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Product Market Efficiency: The Bright Side of Myopic, Uninformed, and Passive External Finance

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  • Thomas H. Noe

    (Saïd Business School and Balliol College, University of Oxford, Oxford OX1 1HP, United Kingdom)

  • Michael J. Rebello

    (School of Management, University of Texas at Dallas, Richardson, Texas 75083)

  • Thomas A. Rietz

    (Henry B. Tippie College of Business, University of Iowa, Iowa City, Iowa 52242)

Abstract

We model the effect of external financing on a firm's ability to maintain a reputation for high-quality production. Producing high quality is first best. Defecting to low quality is tempting because it lowers current costs while revenue remains unchanged because consumers and outside investors cannot immediately observe the defection. However, defection to low quality impairs the firm's reputation, which lowers cash flows and inhibits production over the long term. Financing via short-term claims discourages defection to low quality because the gains from defection are mostly captured by outside investors through an increase in the value of their claims. Therefore, if the firm relies on short-term external financing, it is more likely to produce over the long run, produce high-quality goods, and enjoy high profitability. The aggregate results from a laboratory experiment generally accord with these predictions. This paper was accepted by Brad Barber, finance.

Suggested Citation

  • Thomas H. Noe & Michael J. Rebello & Thomas A. Rietz, 2012. "Product Market Efficiency: The Bright Side of Myopic, Uninformed, and Passive External Finance," Management Science, INFORMS, vol. 58(11), pages 2019-2036, November.
    • Handle: RePEc:inm:ormnsc:v:58:y:2012:i:11:p:2019-2036
    DOI: 10.1287/mnsc.1120.1534
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    More about this item

    Keywords

    adverse selection; financing; reputation;
    All these keywords.

    JEL classification:

    • C91 - Mathematical and Quantitative Methods - - Design of Experiments - - - Laboratory, Individual Behavior
    • D82 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Asymmetric and Private Information; Mechanism Design
    • G31 - Financial Economics - - Corporate Finance and Governance - - - Capital Budgeting; Fixed Investment and Inventory Studies
    • G32 - Financial Economics - - Corporate Finance and Governance - - - Financing Policy; Financial Risk and Risk Management; Capital and Ownership Structure; Value of Firms; Goodwill
    • L15 - Industrial Organization - - Market Structure, Firm Strategy, and Market Performance - - - Information and Product Quality

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