Signaling to Partially Informed Investors in the Newsvendor Model

Abstract

We analyze a signaling game between the manager of a firm and an investor in the firm. The manager has private information about the firm's demand and cares about the short-term stock price assigned by the investor. Previous research has shown that under continuous decision choices and the Intuitive Criterion refinement, the least cost separating equilibrium will result, in which a low quality firm chooses its optimal capacity and a high quality firm over-invests in order to signal its quality to investors. We build on this research by showing the existence of pooling outcomes in which low quality firms over-invest and high quality firms under-invest so as to provide identical signals to investors. The pooling equilibrium is practically appealing because it yields a Pareto improvement compared to the least cost separating equilibrium. Distinguishing features of our analysis are that: (i) we allow the capacity decision to have either discrete or continuous support, and (ii) we allow beliefs to be refined based on either the Undefeated refinement or the Intuitive Criterion refinement. We find that the newsvendor model parameters impact the likelihood of a pooling outcome, and this impact changes in both sign and magnitude depending on which refinement is used.

Keywords: Capacity investment, inventory, signaling game, newsvendor