Overstatement and Rational Market Expect

Overstatement and Rational Market Expect

When an agent overstates his/her true performance, a rational market can simply recalibrate or discount the reported performance, and correctly guess the true performance. This paper shows, however, that such rational market discounting leads to less productive effort by the agent and less performance-pay by the principal. Therefore, a rational market and a profit-maximizing principal can exacerbate the lack of productive effort by the agent. Antifraud legislation that raises the marginal cost of overstatement, however, is shown to decrease the overstatement and increase the productive effort at the same time. Using Dow Jones Industrial firms data, this paper also shows that the elasticity of stock prices to earnings reports increases in the performance-pay, as predicted by the model.