Ignorance Is Bliss: The Screening Effect of (Noisy) Information

TL;DR

This paper explores how noisy internal information impacts a firm's ability to screen managers and make investment decisions, revealing a complex trade-off that affects overall firm value.

Contribution

It introduces a model showing the non-monotonic relationship between information quality and firm value due to screening and investment trade-offs.

Findings

Noisier information can improve manager screening but reduce investment efficiency.

Optimal information quality balances screening benefits and investment precision.

Marginal improvements in information quality do not always enhance firm value.

Abstract

This paper studies the value of a firm's internal information when the firm faces an adverse selection problem arising from unobservable managerial abilities. While more precise information allows the firm to make ex post more efficient investment decisions, noisier information has an ex ante screening effect that allows the firm to attract on-average better managers. The trade-off between more effective screening of managers and more informed investment implies a non-monotonic relationship between firm value and information quality. A marginal improvement in information quality does not necessarily lead to an overall improvement in firm value.