Disclosure as a Tool for Building Trust and Stimulating Investment Radhika Lunawat Econometric Society 2008 North American Summer Meeting Carnegie Mellon University 19th June, 2008

Research Question Relation between disclosure and trust Effect on managerial disclosure decisions Effect on investment

Investment Game Berg, Dickhaut and McCabe, 1995 Sender Gets $10 Sends m Keeps $10-m Receiver Gets 3m Keeps k Sends back R= 3 m - k 3m 3m - k

Reputation Formation Round 1 Round 2 3m 3m Sender Gets $10 Sends m Keeps $10-m Sender 1) Gets $10 2) Sends m 3) Keeps $10-m Receiver 1) Gets 3m 2) Keeps k 3) Sends back 3m-k Receiver 1) Gets 3m 2) Keeps k 3) Sends back 3m-k Sender 1) Gets $10 2) Sends m 3) Keeps $10-m Receiver 1) Gets 3m 2) Keeps k 3) Sends back 3m-k 3m - k 3m - k

Results - Reputation Formation Round 1 Per Cent Returned 100% 50% 0% A B Round 2 A B 100% 50% 0% Per Cent Returned Per Cent Sent A vs B experienced vs. inexperienced. Important carryover is that reputation might be the impetus for designing organizatioins.

Period 1 of Reinvestment Game α1 Re-invest (α1) Retain (k1) R1 k1 I(m1) Not Disclose A B Return (R1) Invest (I) (m1) Disclose Not Invest (NI) NI (10, 0) Key I => k1 + α1 + R1 = λ1 m1 λ1 ε {1, 2, 3, 4} Nature chooses B to be trustworthy or untrustworthy

Period 2 of Reinvestment Game B A R2 α2 k2 Return(R2) Re-invest (α2) Retain (k2) Not Invest (NI) Invest (I) (m2) Not Disclose Disclose Key NI => k2 + α2+ R2= λ2α1 I => k2 + α2+ R2 = λ2 (m2 + α1) λ2 ε {1, 2, 3, 4}

Period 3 of Reinvestment Game B A R3 k3 Return (R3) Retain (k3) Not Invest (NI) Invest (I) (m3) Not Disclose Disclose Key NI => k3 + R3 = λ3α2 I => k3 + R3= λ3 (m3 + α2) λ3 ε {1, 2, 3, 4}

Financial Statements and Assumptions Income statement : (λt - 1) (αt-1 + mt) Balance sheet : αt Risk neutrality, no time discounting, additively separable utility Trustworthy B always re-invests and discloses He returns half of what he receives in last period

Equilibrium of Reinvestment Game Sequential equilibrium A’s threshold B’s mixed strategy Belief revision via Bayesian updating

Reporting Regimes Full Information Benchmark No Disclosure regime Endogenous Disclosure Income Statement only (Partial Disclosure) Balance Sheet only (Partial Disclosure) Both Income Statement and Balance Sheet (Full Disclosure)

Comparing across regimes More investment in regimes with disclosure compared to no disclosure More re-investment in regimes with disclosure compared to full information Disclosure of income statement (balance sheet) increases if disclosure of balance sheet (income statement) is a possibility

Comparing across regimes (contd.) Probability of disclosing income statement (balance sheet) decreases in probability of disclosing balance sheet (income statement) Private-order reputation based institution No dividend payout

Experiment Design Screening round Several sequences of 3 periods each Perfect stranger matching Treatments No Financial Statements Balance Sheet only Income Statement only Both Income Statement and Balance Sheet

Investment Dickhaut, Lunawat, Waymire and Xin, 2007

Zero and Maximum Investments Dickhaut, Lunawat, Waymire and Xin, 2007