Influence and Inefficiency in the Internal Capital Market: Theory and Evidence

Abstract

I model inefficient resource allocations that result from influence activities by division managers in M-form organizations. Division managers distort private information about relative investment opportunities and skew capital budgets in their favor. Corporate headquarters faces a tradeoff between the cost of attaining an accurate private signal and the value of the information the signal provides. To mitigate influence activities, headquarters incorporates implicit investment contracts into capital budgeting processes that alter the sensitivity of investment to private signals (possibly distorted) and public signals (not distorted, but noisy). The contracts lead to inefficient resource allocations relative to first-best and this inefficiency is most pronounced in firms with more influential managers, lower private costs of influencing, and greater uncertainty in investment opportunities. Several predictions of the model are consistent with existing evidence.