A firm is thinking about making a huge new investment. After consultation and deliberation, the CEO and the employees unanimously decide the project should go ahead and initial investment begins. As time passes more and more members of the organization realize that the investment is not a good idea after all. It is better to cut and run. Some costs are sunk and the NPV looking forward is negative.
The CEO is in charge of the continuation decision but his incentives are not aligned with the organization’s. Privately, he was actually reluctant to pursue the project. Publicly, he boasted about the investment, how great it was all going to be, how great the firm would be when the investment paid off. The CEO cannot go back on his word. The market will judge him purely on whether the investment is made and whether it pays off. He cannot cancel the project and instead he forces it through. If it pays off, his career takes off; if it fails, his career is a shambles but is is also in a tailspin if he cancels the project. The employees watch anxiously. They will give him a year and if nothing works, they will look for opportunities elsewhere.
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May 2, 2011 at 9:55 am
twicker
1) Quick note that this assumes that the CEO is looking to be hired elsewhere at some point and is with a publicly-traded company. Both extremely valid assumptions; I just thought of them because I was doing some reading about Koch Industries, where the company is private and the CEO has no plans whatsoever to move to any other company (nor any fear of being fired, since he owns 42% of the company). As it happens, they cut-and-run from projects all the time – lending even more support to what you wrote above.
2) For the company, other options (beyond wait-it-out) include:
a) Quietly helping the CEO find another job, so that s/he can can leave based on successfully starting the company and someone else can come in and quietly (or not so quietly) kill the project
b) Make another huge investment elsewhere that allows the first project to get killed off as part of a “strategic realignment” or some such (there’s actually some good evidence that you can get people to move past escalation of commitment/sunk cost fallacy thinking if you can give them something else to feel competent in)
May 2, 2011 at 10:12 am
kerokan
In international relations this dynamic can be a good or a bad thing. If a state is trying to signal resolve, public statements by the leader can help. Essentially such public statements, which will hurt the CEO if he ever backs down, are tantamount to burning bridges. Only the resolved types will use this strategy which means signaling will work.
However, when you’re not trying to signal, this dynamic can hurt the state. The leader, feeling his only way of remaining in office is a turn of the tide, will “gamble for resurrection” and continue the harmful course of action.
May 2, 2011 at 10:49 am
Team John L
I look at this in terms of a zero-boundary problem. The CEO can never lose any actual money on the deal, so his payout is $100, if successful, $0 if unsuccessful, and $0 if withdrawn. His company’s payout is $1000, $-500, and $0, respectively. Misaligned incentives indeed.
May 2, 2011 at 2:42 pm
ohwilleke
Of course, in a privately held company, or publicly held company with shareholders who hold dominant stakes in the company, the CEO knows that putting his reputation over the ownership’s interests will cost him his job.
This is a core argument for improving the quality of shareholder democracy in public corporations. The excessive pay for senior management is a symptom, but the real harmful consequence of the disease is the bad decision making that can arise in this kind of situation.
May 3, 2011 at 12:35 pm
Sandeep Baliga
Thanks so all the comments. The theory I sketched out is an alternative to the theory presented in my paper Mnemonomics with Jeff which uses limited memory in an environment with individual decision making and no career concerns to generate two versions of the sunk cost fallacy.