Bounded rationality, property rights, and managerial decision making

Separation of ownership and control is inherent in the corporate orga- nizational form. This situation exists even in the face of limitations on the abilities of owners (shareholders) and those in control (managers) to process information and articulate and achieve their respective goals.

The property rights model and the transactions cost, contracts, and principal–agent approaches to the theory of the firm do not explicitly consider these limitations on the part of decision makers. Imperfect and asymmetric information are clearly incorporated into these theories, however, as fundamental problems. Models typically seek to solve the information problem by designing incentive contracts to promote exchanges or contracts that reduce transactions costs or better align principal and agent interests. The problems of processing information (even when it is available) and goal articulation are not considered, however. The question I ask here is, given the separation of ownership and control, in situations of bounded rationality how do property rights affect incentives and managerial decisions? To address this question I consider the implications of behavioral theories of the firm that assume bounded rationality for shareholder and managerial decision behavior. Shareholders, as investors, have as their ostensible goal to obtain the greatest return on their capital investment, that is, to maximize their profit. Under conditions of bounded rationality, however, there is no clear meaning or articulation of this goal. Shareholders do not know what the greatest possible return is, and they cannot fully process the information available to learn what this maximum return could be, or how to achieve it if they knew.

Shareholders have multiple alternatives in which to invest their capital. For simplicity consider only shares of stock of individual corpo- rations and shares of mutual funds which hold corporate stocks, or alternatively, the simple choice of equity (stocks) or debt (bonds) that has been addressed in the literature (Jensen and Meckling, 1976 and Hart, 1988).1 Even with only these limited sets of choices, to maximize share returns requires processing information from a multitude of cor-porate quarterly and annual reports and the prospectus of each poten- tial investment. Bounded rationality simply reflects this quandary so that shareholders accept a given level of reported profit, πR. Given the limits on information processing, shareholders stay with the invest- ment mix that yields (πR) as long as it is good enough, that is, until (πR) falls sufficiently below other profit opportunities with similar risk that are easily observable and easily understood.2

By the same token managers ostensibly want the greatest satisfaction from their positions of control, including income (compensation) but also authority, power, prestige, and other nonpecuniary benefits. I think of this in relative terms: the various attributes are evaluated relative to the position or level previously obtained or relative to the positions or levels obtained by peers (see Pfeffer, 1990, on this point). The lack of homogeneity across and within the complex structures of corporations makes it difficult for any corporate manager to know what the optimal combination of attributes is even in relative terms. Each of these varia- tions contributes to the bounded rationality of the corporate manager. Variations across corporations arise from a number of sources. One is hierarchies. These may include unitary, or U-form, structures, where all divisions report to a single individual; multidivisional, or M-form, struc- tures, where each division operates as a separate profit center; matrix structures, where some decision authorities overlap, and alternative structures such as separating current operations from future planning operations (Jantsch, 1971). A second source is the corporation’s envi- ronment. The environment of a corporation includes the markets and industries of its suppliers and competitors. These are themselves affected by the degree to which each is regulated or not. A third source of variation is mode of operation. The forms of rules which are applied within the corporation reflect cultures and traditions that arise from organizational design and from societal norms.

Variations within corporations arise from its orientation and objec- tives. Orientation here refers to its approach to and use of marketing, sales, design, and accounting procedures. Objectives may include profit, market share, market position, growth, and product quality, among others.

Once the limits on shareholders’ and managers’ abilities to process information and precisely articulate their objectives are understood, it becomes clear that the usual equilibrium of optimization models is infea- sible. The irony of managerial optimization models such as Williamson’s is that the equilibrium positions they define for managers are dependent upon bounded rational behavior on the part of shareholders. The model requires that shareholders are satisfied with the reported level of profit (wR). It must be a normal profit because shareholders can do no better elsewhere; however, this does not mean that is the best, the highest pos- sible profit. It is the best they think they can do because they simply do not have the ability to know if they can do any better. Reported profit is not the precise level of profit that they seek. The reported profit is the profit that they get, and the model relies on the premise that the reported profit is good enough. As Simon (1987b) indicates, for share- holders, the process of finding and investigating alternative invest- ments is lengthy and costly. In his view, it is efficient for shareholders to accept and be satisfied with the reported level of profit. Share- holders in the managerial model of the firm are thus satisficers, not optimizers, but they are not inefficient.

Because shareholders are satisfied with reported profit (πR), bounded rational behavior predicts that there is less incentive to monitor man- agers by investigating the many alternatives to determine if some profit π > πR is even possible. Even if π > πR is observed elsewhere, bounded rationality precludes instantaneous response by shareholders, as pre- dicted by the neoclassical (and other) optimization models. If the reported profit earned by shareholders is less than  the  normal  profit, that is, what they can easily see that they can earn elsewhere, then shareholders would be expected to either engage in additional moni- toring of the manager or sell their shares, moving their capital to invest- ments that provide the higher return that they are confident they can obtain. Even so, the sale of shares is neither immediate nor inevitable, however, under conditions of bounded rationality.

The implications of bounded rational managerial behavior are ambiguous. On the one hand, less monitoring by owners who are also subject to bounded rationality in their investment choices implies a greater opportunity for managers to exercise managerial economic rights and to expropriate shareholder returns. On the other hand, limits on information processing and goal articulation imply that managers who achieve a satisfactory combination of attributes in their position and who cannot know precisely what monitoring levels are in place may engage in less opportunistic behavior than would be predicted by opti- mization models. That is, managers may be either less responsive or more responsive to incentives designed to align their interests with those of shareholders under conditions of bounded rationality. It is more likely, however, that shareholders are less informed than are managers because of the many possible investment alternatives that they face. In this case, greater managerial opportunistic behavior would be expected.

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.

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