value of additional information depends on the manager's pre-contract information (i.e., on the manager's type). Using the observed variables (project choice and realized profit), the optimal contract must (1) motivate a subset of manager types to select the project after expending effort on information search, and (2) motivate the complementary set to condition project selection on their pre-contract information alone. The model considered here is related to that of Demski and Sappington (1987) which considers issues involved in contracting with an "expert" who is uniquely qualified to acquire pertinent information, and Lambert (1986) applying this concept to a project-selection setting. Pre-contract asymmetry about the value of search is the crucial difference between previous research and this study. Absent information asymmetry (in the first-best solution), the information-acquisition problem is separable from the resource-allocation problem. The owner asks for search only from those manager types for whom the value to search exceeds cost. (The set of such manager types is convex because the value to search is concave in manager type.) Also, the manager uses all available information to choose the more profitable project. However, the owner cannot attain this first-best solution without information about manager type and information search. The two problems cannot be decomposed. As a result, the optimal (second-best) contract always induces distortions in information acquisition and, for the case of the risk-averse manager, induces overinvestment in the risky project. Furthermore, communication of the search result is strictly valuable. The results suggest that optimal responses to information asymmetry among the members of the firm could result in practices that seem to disregard the value of information search and to use acquired information sub-optimally. The results also lend support to the use of accounting reports, such as budgets, in managerial performance evaluation.

Information Acquisition and Resource Allocation Decisions

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