INPUT CONTROL AND INFORMATION ASYMMETRY

In a production process with a labor and a nonlabor input we show that the principals profits increase when she controls the nonlabor input. Furthermore output increases since the principal can allocate capital to help mitigate her information costs. However this mitigation of information costs distorts the capital labor ratio away from its production-efficient level. This distortion is socially costly. Overall the distortion may dominate the gains realized through the increase in output and the reduction of information rents. Our result differs from the classic finding of Averch and Johnson who found that costplus pricing induces overinvestment in capital equipment that is socially costly. Unlike their analysis the problem we consider contains two off-setting social costs: asymmetric information regarding agent ability, and the production distortion in the input ratio. Neither one of the costs necessarily dominates the other so that the social implication of input control by the principal is not a priori determinate.