IMPACT OF 'ADVERSE SELECTION' ON MANAGERS' PROJECT EVALUATION DECISIONS.

Abstract

Agency theory can be used to explain decisions to continue a failing project. The results of a decision-making experiment provide empirical support for the proposition that when the conditions for adverse selection exist-an agent has private information and an incentive to shirk-such decisions, apparently irrational from a principal's perspective, may be rational from the agent's perspective. The traditional approach to rational decision making derived from economic theory assumes a firm's managers will reach decisions that maximize the profitability of their firms. Managers should invest resources in the projects projected to provide the greatest profits to a firm and then periodically evaluate the economic performance of those projects. They should continue the projects projected to be profitable and, to avoid losses, discontinue those projected to be unprofitable (Horngren & Foster, 1991: 366-380).1 Prior research has provided empirical support for the proposition that managers who initiate projects that become unprofitable are more likely to continue supporting those projects than managers who did not initiate them (Arkes & Blumer, 1985; Staw, 1976, 1981; Staw & Fox, 1977; Staw & Ross, 1978). The rationale given for this seemingly irrational behavior is that the