The impact of an ethical environment on managers' project evaluation judgments under agency problem conditions

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Abstract

This paper proposes that a strong ethical environment will be effective in reducing the tendency for managers to continue failing projects in both the presence and absence of agency problems. The findings support these propositions, with a strong ethical environment found to significantly reduce managers' tendency to continue failing projects. Also, while agency problem effects were still present under a strong ethical environment, their impact was similar to the case of a weak ethical environment in the absence of agency problems. These findings suggest that creating a strong ethical environment may be a highly desirable control option for organizations generally.

Introduction

A large body of research has been conducted which examines decision bias in project evaluation decisions (e.g. Chenhall and Morris, 1991, Northcraft and Wolf, 1984, Staw, 1976, Staw and Fox, 1977). The general tendency that emerges from this body of work is that under certain conditions managers are biased towards continuing failing projects; the escalation of commitment phenomenon (Brockner, 1992). One stream of this research supports the agency theory view that agency problems1 are an important set of conditions under which escalation of commitment to failing projects arises (Harrell and Harrison, 1994, Harrison and Harrell, 1993). Agency theory posits that an agency problem exists when managers' economic interests differ from those of their firm (e.g. a potential job promotion dependent on management of only successful projects) and they possess relevant information not available to their superiors (e.g. private knowledge of a failing project which should be discontinued) Baiman, 1982, Baiman, 1990, Eisenhardt, 1989). Under such conditions managers have both an incentive to act against the interests of the firm and the opportunity to do so without their superiors detecting their self-interested action. Under these conditions, the work of Harrell and Harrison suggests that managers will act in their own self-interest to continue projects that are failing. Passmore, 1995, Rutledge and Karim, 1999 have confirmed this finding in similar experimental studies.

While these findings are consistent with the expanded view of rational decision-making incorporated into agency theory,2 recently Rutledge and Karim (1999) proposed that this decision-making model was incomplete as it ignored the influence of managers' ethical reasoning on their economic decisions. Drawing upon Noreen's (1988) critique of the boundaries of the applicability of the pure agency model, they argued that not all managers are motivated by self-interest but may be constrained by their own ethical sensibility or conscience, and that this may explain why in Harrell and Harrison's work some subjects who experienced agency problem conditions still acted in the interests of their firm. In short, if acting in one's own interest against the interests of the firm is perceived as being unethical, then managers may moderate the tendency to continue failing projects.3 In a behavioral decision-making experiment, Rutledge and Karim (1999) found that the strongest tendency for managers to continue failing projects was where an agency problem existed and managers had relatively lower levels of ethical reasoning. However, where no agency problem existed or managers had relatively higher levels of ethical reasoning, then the tendency was for managers to make decisions consistent with the interests of the firm.

Rutledge and Karim (1999) demonstrate that an improved model of managers' decision-making behavior can be gained by including ethical considerations through variations in managers' level of ethical reasoning. However, a manager's level of ethical reasoning is only one source of the potential interaction of ethical considerations with agency problem conditions. Consistent with Noreen's (1988) arguments that ethical behavior by managers might be more common than opportunistic behavior, it has been suggested that the “…ability to see and respond ethically may be related more to attributes of corporate culture than to attributes of individual employees” (Chen, Sawyer, & Williams, 1997, p. 856, quoted in ICAC, 1998, p. 10). Similarly, it has been argued that organizations can foster an ‘epidemic of ethical behaviour’ (Arnold et al., 1999, Arnold et al., 2000) and act as ‘moral agents’ where ethical decisions involve more than individual values and standards (Metzger & Dalton, 1996). Where the mission and values, leadership and management influence, peer group influence, procedures, rules and codes of ethics, ethics training, and rewards and sanctions of an organization are all directed to supporting ethical decision-making, they mutually reinforce each other to create a strong ethical environment that promotes greater levels of ethical decision making by all managers (Ford & Richardson, 1994).

A strong ethical environment provides a specific context within which an organization operates and all managers make decisions, and thereby can be considered as distinct from ethical reasoning, which is an internal characteristic of a manager. Therefore, regardless of their level of ethical reasoning, a strong ethical environment may lead to a general tendency for managers to act in the interests of their organizations and, more specifically, a reduced tendency for managers to act opportunistically under agency problem conditions. This proposition is consistent with the arguments by Arnold et al., 1999, Arnold et al., 2000 that an organization can create an ethical culture that becomes contagious and ultimately leads to a more ethical organization.

The purpose of this study is to provide another perspective on how an improved model of managers' decision-making behavior can be derived. It does this by considering how one important component of the organizational context of decision-making, the strength of the ethical environment, influences managers' economic decisions. Such a perspective is important as it moves beyond the individual traits (self-interest, ethical reasoning) focus in prior research to explicitly consider how the context within which managers' make decisions impacts on their judgments.4 We propose that a strong ethical environment reduces project managers' tendency to continue a failing project both in the absence and presence of agency problems. However, the impact of a strong ethical environment is expected to be stronger in the latter case than the former. Thus, we also propose an interaction effect between the form of ethical environment and agency problem conditions. These propositions are explored in a behavioral decision-making experiment and support is found for the proposed role of strong ethical environments in reducing escalation of commitment to failing projects.

The remainder of this paper is divided into four sections. The first section develops hypotheses based upon the prior research on agency theory and arguments on how an ethical environment may impact upon managers' economic decisions both generally and specifically in the case of agency problems. The second section overviews the research design, dependent and independent variables and the third presents the results of the experiment. The final section discusses the results, presents conclusions derived from the study and provides suggestions for future research.

Section snippets

Agency theory and managers' project evaluation decisions

Consistent with Conlon and Leatherwood's (1989) proposal to consider approaches that provide rational economic explanations rather than just irrational affective ones for managers' tendency to continue failing projects, a number of experimental and analytic studies have considered agency theory explanations for managers' normatively incorrect project evaluation decisions (Harrell and Harrison, 1994, Harrison and Harrell, 1993, Kanodia et al., 1989, Passmore, 1995, Rutledge and Karim, 1999).

Overview of design

Based upon the decision-making case used by Harrell and Harrison (1994), a laboratory experiment was conducted to investigate H1, H2. A 2×2 fully crossed factorial experimental design was used, with agency problem (present/absent) and ethical environment (strong/weak) as the independent variables. The dependent variable was subjects' preference for dis/continuing a project. The subjects, procedures and variables are described in the following subsections.

Statistical tests

An overall 2×2 analysis of variance (ANOVA) test was conducted. This test was used to establish whether there was a significant difference between the agency problem treatment groups, the ethical environment treatment groups (H1) and to test for any interaction between agency problem and ethical environment (H2) treatments. All analyses were conducted using SYSTAT 1013 at an alpha

Discussion and conclusions

Agency theory proposes that under conditions of an agency problem, it is economically rational for managers to continue with projects that are failing. However, as Noreen (1988) argued, under agency problem conditions in practice not all managers display opportunistic behavior. Such arguments suggest that the expanded view of rational decision-making incorporated in agency theory is incomplete. Rutledge and Karim (1999) recently provided evidence that managers' high ethical predisposition may

Acknowledgements

We would like to acknowledge Adrian Harrell for providing copies of his research instruments, the pilot work for this project undertaken by David Passmore as his thesis for Bachelor of Business (Honours) at the University of Technology, Sydney, and David Brown for research assistance on this project. We would also like to thank Peter Luckett, David Smith, Cynthia Jeffrey, Steve Salterio, Chris Ittner, participants at the 1998 AAANZ and ABO conferences and the two anonymous referees for their

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