Beyond self-interest: Cognitive bias as a source of agency costs

Abstract

Agency theory posits that the separation of ownership and control in a company allows self-interested managers to pursue their own interests by taking advantage of their superior information compared to shareholders. In this paper, we present evidence that agency costs (i.e., flawed director decision-making) can arise because of directors’ limited competence and the problem of specification of objectives, independent of information asymmetry and director independence. Using a 2x2 experimental design addressed to 180 directors, we demonstrate that anchors (Angeletos & Huo, 2021) and the mechanism of fairness (Mussel et al., 2022) may cause directors to deviate from the rational choice that maximizes a given utility function. We argue that the decision-making process can undermine a director’s ability to effectively monitor by exploiting their limited rationality, and this aspect remains inadequately specified in existing agency models. Consequently, we contribute to the literature that examines the board as a decision-making group by showcasing how a focused analysis of the decision process can unveil new mechanisms within the governance process.