The effects of reputation, investment monitoring and compensation on escalation errors

The purpose of this dissertation is to investigate the effects of reputation, private information and investment monitoring on capital budgeting decisions. The research investigates whether agency theory provides an explanation for escalation errors made by individuals faced with a project abandonment decision. Agency theory is a theory of decision making which uses both incentive to shirk and private information to explain the relationship between a principal and agent. It can also be used to explain why agents may tend to erroneously escalate commitment in business situations. An agent\u27s business decision may be highly rational if viewed from the perspective of the individual, not the firm, if potential effects on that agent\u27s future reputation are considered. This dissertation also investigates the effect of monitoring on a decision maker\u27s tendency to escalate commitment to an apparently failing project. Agency theory contends that monitoring reduces the agent\u27s incentive to shirk which should also affect the agent\u27s tendency to commit escalation errors. The hypotheses were empirically tested by conducting a controlled experiment in which 188 graduate students from five universities were asked to respond to a project abandonment case. The case instrument provided subjects with either private or non-private information, personal reputation effects or no personal reputation effects and monitoring or no monitoring. The results were not consistent with an agency theory explanation of escalation of commitment. Although the hypotheses that either reputation effects or private information alone would not affect escalation were supported, there were no significant interactions between the levels of private information and reputation effects as suggested in hypothesis three. Monitoring, as operationalized in this study, did not affect the decision maker\u27s tendency to escalate. The dissertation includes a discussion of the implications of these findings, and opportunities for future research