Limits on information availability and on information processing that give rise to bounded rational behavior exist in all forms of organiza- tions. The limits exist on both sides of the principal–agent relationship. The implications of bounded rationality within the corporate struc- ture of a firm are ambiguous for managers and less so for shareholders. Shareholders (the principals) in this situation have a profit target, where the required or expected profit is less than although possibly equal to an absolute maximum possible profit level. The problem, of course, is that shareholders do not know what the absolute maximum possible profit level is, so even if they achieve it, they do not know this. If actual profit received is below their expected (target) profit, then shareholders respond. They can either increase monitoring or sell their shares in order to reinvest their funds in a more profitable venture. If the actual profit that they receive at least meets their expected target level, then less (or no) monitoring will take place. This behavioral response is the same as that predicted by models based on unbounded rational behavior; however, the point at which this behavior is triggered will be different under conditions of bounded rationality than under unbounded ration- ality. Because of bounded rationality, the target level for shareholder profits occurs over a wider range of possible satisfactory profit levels than a single, maximum profit required in the models characterized by unbounded rationality. This implies greater managerial discretionary ability under conditions of bounded rationality than under conditions of unbounded rationality.
There is some slack in the bounded rational model beyond that attrib- uted to managers in the unbounded rational (managerial utility maxi- mizing) models. In this case there is slack not only because owners are not fully informed or fully able to process information, but also because corporate managers are themselves not fully informed or fully able to process information either about what owners expect, or about the detailed production processes in the complex hierarchical organizations that they manage. Managers must process information not only on shareholder interests but also on the production function in order to determine the state of attributes that generate managerial utility. The attributes of production and of the organization cannot be known with any certainty or precision, and so are likely to be evaluated relative to their previous period value. If current period values are lower, then managerial satisfaction is reduced. This could occur as a result of endogenous factors such as reduced discretionary profit from higher than expected produc- tion costs or loss of authority that unintentionally permits employee or staff shirking.
Managerial satisfaction can also be reduced as a result of exogenous factors that reduce discretionary profit when actual profit is below shareholder expectations due to changes in factor markets (for example, a strike) or product markets (for example, entry or innovation by new competitors). Of course, conditions of bounded rationality indicate that it may not be possible to know the source of the reduced discretionary profit with any degree of certainty, either for shareholders or for man- agers. This suggests that shareholders could believe that managers are responsible for any poor performance of the corporation even if this were not the case. Managers who believe that this is possible would be more likely to be more conservative, that is, risk averse, in their deci- sions, and less inclined toward opportunistic behavior under conditions of bounded rationality.
There remains the possibility that managers may also count on share- holders’ limited information and become more opportunistic rather than less so. This response would be more likely where there is significant information asymmetry and where limits on information are greater for shareholders than for managers, or expected to be so, and that managers are aware of this. Tullock (1971) corroborates this with his remark that the prospectuses of corporations provided to potential purchasers as required by the US Securities and Exchange Act ‘are in most cases thrown away unread’ (p. 137).
In the public sector bounded rationality is more likely with legislators than with bureau managers because they are ‘outsiders’ who may find it difficult to understand the production process within the hierarchy of the bureau, as suggested by Spencer (1982, p. 199). The implications of bounded rationality in public sector organizations are likely that both legislators and bureau managers are likely to overallocate resources to those interests and activities that are most easily observed and which are narrowly focused on a specific benefit-generating individual or group. For legislators, this suggests that more resources would be allo- cated and funds appropriated to programs and projects valued by special interest groups or political action committees than those valued by a more widespread citizenry of constituents and taxpayers, as Becker (1983) suggests. For bureau managers, this suggests that more resources, such as budget and staff, will be allocated to those programs or projects, or specific attributes of these, that are most noticeable, rather than those which provide greater social benefits but which are more difficult to observe. Thus resources will be allocated inefficiently by both legisla- tors and bureau managers because the resulting allocation does not maximize net social benefits.
A major source of this problem is that constituents and taxpayers are also subject to bounded rationality. They may be less likely to monitor effectively, or monitor at all, not only because of a free rider problem but because of limited ability to access and process information on deci- sions made by legislators and even more so for decisions made by bureau managers. Even with voting record information, citizens have limited access to how this information translates into the process of service provision through public sector organizations.
Simon (1957, p. 121) proposes that under conditions of bounded rationality nonprofit organizations are subject to less conflict than for- profit organizations are, primarily because there is no need to be con- cerned about an acceptable profit level. The reduced conflict permits more efficient operation of the organization. Due to the nature of infor- mation processing problems, however, bounded rationality may also indicate the potential for inefficiencies in nonprofit organizations. For example, the generalized nature of typical nonprofit mission statements clearly reflects the use of ideals or targets rather than specific and absolute outcomes. Donors and grantors have limited information on the production process of the nonprofit organization(s) that they fund, and also have limited ability to process information that may be available, such as to translate a nonprofit’s mission statement into measurable out- comes (Quarter and Richmond, 2001). The degree of hierarchical structure of the organization can add to these informational and computational difficulties for managers as well as donors and grantors. Thus there is con- siderable uncertainty regarding the way that the funds donated may be translated by nonprofit managers into their preferences.
Managers of nonprofit organizations also have limited ability to process information on donor preferences and those of employees and volunteers, and possibly also clients. To mitigate this problem rules may be developed, particularly in larger more complex nonprofits. The use of rules also serves to separate rather than align preferences of donor/ investors, managers, and employees and volunteers if they are seen as arbitrary and rigid. While rules may be seen as standard fare in public sector organizations, in nonprofits there may be more resistance to them. Under conditions of bounded rationality, actions and decisions are more likely to be made on the basis of perceptions rather than facts, particularly when facts are not entirely clear (Simon, 1957). This also suggests that better communications (that is, information processing) may occur in smaller organizations. I explore this issue more fully in Chapter 10.
Source: Carroll Kathleen A. (2004), Property Rights and Managerial Decisions in For-Profit, Nonprofit, and Public Organizations: Comparative Theory and Policy, Palgrave Macmillan; 2004th edition.