Abstract
The escalation of commitment process involves a decision-maker continuing commitment to an investment after receiving negative information. This study develops a principal-agent model to explore how escalation decisions are linked with departures of CEOs from the position. With asymmetric information, a CEO has an incentive to conceal prior decision errors by escalating commitment to failing investments and leaving the firm before the outcome of investment decisions is disclosed publicly. Results of empirical analysis based on a sample of over 3,000 US firms are consistent with the theory and demonstrate that firms’ reporting of low financial performance relative to their industry as well as initiation of new discontinued operations are preceded, and not followed, by unplanned CEO departures.
Highlights
Escalation of commitment exists when a decision-maker continues investments after receiving negative information
This study explores the link between the incentive to escalate commitment to an investment and turnover by chief executive officers (CEOs)
In the principal-agent model, information asymmetry creates an incentive for a CEO to continue failing investments and limit public revelation of prior mistakes
Summary
Escalation of commitment exists when a decision-maker continues investments after receiving negative information. This study provides several contributions to the economic literature on escalation and de-escalation of commitment, as well as the literature on CEO turnover It links the incentive for escalation of commitment with the departure of the CEO from the firm in an economic model of asymmetric information. In the presence of escalation of commitment, negative changes at the firm are observed not before the CEO departures, but after these, as the new leadership attempts to address escalated investments that may have been concealed by the departing executives. The empirical results demonstrate that significant economic changes at the firm are observed on financial statements published after the departure of a CEO. The results indicate no significant link between CEO departures and economic changes at the firm for cases of departure due to planned succession or illness.
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