Signaling Models and Product Market Games in Finance: Do We Know What We Know?

Abstract

Important results in a large class of financial models of signaling and product market games hinge on assumptions about the second order complementarities or substitutabilities between arguments in the maximand. Such second order relationships are determined by the technology of the firm in signaling models, and market structure in product market games. To the extent that the underlying economics (in theoretical specifications) or the data (in empirical tests) cannot distinguish between such complementarities and substitutabilities, the theoretical robustness and the empirical tests of many models are rendered questionable. Based on three well-known models from finance literature, we discuss the role that these assumptions play in theory development and provide empirical evidence that is consistent with the arguments advanced here.