Agency in Project Screening and Termination Decisions: Why is Good Money Thrown after Bad?

Abstract

We construct an agency model in which the agent makes project starting and termination decisions on behalf of the profit maximizing principal. The model shows that, to induce the agent's effort to gather information about the projects, the optimal incentive contract should impose restrictions on project starting and termination. As a result, the agent can not start all projects that he expects to be ex ante efficient and nor can he terminate all projects that are ex post inefficient. The model offers a rational explanation for such organizational behavior as "commitment to mistakes". When applied to planned economies, the model suggests that hardening budget constraints in such economies is difficult even under an "ideal" setting when these economies are free of social considerations and political frictions. When interpreting project starting and termination as hiring and firing workers respectively, the model offers insights to understanding some labor market institutions such as rigid layoff rules.

JEL Classification: D81, D82