Forthcoming in Journal of Economic Behavior and Organization Influence and Inefficiency in the Internal Capital Market

I model inefficient resource allocations in M-form organizations due to influence activities by division managers that skew capital budgets in their favor. Corporate headquarters receives two types of signals about investment opportunities: private signals that can be distorted by managers, and public signals that are undistorted but noisy. Headquarters faces a tradeoff between the cost of attaining an accurate private signal and the value of the information the signal provides. In contrast to existing models of “socialism” in internal capital markets, I show that investment sensitivity to Q is higher than first-best in firms where division managers hold equity. When managers face high private costs from distorting information, headquarters may commit to investment contracts that ignore private signals and place too much weight on public signals (i.e. Q). This key result is consistent with evidence presented in Scharfstein (1997). JEL Classification: G31, D82, D21, D23