Behavior and Rationality in Corporate Governance

By Marnet, Oliver | Journal of Economic Issues, September 2005 | Go to article overview

Behavior and Rationality in Corporate Governance

Marnet, Oliver, Journal of Economic Issues

The governance debate identifies the central problem of the separation of ownership and control in the large corporation and centers on the alignment of the agent's interests with those of the principal. Key factors in monitoring senior managements' performance include the composition and independence of outside board members, issues of transparency, outside reporting, accounting standards, and shareholder composition. Empirical research on corporate governance (e.g., Klein 2000; Peasnell et al. 2002) typically investigates quantifiable relationships between measures of corporate performance and specific remedies to agency problems, including the number and independence of directors on a company board or board committees and the independence of external auditors. This large body of research identifies important aspects of the problem of minimizing the conflicts between principal and agent.

Until fairly recently, however, issues of bias in human cognition and perception, decision making under uncertainty, risk assessment, and the impact of emotion and affect on behavior received somewhat less attention in this literature. Monitors are frequently assumed to be rational actors (Fama 1980; Shleifer and Vishny 1997; Prentice 2000). (1) Findings from cognitive psychology and behavioral studies, however, indicate that judgment, decision making, and behavior are not exclusively based on logical reasoning but are also subject to numerous heuristics and cognitive biases (Tversky and Kahneman 1974; Kahneman and Tversky 1979; Fischhoff 2002), affect (Slovic et al. 2002), visceral factors (Schelling 1984; Loewenstein et al. 2001), and pressures toward conformity with the group or authority (Asch 1956; Janis 1982). Divergence from utility maximization over time adds a temporal dimension to this literature (Strotz 1955; Thaler 1981). These influences tend to steer human judgment, inference, and behavior away from the predicted outcome of expected utility theory and lead to systematic violations of the normative assumptions central to the economist's rational model.

Members of the board of directors and external auditors are, for example, expected to care about their reputation and their prospects in the job market, which is theorized to discipline their actions. There are, however, limits to reputation as a determinant to behavior. Auditors and board directors are, no less than other individuals, subject to the common human preference for immediate gratification, typically with insufficient regard for potential negative future consequences. The gratification from a bonus, re-election to a board of directors, renewal of an auditing contract, or the prospects of employment in a client's firm is certain and experienced in the present or the immediate future. In contrast, expected damage from questionable activities, including reputational damage, legal or financial sanctions, and loss of career is merely potential and in the more distant future. The magnitude of negative outcomes may be further discounted and reduced in perceived severity and probability by self-serving justifications and overoptimism. (2)

This paper examines corporate governance from an agency perspective and asks why some of the standard means of monitoring the activities of senior decision makers in large corporations are prone to failure. The focus of the paper is on issues of agent behavior, questioning some of the assumptions of the familiar neoclassical maximizing model. The issue of corporate governance touches on core assumptions in economics concerning the behavior of individual agents, the tendency toward equilibrium in financial markets, the role of the corporate firm, and the subject of regulation. Institutional economics has a long tradition of fundamental criticisms of some of the core assumptions of mainstream economics, in particular with regard to the strict assumptions about rationality and utility maximization. The unease of this school with the neoclassical assumption of perfectly optimizing behavior of agents predates the discussion of human cognition and decision making under uncertainty. …

The rest of this article is only available to active members of Questia

Already a member? Log in now.

Notes for this article

Add a new note
If you are trying to select text to create highlights or citations, remember that you must now click or tap on the first word, and then click or tap on the last word.
One moment ...
Default project is now your active project.
Project items

Items saved from this article

This article has been saved
Highlights (0)
Some of your highlights are legacy items.

Highlights saved before July 30, 2012 will not be displayed on their respective source pages.

You can easily re-create the highlights by opening the book page or article, selecting the text, and clicking “Highlight.”

Citations (0)
Some of your citations are legacy items.

Any citation created before July 30, 2012 will labeled as a “Cited page.” New citations will be saved as cited passages, pages or articles.

We also added the ability to view new citations from your projects or the book or article where you created them.

Notes (0)
Bookmarks (0)

You have no saved items from this article

Project items include:
  • Saved book/article
  • Highlights
  • Quotes/citations
  • Notes
  • Bookmarks
Cite this article

Cited article

Citations are available only to our active members.
Buy instant access to cite pages or passages in MLA, APA and Chicago citation styles.

(Einhorn, 1992, p. 25)

(Einhorn 25)

1. Lois J. Einhorn, Abraham Lincoln, the Orator: Penetrating the Lincoln Legend (Westport, CT: Greenwood Press, 1992), 25,

Note: primary sources have slightly different requirements for citation. Please see these guidelines for more information.

Cited article

Behavior and Rationality in Corporate Governance


Text size Smaller Larger Reset View mode
Search within

Search within this article

Look up

Look up a word

  • Dictionary
  • Thesaurus
Please submit a word or phrase above.
Print this page

Print this page

Why can't I print more than one page at a time?

Full screen

matching results for page

    Questia reader help

    How to highlight and cite specific passages

    1. Click or tap the first word you want to select.
    2. Click or tap the last word you want to select, and you’ll see everything in between get selected.
    3. You’ll then get a menu of options like creating a highlight or a citation from that passage of text.

    OK, got it!

    Cited passage

    Citations are available only to our active members.
    Buy instant access to cite pages or passages in MLA, APA and Chicago citation styles.

    "Portraying himself as an honest, ordinary person helped Lincoln identify with his audiences." (Einhorn, 1992, p. 25).

    "Portraying himself as an honest, ordinary person helped Lincoln identify with his audiences." (Einhorn 25)

    "Portraying himself as an honest, ordinary person helped Lincoln identify with his audiences."1

    1. Lois J. Einhorn, Abraham Lincoln, the Orator: Penetrating the Lincoln Legend (Westport, CT: Greenwood Press, 1992), 25,

    Cited passage

    Thanks for trying Questia!

    Please continue trying out our research tools, but please note, full functionality is available only to our active members.

    Your work will be lost once you leave this Web page.

    Buy instant access to save your work.

    Already a member? Log in now.

    Author Advanced search


    An unknown error has occurred. Please click the button below to reload the page. If the problem persists, please try again in a little while.