First-best Investment Research Articles

Optimal subsidization for the adoption of new irrigation technologies

Cost-sharing subsidies partially cover the fixed costs of water-saving technologies, promoting their adoption as one of the major irrigation water demand management tools that improve on-farm irrigation system efficiency and potentially free up more water for higher-value uses in water-scarce areas. In this study, we investigate the optimal subsidization scheme in the presence of adverse selection problems where the farmer’s wealth is her private information using a theoretical model of a centralized regulatory structure. In the model, we show that the first-best investment levels can be implemented when the regulator has enough resources for subsidization. Otherwise, the outcome depends on which farmer – the high-wealth farmer or the low-wealth one – contributes more to the social welfare when confronted with their first-best investment levels. Particularly, the model’s findings suggest that an optimal subsidization scheme might involve either high or low wealth farmer’s investment level being downward distorted from their first-best levels. Furthermore, in some circumstances, if the wealth disparity is sufficiently large, it is optimal to subsidize high wealth farmers only. Overall, prioritizing economic efficiency may help conserve scarce irrigation water, but it may also conflict with social equity by denying some farmers access to public subsidies.

Joint investment on resilience of cross-country transport infrastructure

• We examine the joint resilience investment on the cross-country transport infrastructure. • The first-best outcomes can be achieved if the resilience investment is verifiable. • The non-verifiability leads to a downward distortion on investment under higher disruption. • The first-best outcomes can still be achieved under non-verifiability if the disruption is low. Unlike the domestic transport infrastructure, the cross-country ones are subject to more diverse and unconventional disruption risks due to the unstable geopolitical conditions, terrorist attacks, and complex landscape and extreme weather events, thus calling for resilience-related investments from different countries. However, such resilience investment made by one country to deal with such unconventional disruption risk is very hard to be verified by other countries (i.e., non-verifiability). This paper establishes an integrated economic model to analytically examine countries’ joint resilience investments on the cross-country transport infrastructure in presence of non-verifiability. Specifically, there is one “investing country” who constructed the infrastructure which is also used by a “host country”. Our analytical results suggest that the first-best investment and market outcomes for the global welfare maximization can be achieved if the resilience investment is verifiable. The non-verifiability is, however, found to cause a downward distortion in the resilience investment and an upward distortion in transport price when the probability of the disruption is higher such that the resilience investment only partially covers the potential loss. On the contrary, when the probability of disruption is low so that the resilience investment can lead to the full loss coverage, the first-best outcomes can still be achieved without any distortion. Our analytical model is also extended to account for the intermodal competition. Although our main conclusions still qualitatively hold, the intermodal competition is found to have uncertain effects on the market outcomes, depending on the interaction between the resilience investment cost and the degree of the intermodal competition.

Agency problems in public-private partnerships investment projects

This paper examines concession contracts between a private firm and a government in the presence of moral hazard within a real-options framework. The design of optimal contracts to provide incentives to the private firm to exert effort is analyzed. We show that although first-best investment timing can be implemented, contracts often do not provide firms with proper incentives to exert effort, resulting in high-cost projects being undertaken. This problem can be alleviated through the use of a monitoring technology that imposes a penalty on the shirking firm. Although monitoring distorts the investment timing leading to a delayed investment, it increases the government’s profits at the expense of the firm, so that the government finds it optimal to induce effort exertion, increasing the likelihood of low-cost projects. Considering jointly incentives and an exit option, we show that the regular compensation of firms and their compensation upon termination act as substitutes in providing incentives. Governments should set these remunerations jointly in order to minimize the cost of a bailout option for the society.

Contracts and Capacity Investment in Supply Chains

Suppliers are often reluctant to invest in capacity if they believe that they will be unable to recover their investment costs in subsequent transactions with buyers. In theory, a number of different contracts can solve this issue and induce first-best investment levels by the supplier. In this study, we investigate the performance of these contracts in a two-tier supply chain. We develop an experimental design where retailers and suppliers bargain over contract terms—and have the ability to make multiple back-and-forth offers—while also providing feedback on the offers they receive. One key result from our study is that an option contract and a service-level agreement are best at increasing first-best investment levels and overall supply chain profits. However, these same contracts also generate the largest inequity in expected profits between the two parties. We find that both of these results are driven by the bargaining tendencies of retailers and suppliers, which we refer to as “superficial fairness.” In particular, retailers and suppliers place more emphasis on negotiating the wholesale price, while partially overlooking any secondary parameter, such that final wholesale prices end up roughly halfway between the retailer’s selling price and the supplier’s production cost. We show that this bargaining behavior contributes to higher investment levels observed in the option contract and service-level agreement, along with the inequitable payoffs.The online appendix is available at https://doi.org/10.1287/msom.2017.0654 .

R&D Investments in the Presence of Knowledge Spillover and Debt Financing: Can Risk Shifting Cure Free Riding?

In an industry with knowledge spillover and debt financing, equilibrium investments in research and development (R&D) projects are subject to three economic forces. First, knowledge spillover among firms enables free dissemination of new technologies and produces investment synergies. Second, knowledge spillover also causes free riding: in equilibrium, firms underinvest in R&D expecting to benefit from investments by others. Third, debt financing creates incentive for risk shifting: equity holders overinvest in riskier R&D projects. We study how interactions among these forces affect a firm’s investment decisions and equilibrium industry outcomes using a three-stage game between two firms and the external debt market. We characterize subgame perfect, Pareto-dominant equilibria and show that for some parameter choices, free riding and risk shifting cancel each other in the decisions of individual firms, resulting in the first-best investments. Interestingly, for some cases, the equilibrium with first-best investments becomes possible only when risk shifting by one firm enables free riding by the other firm. We also show that debt can be used by firms as a commitment device in a multistage game. This value of debt is shared with investors, who can earn positive profits despite being perfectly competitive. This enriches the understanding of the financial pecking order theory by showing that even firms with unlimited internal capital may prefer external debt financing.This paper has been accepted for the Manufacturing & Service Operations Management Special Issue on Interface of Finance, Operations, and Risk Management.

Dynamic Certification, Reputation for Quality and Industry Standard

We study firm's incentives to invest and build reputation for quality, when quality can be certified at a cost. We consider two types of equilibria: one in which certification decisions are made based on firm's reputation and the second in which they are made based on the time since last certification. We show that reputation-based certification has a very limited effect on incentives to invest in quality, so that in equilibrium the firm invests only its reputation is the lowest. We also show that the firm in this case suffers from an over-certification trap in which the benefits of reputation are dissipated by excessive certification. These problems can be avoided with time-based certification, which can allow first-best investment in quality for sufficiently small certification cost, despite investment being unobservable. We also show that the optimal certification duration results in the firm certifying when its reputation is high.

Interaction between Dynamic Financing and Investments: The Role of Priority Rules

We analyze in a dynamic model how debt priority rules influence firms' initial capital structure choice, investment timing, and subsequent debt issues. We quantify deviations from first-best investment behavior that arise from different debt priority rules, and document surprisingly large deviations caused by well-known rules such as the absolute priority rule. We introduce a new rule, called the efficient priority rule (EPR), that gives equity holders incentives to choose first-best investment timing and financing. Under EPR, old debt has the same value and risk characteristics as if the firm had not invested and new debt had not been issued.

Dynamic Certification and Reputation for Quality

We study firm's incentives to invest and build reputation for quality, when quality can be certified at a cost. We consider two types of equilibria: one in which certification decisions are made based on firm's reputation and the second in which they are made based on the time since last certification. We show that reputation-based certification has a very limited effect on incentives to invest in quality, so that in equilibrium the firm invests only its reputation is the lowest. We also show that the firm in this case suffers from an over-certification trap in which the benefits of reputation are dissipated by excessive certification. These problems can be avoided with time-based certification, which can allow first-best investment in quality for sufficiently small certification cost, despite investment being unobservable. We also show that the optimal certification duration results in the firm certifying when its reputation is high.

Maturity rationing and collective short-termism

Financing terms and investment decisions are jointly determined. This interdependence, which links firms׳ asset and liability sides, can lead to short-termism in investment. In our model, financing frictions increase with the investment horizon, such that financing for long-term projects is relatively expensive and potentially rationed. In response, firms whose first-best investments are long-term may adopt second-best projects of shorter maturities. This worsens financing terms for firms with shorter-maturity projects, inducing them to change their investments as well. In equilibrium, investment is inefficiently short-term. Equilibrium asset-side adjustments by firms can amplify shocks and, while privately optimal, can be socially undesirable.

Real options game over the business cycle

This paper studies the impact of business cycles on firms' strategic investment decisions by developing and solving a continuous time regime-dependent real options game in an asymmetric duopoly. The value functions, roles and optimal investment timing decisions of the two firms in the expansion and recession states are jointly determined. We show that the preemptive investment equilibrium, where the leader invests earlier than its own first-best investment timing, is pro-cyclical. Moreover, the simultaneous investment equilibrium, where the firms simultaneously invest late and enjoy waiting flexibility as a tacit collusion, is counter-cyclical. In addition, we specifically demonstrate that the values of the leader and follower in the expansion state are smaller than those in the recession state when the preemptive equilibrium prevails in the expansion state and the simultaneous equilibrium prevails in the recession state.

The effect of power imbalances on incentives to make non-contractible investments

We use an experiment to study the effect of ex-post sharing rules on relationship-specific investments in an incomplete contracting context. We find that no power structure can induce first-best investments and that equally productive partners reach more efficient outcomes with a balanced power structure (i.e., equal sharing of returns) than with an asymmetric one. In addition, we find evidence for behavioural effects: partners make higher investments and reach higher efficiency levels than own-payoff maximisation would suggest. This behaviour is in line with a model where decision-makers care about social efficiency. It is not consistent with inequity-averse preferences.

CEO optimism and forced turnover

We show theoretically that optimism can lead a risk-averse Chief Executive Officer (CEO) to choose the first-best investment level that maximizes shareholder value. Optimism below (above) the interior optimum leads the CEO to underinvest (overinvest). Hence, if boards of directors act in the interests of shareholders, CEOs with relatively low or high optimism face a higher probability of forced turnover than moderately optimistic CEOs face. Using a large sample of turnovers, we find strong empirical support for this prediction. The results are consistent with the view that there is an interior optimum level of managerial optimism that maximizes firm value.

Moral hazard strategy and quality contract design in a two-echelon supply chain

Based on game theory and principal-agent theory, this paper focuses on how to control product quality and design quality contract in supply chain when moral hazard exists. We set up the supplier and buyer’s expected profits function model, in which the supplier makes production process investment-level decision and decides on the product quality prevention level, whereas the buyer makes quality evaluation decision and decides on the product quality inspection level. The supplier with a moral hazard of reducing investment level may lack investment in the production process; thus, the buyer will pay the information rent to incentivize the supplier to improve the investment level. The buyer creates the moral hazard of exaggerating the product quality defective rate, who may overinvest in the inspection process. We use the optimal condition to solve supplier’s first-best investment level, product quality prevention level, and buyer’s first-best quality inspection level, internal penalty, and apportionment ratio of external failure cost. We also conduct a simulation test that shows the following: When the supplier improves its investment level, its product quality prevention level will increase, and the buyer’s quality inspection level will decrease. With the improvement in the buyer’s product quality inspection level, its internal penalty will increase, and the supplier’s external failure cost will also increase while its expected profits will decrease. Hence, the buyer will design an incentive contract, the expected profits of which will increase, and the whole supply chain’s joint expected profits function may become an inverse U shape. Finally, we develop a simulation example and propose suggestions for quality control strategy and contract design in the supply chain under the conditions of asymmetric information.

Investment timing, liquidity, and agency costs of debt

This paper examines the effect of debt and liquidity on corporate investment in a continuous-time framework. We show that stockholder–bondholder agency conflicts cause investment thresholds to be U-shaped in leverage and decreasing in liquidity. In the absence of tax effects, we derive the optimal level of liquid funds that eliminates agency costs by implementing the first-best investment policy for a given capital structure. In a second step we generalize the framework by introducing a tax advantage of debt, and we show that an interior solution for liquidity and capital structure optimally trades off tax benefits and agency costs of debt.

On and Off Contract Remedies Inducing Cooperative Investments

A party dissatisfied with the contractual performance of a counterparty is typically able to pursue a variety of legal recourses. Within this apparent variety lurk two fundamental alternatives. The aggrieved party may (i) “affirm” the contract and seek money damages or specific performance; or (ii) “disaffirm” the contract with the remedy of rescission and restitution. This simple dichotomy of contract remedies applies broadly in both common law and civil law practice. We show here that this remedial regime allows parties to write simple contracts that induce first-best cooperative investments.

Temporal Resolution of Uncertainty, the Investment Policy of Levered Firms and Corporate Debt Yields

This paper attempts to link the agency literature (concerned with the fact that tensions between bondholders and shareholders may trigger suboptimal investment decisions) with the one dealing with temporal resolution of uncertainty (TRU). We consider here how the speed of resolution of the uncertainty characterizing the firm's operations affects the risk-shifting behavior of a shareholder-aligned manager. It is assumed that investors are risk neutral and that the return on the risky technology is normally distributed. It is shown that the speed of TRU affects monotonically the extent of risk shifting as well as bond yields, even after optimal contracts mitigating deviations from the first-best investment policy have been written. In particular, the optimal investment-restricting covenant is endogenously characterized. Empirical implications are derived and discussed.

Ambivalent Investment and the Hold-Up Problem

In this paper we add to the foundations of incomplete contracting literature. We study the hold-up problem with ambivalent investment, where investment benefits the investing party if ex post the right decision is undertaken but harms the investing party if the wrong decision is made. In this context, we show that the power of contracts to provide investment incentives depends on three factors: the commitment value of contracts, the amount of quasirents that the investing party can expect in the case of out-of-contract renegotiation, and the degree of ambivalence of investment. First, contracts provide first-best investment incentives when parties can commit to a contract regardless of the type of investment. Second, with sufficiently ambivalent investment, if parties cannot commit not to renegotiate a contract and if the investing party's bargaining power is intermediate, contracts cannot improve investment incentives above those provided by no contract. In contrast, a simple buyer or seller option contract is optimal when the investing party's bargaining power is extreme.

Divisional performance measurement and transfer pricing for intangible assets

This paper examines the effectiveness of three transfer pricing methodologies for an intangible asset that is developed through bilateral, sequential investment. In general, a royalty-based transfer price that can be renegotiated provides better investment incentives than either a non-negotiable royalty-based transfer price or a purely negotiated transfer price, and in some cases induces first-best investment. This result contrasts with previous research that finds that the inability to limit renegotiation of initial contracts reduces investment efficiency. Further, I examine how tax transfer pricing rules inform optimal internal transfer prices when the firm decouples internal and external transfer prices.

The Effect of Sunk Costs on the Outcome of Alternating-Offers Bargaining Between Inequity-Averse Agents

When investments are specific to a relationship and contracting possibilities are incomplete, the efficiency of a joint venture may be severely impaired by ex-post opportunistic and hold-up type behavior. How is the logic of this argument affected by inequity aversion? In this paper I show that incentives to invest are stronger with inequity aversion because a higher investment by an individual agent increases not only the total surplus to be divided, but also, generally, the relative share of the surplus obtained by this agent in the ex-post negotiation. In fact, when production is sufficiently profitable and agents are sufficiently patient, then first-best investment levels may be approximated without any contract.

Joint Ownership and Incomplete Contracts: The Case of Perfectly Substitutable Investments

Prominent results of the property rights approach based on incomplete contracts as outlined by Hart (1995) say that all ownership structures lead to underinvestment and that joint ownership cannot be optimal, provided that investments are strategic complements and affect human capital only. We show that in cases where only the total amount invested matters, these conclusions are still true in the static setting, even if investments are in physical capital. However, if the parties can invest and generate a surplus twice, then joint ownership may imply first-best investments in the first stage and can well be the optimal ownership structure.