Self-Imposed Investment Rationing in Light of Discretionary Disclosures

The role of investment rationing by one party to discipline reporting of private information by another is well recognized. Formally, adverse selection models succinctly capture this effect via the crisp information rents vs. efficiency tradeoff. This paper takes a different slant to investment rationing by showing that production cuts can also be self-imposed: by scaling down his upfront investments, an entrepreneur can discipline his own subsequent aggressive reporting behavior. In particular, in this paper, a higher investment by an entrepreneur raises his stakes, magnifying his incentives to acquire and selectively disclose information in order to manipulate market price. Of course, the rational market is not fooled and responds by suitably discounting price. As a consequence, the upfront lowering of investment permits the entrepreneur to credibly signal to the market that he will limit his shenanigans thereby also limiting retaliatory market penalties