RESEARCH

Publications

"Rational Overoptimism (and Other Biases)", American Economic Review, 94, September 2004, 1141-1151 [similar pdf]
Earlier working paper version : "Skill or Luck: Biases of Rational Agents" [ pdf]

"Organizational Beliefs and Managerial Vision," , Journal of Law, Economics, and Organization, 21 (1), Spring 2005, 256-283 [similar pdf]
Earlier working paper version : July 2001[pdf]

"Essays on the Managerial Implications of Differing Priors," May 2001, PhD Dissertation, Stanford Business School [pdf]

"Human Capital and Corporate Governance," with John Roberts, in Corporate Governance: A Volume in Honor of Horst Albach, J. Schwalbach ed., Berlin, Springer Verlag, 2000
 

Working Papers

"Interpersonal Authority in a Theory of the Firm", July 2007, working paper [pdf]

"The Cost of Incentives under Disagreement (Can an Employee be Too Motivated?)", March 2007, working paper [pdf]
Earlier working paper version: "Too Motivated?", June 2005, working paper [pdf]

"Managing Know-How" (with Deishin Lee) , December 2006, working paper [pdf]

"The Limits of Authority: Motivation versus Coordination", June 2006, working paper [pdf]

"Disagreement and the Allocation of Control", June 2006, working paper [pdf]

"Too Motivated?", June 2005, working paper [pdf]

"On the Origin of Shared Beliefs (and Corporate Culture)," August 2005, working paper [pdf]
Earlier working paper April 2004[pdf]

"The Costs and Benefits of Homogeneity, with an Application to Culture Clash", April 2004, working paper [ pdf]

"Overconfidence by Bayesian Rational Agents", March 2004, working paper [ pdf]

"Equity Participations, Hold-up, and Firm Boundaries," February 2002, working paper [pdf]

"Shareholder Interests, Human Capital Investments and Corporate Governance," with John Roberts, April 2000, Stanford GSB Working Paper 1631 [pdf]

"The Threat of Bankruptcy Can Eliminate the Hold-up Problem," July 2000, working paper [pdf]

Interpersonal Authority in a Theory of the Firm

This paper proposes a theory of the firm in which a firm's centralized asset ownership and low-powered incentives are mechanisms to give a manager `interpersonal authority' over employees, in a world with differing priors. The paper thus provides micro-foundations for the idea that bringing a project inside a firm gives the manager authority over that project, while - in the process - explaining concentrated asset ownership, low-powered incentives, and centralized authority as typical characteristics of firms. It also uses this theory to derive new results for firm boundaries.
I study 'interpersonal authority' (i.e., the ability of a manager to make subordinates obey her orders), as opposed to the 'decision authority' (i.e., her ability to make an impersonal decision) that has been more common in the literature. I derive interpersonal authority as an equilibrium phenomenon that arises through an efficiency-wage type contract between two originally symmetric players. Shifting asset ownership from an (equilibrium) 'agent' to a 'principal' strengthens the principal's interpersonal authority through a change in the outside options of the efficiency-wage contract, while a flat wage makes the agent willing to obey orders that he disagrees with. Based on this, I show that one party should own all the assets for a project and that that owner should also be the project's residual claimant. This owner hires employees for the project under low-powered incentives (or a fixed-wage contract), while the employees accept orders from the owner. Different projects are often optimally owned by different people.
As an application of this theory to firm boundaries, I propose a new theory for integration: the risk of 'break-up'. In particular, I show that fundamental disagreement may cause two separate firms to go their own ways despite coordination being optimal from an outsider's perspective. Beyond the direct losses involved, the anticipation of such break-up may also prevent relation-specific investments. I show that a merger may be strictly optimal, even when the relation-specific investments are ex-ante contractible and there is perfect ex-post Coasian bargaining about the decisions. By unifying all interpersonal authority in the hands of one owner, the merger eliminates the risk of future fundamental disagreement. Note that ownership thus matters despite perfect ex-post Coasian bargaining.

The Cost of Incentives under Disagreement

This paper identifies a new cost of pay-for-performance incentives when principal and agent may disagree on the optimal course of action. In particular, pay-for-performance gives the agent a reason to disobey the principal, and thus act against his principal's interests, when the two of them disagree. In other words, high-powered incentives may decrease the agent's `zone of acceptance' (Simon 1947) when principal and agent disagree. As a consequence, disagreement forces a trade-off between motivation and authority.
This effect has a number of implications. First, and most importantly, agents who are subject to authority will have low-powered incentive pay. Second, intrinsically motivated agents with strong views will be more likely to disobey and thus, in equilibrium, less likely to be subject to authority and more likely to be independent entrepreneurs. A surprising result is that an increase in intrinsic motivation may actually decrease all players' expected utility. Finally, subjective performance pay will be optimal when (and only when) the principal tries to exert interpersonal authority, and not just second-best when the outcome is difficult to measure or contract. I also discuss some potential implications for the theory of the firm.
Through this analysis, the paper identifies an important difference between differing priors and private benefits (or private information): with differing priors, pay-for-performance may create agency problems rather than solving them.

Managing Know-How

We use an economic model to study the optimal management of know-how, defined here as employee-generated information about the performance of specific solutions to problems that may or will recur in the future.
We derive three main results. First, information about successes is typically more useful than information about failures, since successful methods can be replicated while failures can only be avoided. This supports firms' focus on 'best practice'. Second, recording mediocre know-how can actually be counter-productive, since such mediocre know-how may inefficiently reduce employees' incentives to experiment. This is a strong-form competency trap. Third, the firms that gain most from a formal knowledge system are also the ones that should be most selective when encoding information (i.e., the ones that are most at risk from the competency trap); namely, large firms that repeatedly face problems about which there is little general knowledge and that have high turnover among their employees.
Beyond these main principles, we also show that it may be optimal to disseminate know-how on a plant-level but not on a firm-level, and that storing back-up solutions is most valuable at medium levels of environmental change..

The Limits of Authority: Motivation versus Coordination

This paper studies the effects of open disagreement on motivation and coordination. It shows how, in the presence of differing priors, motivation and coordination impose conflicting demands on the allocation of authority, leading to a trade-off between the two.
The paper first derives a new mechanism for delegation: since the agent thinks, by revealed preference, that his own decisions are better than those of the principal, delegation will motivate him to exert more effort when effort and correct decisions are complements. A need for implementation effort will thus lead to more decentralization. The opposite is true when effort and decisions are substitutes.
Delegation, however, reduces coordination when people disagree on the right course of action. The paper shows that, with differing priors, the firm needs to rely more on authority (as opposed to incentives) to solve coordination problems, relative to the case with private benefits. An interesting side-result here is that the principal will actively enforce her decisions only at intermediate levels of the need for coordination.
The combination of the two main results implies a trade-off between motivation and coordination, both on a firm level and across firms. I derive the motivation-coordination possibility frontier and show the equilibrium distribution of effort versus coordination. I finally argue that strong culture, in the sense of homogeneity, is one (costly) way to relax the trade-off.

Disagreement and the Allocation of Control

I study how to allocate control (over one or multiple projects) when people may openly disagree on the optimal course of action.
I first show that, in the efficient allocation, complementary decisions should be decided by the same person, while substitute decisions should be decided by different people. Furthermore, people who are confident about the right course of action and have a large stake in the outcome should get more control, while no decision should be left to chance.
The model then derives an intuitive self-reinforcing mechanism for the co-location of income and control: as a person gets more control rights, she values (by revealed preference) income rights higher, so that it is optimal to give her more income rights; as a person gets more income rights, she values control rights higher, making it optimal to give her more control rights. Different projects, however, should often be allocated to different people. While appealing, I show that these intuitions do not hold in an analogous model with private benefits but common priors. First, all players then value residual income identically. Second, an increase in a player's share of residual income may make him value control less, since the decisions necessary to maximize residual income may conflict with his private benefits.
I also study a competitive allocation of control and show that while the efficient and competitive allocation coincide in the differing priors model, they often do not in the analogous private benefits model. I finally suggest how the framework can be used to explore the role of veto-rights or majority voting.

Too Motivated?

I show that an agent's motivation to do well (objectively) may be unambiguously bad in a world with differing priors, i.e., when people openly disagree on the optimal course of action. The reason is that an agent who is strongly motivated is more likely to follow his own view of what should be done. As a result, the agent is more willing to disobey his principal's orders when the two of them disagree on the right course of action.
This effect has a number of implications. First of all, agents who are subject to authority will have low-powered incentive pay. Second, intrinsically motivated agents will be more likely to disobey and less likely to be subject to authority. Firms with intrinsically motivated agents will need to rely on other methods than authority for coordination. Moreover, an increase in intrinsic
motivation may decrease all players' expected utility, so that it may be optimal for a firm to look for employees with low intrinsic motivation. Finally, subjective performance pay may be optimal, even when the true outcome of the project is perfectly measurable and contractible.
Through this analysis, the paper identifies an important difference between differing priors and private benefits (or private information): with differing priors, pay-for-performance can create agency problems rather than solving them.

Rational Overoptimism (and Other Biases)

Rational agents with differing priors tend to be overoptimistic about their chances of success. In particular, an agent who tries to choose the action that is most likely to succeed, is more likely to choose an action of which he overestimated, rather than underestimated, the likelihood of success. After studying the comparative statics of this mechanism, I show that it also causes agents to attribute failure to exogenous factors but success to their own choice of action, to disproportionately believe that they will outperform others, to overestimate the precision of their estimates, and to overestimate their control over the outcome. (JEL A12, B49, C70, D81, D84)

Skill or Luck

This paper shows why, in a world with differing priors, rational agents tend to attribute their own success more to skill and their failure more to bad luck than an outsider. It further shows why each agent in a group might think he or she is the best, why an agent might overestimate the control he has over the outcome, and why two agents' estimated contributions often add up to more than 100%. Underlying all these phenomena is a simple and robust mechanism that endogenously generates overoptimism about one's own actions. The paper also shows how these biases hinder learning and discusses some implications for organizations.

Organizational Beliefs and Managerial Vision

Can managers have an impact on their firm that goes beyond their direct actions and decisions? This paper shows that a manager with strong beliefs about the right course of action for the firm will attract, through sorting in the labor market, employees with similar beliefs. This alignment of beliefs gives direction to the firm and has important implications for incentives and coordination. The paper then defines vision, in accordance with the management literature, as such strong beliefs about the right course of action and shows that, because of this sorting effect, it is often optimal for a board to hire visionary managers. It also discusses succinctly the link with corporate culture.

On the Origin of Shared Beliefs (and Corporate Culture)

This paper shows why members of an organization often share similar beliefs. I argue that there are two mechanisms. First, when performance depends on making correct decisions, people prefer to work with others who share their beliefs and assumptions, since such others 'will do the right thing'. Second, beliefs will converge over time through shared learning.
While such homogeneity reduces agency problems, it does so at a cost. I show that, from an outsider's perspective, firms invest on average too much in homogeneity. The theory further predicts that homogeneity will be strongest in successful and older firms where employees make important decisions. Within a firm, homogeneity will be stronger among more important employees. Homogeneity will also be path-dependent, making managers more selective on early hires.
Since shared beliefs are an important aspect of corporate culture (Schein 1985, Kotter and Heskett 1992), I finally show that the model matches some observations on corporate culture, such as the influence of a manager on her firm's culture and the persistence of culture in the face of turnover. A fundamental difference from earlier economic theories of corporate culture is that I show that culture, instead of being created for its own good, can be a side-effect of other purposeful actions. As a consequence, there can be too much culture in firms.

The Costs and Benefits of Homogeneity, with an Application to Culture Clash

Firms are more homogenous than society in general. This paper studies the costs and benefits of, in particular, homogeneity in beliefs and preferences. It shows that, in a world with differing priors, such homogeneity facilitates delegation and coordination, reduces monitoring and influence activities, improves the quality of communication, and increases effort and expected utility. It reduces, however, the incentives to collect new information.
Starting from the definition of culture as shared beliefs and preferences, these results have implications for an economic theory of `culture clash' in mergers and acquisitions. In particular, when two firms that are each internally homogenous but different from each other, try to merge, agency problems will generally increase and hurt their performance, although the decrease in homogeneity may sometimes have beneficial effects. The paper derives specific empirical implications.

Overconfidence by Bayesian Rational Agents

This paper shows why, in a world with differing priors, Bayesian rational individuals will tend to be overconfident about their estimates and predictions. The intuition behind the main result is slightly ironic: in trying to update optimally, agents overweigh information of which they over-estimate the precision and under-weigh in the opposite case. This causes an overall over-estimation of the precision of the final estimate.

Equity Participations, Hold-up, and Firm Boundaries

Equity participations affect the hold-up problem in two ways. On the one hand, they allow to reduce the externality that is created ex-post by hold-up. On the other hand, they change the bargaining positions by partially internalizing the threat of walking away from the bargaining. It turns out that, for firms that are run by professional managers and that bear the costs of the relevant investments, the bargaining effect is the more important. In some cases, it even allows to achieve complete efficiency. In particular, with one-sided dependency, a 50% participation gives full efficiency. In the case of bilateral dependency, the unique efficient solution is equivalent to a merger. This basis for determining optimal firm boundaries is essentially one of incentive design, as suggested by Holmstrom (1999), rather than property rights. The theory also shows how joint ventures can sometimes realize the benefits of equity participations, while avoiding some concurrent problems.

Shareholder Interests, Human Capital Investments and Corporate Governance (with John Roberts)

This paper shows that the pursuit of shareholder interests may require ceding a role in corporate governance to employees, in order to motivate their investing in firm-specific human capital. Doing so becomes more attractive as these investments increase in importance. This result also bears on the debate about reforming European and Japanese governance systems in the direction of the American system, reducing employees’ influence. In this context, we present a model on the optimal choice of governance systems, along ideas suggested by Holmström.

The Threat of Bankruptcy Can Eliminate the Hold-up Problem

This paper shows that hold-up inefficiencies disappear completely when the firm making the specific investments would go bankrupt if no ex-post agreement were reached. The result can explain the efficiency of close alliances and the use of option-like rewards (and layoffs) as incentive mechanisms. The model also shows how sunk investments  sometimes do play a role in the ex-post bargaining, when firms have limited liability.