Optimal Information Asymmetry

48 Pages Posted: 10 Dec 2011

See all articles by Madhav V. Rajan

Madhav V. Rajan

Booth School of Business, University of Chicago

Richard E. Saouma

Eli Broad College of Business, Michigan State University

Date Written: February 5, 2005

Abstract

At the heart of decentralization lies the notion that tasks are delegated by owners to managers who possess superior local information. The extent of this information asymmetry is often an endogenous construct, as it is influenced by the owner’s choice of internal accounting systems and the manager’s investment in acquiring local expertise. In this paper, we explore how varying levels of pre-contract, asymmetric information affect the owner-manager relationship. We provide three main sets of insights. First, we find that the owner’s payoffs are initially decreasing, and strictly convex everywhere, in the quality of the manager’s private information. The owner thus prefers to deal with either a perfectly informed or a perfectly uninformed manager, and we characterize conditions for either to be the preferred choice. Second, in contrast to recent work, we demonstrate that when information can be communicated internally, the optimal strength of managerial incentives unambiguously decreases as the manager becomes better informed. Third, we derive the surprising result that a self-interested manager does not always prefer to maximize his informational advantage. Our work has implications for the optimal design of organizations, and for internal accounting and control systems in particular.

Keywords: optimal adverse selection, information asymmetry, contract theory

JEL Classification: D82, D83

Suggested Citation

Rajan, Madhav V. and Saouma, Richard E., Optimal Information Asymmetry (February 5, 2005). Accounting Review, Vol. 81, No. 3, 2006, Available at SSRN: https://ssrn.com/abstract=1966852

Madhav V. Rajan

Booth School of Business, University of Chicago

1101 East 58th Street
Chicago, IL 60637-1561
United States

Richard E. Saouma (Contact Author)

Eli Broad College of Business, Michigan State University ( email )

Agriculture Hall
East Lansing, MI 48824-1122
United States

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