PROJECT EVALUATION AND CONTROL IN DECENTRALIZED FIRMS - IS CAPITAL RATIONING ALWAYS OPTIMAL

When capital investments are made in an agency setting, we show that, even without risk considerations, capital rationing need not be the on ly rational outcome. We analyze a principal-agent model with risk neut rality and with two productive inputs: the agent's efforts and capital investment. The two inputs can be either economic complements or subs titutes. The agent has pre-contract private information about his own type. The output is measured with an additive noise. We show that when the two inputs are substitutes, the optimal solution entails a margin al capital rationing. But when the two inputs are complements, then ei ther a marginal capital rationing or a marginal leniency could be the optimal response. Our results, therefore, provide an explanation for w hy firms may employ a capital rationing for a project that may increas e manufacturing complexity and hence may reduce (managerial) labor pro ductivity, yet employ a less strict criterion for evaluating a product ivity-enhancing project. This result contrasts with earlier results wh ere only a capital rationing is shown to be optimal.