Project evaluation and control in decentralized firms: Is capital rationing always optimal?

When capital investments are made in agency setting, the authors show that, even without risk considerations, capital rationing need not be the only rational outcome. They analyze a principal-agent model with risk neutrality and with two productive inputs: the agent’s efforts and capital investment. The two inputs can be either economic complements or substitutes. The agent has pre-contract private information about his own type. The output is measured with an additive noise. The authors show that when the two inputs are substitutes, the optimal solution entails a marginal capital rationing. But when the two inputs are complements, then either a marginal capital rationing or a marginal leniency could be the optimal response. The present results, therefore, provide an explanation for why firms may employ a capital rationing for a project that may increase manufacturing complexity and hence may reduce (managerial) labor productivity, yet employ a less strict criterion for evaluating a productivity-enhancing project. This result contrasts with earlier results where only a capital rationing is shown to be optimal.