Delegating Decisional Rights for Investment Projects: Lifting the Curse of Unwarranted Escalation?

Abstract:     
Unwarranted escalation of commitment to a failing course of action has been a predominant problem confronting organizations. Without paying heed to warning signs of impending failure, unwarranted escalation behaviors culminate in investment decisions that exhaust valuable firm resources with no prospects of positive remuneration. This study devises a contract in a principal-agent relationship to contain an agent's unwarranted escalation behavior when investment opportunities are valuated as real options. We then investigate whether the inducement of optimal investment decisions are always attainable via the recommended contract. A key conclusion to be drawn from our analysis is that while a contract can always be crafted to prevent an agent's biased investment decision, the cost of contract enactment may be prohibitively expensive to the principal such that she might be better off in simply undertaking the risk of unwarranted escalation.

Keywords: Unwarranted Escalation, Optimal Contract, Efficient Decision Making, Investment Decisions, Principal-Agent Relationship, Personal Benefit

JEL Classifications: D81, D82, G11

Working Paper Series