Budgets as a Credible Threat: An Experimental Study of Cheap Talk and Forward Induction.

This research examines the ox ante role of budgeting as a strategic deterrent to dissuade divisions from proposing projects that are unfavorable to the firm as a whole. We conduct a laboratory experiment (120 subjects) with monetary Incentives to examine the strategic Interactions between a firm and a decentralized division. Factors in the 2 × 3 design are (1) the presence or absence of a budgetary communication channel from the firm to the division (two levels), and (2) the degree of information asymmetry (three levels). Results indicate an inverted U-shaped relationship between the degree of information asymmetry and the effectiveness of budgetary communication. Specifically, budgetary communication does not significantly affect behavior when the firm has no signal or a perfect signal of the division's information. In the more realistic case of uncertain information, however, the presence of budgetary communication significantly reduces the propensity of divisions to propose projects that would be unfavorable to the firm.