An Experimental Study on the Relevance of

"Fairness" in Capital Budgeting and Resource

Sharing Decisions

Bobby Mak

A master thesis submitted in partial fulfilment of the requirements of the degree

of Master of Commerce (Honours) at the University of New South Wales.

1998 DECLARATION

I hereby declare that this submission is my own work and that, to the best of my knowledge and belief, it contains no material previously published or written by another person nor material which to a substantial extent has been accepted for the award of any degree or diploma of the university or other institute of higher learning, except where due acknowledgement is made in the text.

Bobby Mak

1998

11 ABSTRACT

Traditional analyses of capital budgeting and resource sharing negotiations emphasise wealth-maximising behaviour. The concern for distributive fairness has been less well studied. This study attempts to expand the set of relevant variables in capital budgeting and resource sharing decisions, by investigating situations that invoke a consideration of distributive fairness.

Three experiments were conducted.

The first experiment investigates a manager's level of investment in a risky project involving another party. Contrary to the traditional wealth­ maximisation approach, the study predicts that the manager will be concerned with equity variables that do not affect the project's potential to maximise his or her wealth. In particular, it is hypothesised that the chosen level of investment would be lower when the returns offered to the parties did not reflect the relative level of effort expended by each party towards the initial development of the project. The results from the first experiment do not support this hypothesis.

The second experiment modified the first experiment to exclude possible confounding effects of risk preference and commitment escalation (from prior

lll effort). Subjects, whose project returns were held constant, were allowed to choose the return to the other party in the joint project. Results indicate that subjects chose returns that significantly reflected the relative level of effort expended by each party towards the initial development of the project.

The third experiment examines a manager's level of cost and benefit allocated to another party sharing a common resource. Subjects significantly deviated from wealth-maximising options. Considerations of fairness were observed. The experiment also investigates whether prior unfair treatment received by the manager will affect his or her subsequent level of allocation.

Predicted effects were not found. A potentially interesting explanation is offered for these results.

IV ACKNOWLEDGEMENTS

I wish to express my sincere thanks to my supervisors, Professor Chua Wai

Fong and Cameron Hooper, for their encouragement, guidance, commitment and patience throughout the course of the study.

Special thanks are also due to Axel Schulz for his assistance in performing some of the statistical tests; Tan How Teck and Ker Bee Kuan for their assistance in conducting the experiments.

V TABLE OF CONTENTS

Page

Declaration 11

Abstract m

Acknowledgements v

Table of Contents v1

List of Figure and Tables vm

Chapter I: Introduction and Motivation 1

Chapter II: Literature Review 11

Chapter III: Hypothesis Development 23

Chapter IV: Experimental Design 35

Chapter V: Results and Discussion 51

Chapter VI: Conclusion, Implications and Limitations of the study 71

Appendix A 75

Appendix B 76

Appendix C 86

Appendix D 88

Appendix E 89

Appendix F 90

Vl Appendix G 91

Appendix H 92

Appendix I 93

Appendix J 94

Bibliography 95

Vil List of Figure & Tables

Figure Heading Page

I Level of future investment by Relative expected 28 return to the other party (higher or lower than the manager) and Relative prior contribution by the other party (more or less than the manager)

Table

I Experiment I - Experimental treatments 39

2 Experiment 3 - Experimental treatments 48

3 Experiment I - Mean and Standard deviation of 52 Amount invested by treatment

4 Experiment I - 2 x 2 Analysis of variance on 53 Amount invested by Relative expected return and Relative prior contribution

5 Experiment 2 - Choice of project by Relative prior 55 contribution by the other party

6 Experiment 2 - Wald Chi-Squared test 57

7 Experiment 3 - Descriptive statistics of Cost 58 proposed

8 Experiment 3 - Descriptive statistics of Benefit 58 allocated by cell

9 Experiment 3 - Significance level (adjusted for 65 multiple comparisons) ofTukey HSD test on Benefit allocated by cell

10 Summary of results 70

Vlll Chapter I: Introduction and Motivation

Many accounting theories adopt the perspective that the human being is an utility-maximiser (e.g. Zimmerman, 1979; Baiman, 1982). From this perspective, human behaviour is purposive; its purpose is to optimise a criterion; and that criterion is utility. As such, an individual is regarded as a

"maximising" person who "acts for'' his or her "best interest''.

What indeed is in a person's best interest? Bentham (1948) presents one of the foremost descriptions of a person's utility (i.e. best interest) as

... that principle which approves or disapproves of every action whatsoever, according to the tendency which it appears to have to augment or diminish the happiness of the party whose interest is in question. (p.2)

Many other interpretations of the utility notion are also available, such as

"satisfaction", "taste", "welfare", "want-satisfying power" and "something such that more of it is always desirable". Unfortunately, none of these definitions could substantiate what actually is in a person's best interest. Over the years, researchers in different disciplines have been searching for an adequate approximation of the utility function. Suggestions to its constituents include physiologic well-being, safety, aesthetic appreciation (Maslow, 1954), affiliation, achievement, power (McClelland, 1961, 1975) and sexual pleasure

(Freud, 1977). In the field of accounting, there is a dominance of emphasis on the wealth component of the manager's utility function. For instance, Watts &

Zimmerman ( 1978) assume that

. . . management's utility is a positive function of the expected compensation in future period (or wealth) and a negative function of the dispersion of future compensation (or wealth) 1. (p. 114)

All the three most frequently tested hypotheses on the manager's accounting practice underscore wealth objectives. The bonus plan hypothesis expects the manager to manipulate accounting options to boost compensation (Healy, 1985;

Holthausen, Larcker & Sloan, 1995). The debt/equity hypothesis predicts the manager to select accounting procedures to regulate debt-covenant violation cost (DeFond & Jiambalvo, 1994; Sweeney, 1994). The political cost hypothesis anticipates the manager to choose accounting methods to control political effect (Jones, 1991, Cahan, 1992). Even studies that differentiate the

"efficient" from the "opportunistic" accounting practice ( e.g. Christie &

Zimmerman, 1994) emphasise only wealth consequences.

Studies over a wide range of accounting-related behaviour highlight the effects and consequences of wealth. In the name of wealth, the manager is expected to affect the transfer price (DeJong, Forsythe, Kim & Uecker, 1989), budget (Chow, Cooper & Haddad, 1991), pension settlement (Haw, Jung &

1 The dispersion of future compensation is also known as the risk or uncertainty of future compensation. Its concern is regarded as part of the concern for wealth. Quoting Seitz & Ellison ( 1995):

2 Lilien, 1991 ), research & development activity (Dechow & Sloan, 1991 ), investment (Nagarajan, Sivaramakrishnan & Sridhar, 1995), equity offer (Healy

& Palepu, 1990a), dividend policy (Healy & Palepu, 1990b), information disclosure (Lewellen, Park & Ro, 1996), choice of auditor (DeFond, 1992) and even legislation (Dechow, Hutton & Sloan, 1996). Ironically, the manager is likely to bear the cost of his or her own opportunistic behaviour (Jensen &

Meckling, 1976). In the face of such self-interested behaviour in self and others, the manager is also expected to demand various bonding and monitoring mechanisms including accounting and auditing (Chow, 1982). Collectively, these studies have emphasised wealth as being the purpose driving managerial behaviour. That is, wealth-maximisation has been regarded as the criterion underlying managerial decisions.

Furthermore, wealth-maximisation is often used as a basis for justifying the use of various management accounting techniques [e.g. cost-volume-profit analysis (Magee, 1975); relevant cost evaluation (Banker, Datar & Kekre,

1988); cost and resource allocation (Kaplan & Welam, 1974; Hansen & Magee,

1993); transfer pricing (Edlin & Reichelstein, 1995); managerial incentive compensation (Hemmer, 1993) and performance evaluation (Baiman & Noel,

1985; Suh, 1987)]. In the introductory chapter of their book on capital budgeting, Seitz & Ellison ( 1995) state:

... consideration of risk is part of the process of making wealth-maximizing choices. (p. 5)

3 The purpose of this book is to help current and prospective managers make better investment and financing decisions. If a choice is better, it must be better by some standard. Otherwise, one alternative is as good as the next. That standard is wealth maximisation. (p. 4-5)

Comparatively, the manager's utility for non-wealth factors has received very little attention by accounting researchers. Although agency studies do recognise the manager's utility for leisure (Tiessen & Waterhouse, 1983), many other possible non-wealth elements of the manager's utility function are not well discussed in the accounting literature.

In recent years, there is a growing body of literature on econmruc decisions which documents the significance of various "social" considerations, such as "altruism" (Andreoni, 1990), "kindness" (Andreoni, 1995) and "trust"

(Guth, Ockenfels & Wendel, 1993; Berg, Dickhaut & McCabe, 1995). These significant considerations are not only non-wealth in nature, they also appear to be in conflict with wealth-maximisation as they usually involve the sacrifice of wealth.

In particular, many researchers observe the suboptimisation of wealth when the issue of fairness in distribution is in question (Prasnikar & Roth,

1992; Camerer & Thaler, 1995). Studies report situations where people choose to suffer wealth loss to resist "unfair2" allocation proposals (Selten, 1988; Roth,

2 Technically speaking, the term 'unfair' applies to all contexts that are perceived to disobey the rule of fairness, regardless of whether one is in a beneficiary or loser position. However, for brevity, it is used here and many other parts of the study to refer to strictly loser contexts.

4 1995). The wealth-maximisation hypothesis may justify the resistance of unfair proposals but not when they are known to result in an overall wealth loss.

Authors also cite realistic examples of "travelers on interstate highways" who

"leave tips for waitresses they will never see again" (Frank, 1987, p. 593); employers who "rarely try to elicit wage cutting on the part of their laid-off employees, even in a buyer's market for labor'' and unemployed workers who

"rarely try to displace their employed counterparts by offering to work for less"

(Solow, 1980, p. 5).

These observations suggest that individuals do not always seek to maximise wealth. In some circumstances, they are willing to suboptimise wealth in order to achieve a "fairer" wealth distribution. Such wealth­ suboptimising behaviour can take two different forms. One, it can be a response to resist a distribution perceived to be unfair to oneself. Two, it can be a voluntary action to distribute wealth to others so as to achieve a fairer distribution to others.

These observations imply that the individual's utility function may also include the element of "fairness" or "equity", besides wealth. Sometimes, this utility for fairness or equity may conflict with and even overcome the utility for wealth, leading to the observed wealth-suboptimising behaviour.

5 Such implications offer an opportunity for us to reevaluate existing accounting studies, which are accustomed to wealth being the sole fundamental criterion underlying the behaviour studied. In addition, the implications suggest a need for us to extend our understanding on the notion of fairness in the use of accounting information. In a recent study, Luft (1997) argues that the predominance of the wealth-maximisation model in accounting research "has arisen in part because plausible alternative-model predictions have not been made, not because plausible alternative predictions have been made and rejected by empirical evidence" (p. 204). Investigations into the utility for fairness can therefore help enrich the basic theoretical framework and explain discrepancies with observed accounting practice.

Recently, the notion of fairness has begun to receive more attention in the accounting literature. Studies have examined the role of perceptions of fairness in the decision-making behaviour of subjects assuming the role of consumer, owner, worker, taxpayer and manager ( e.g. Kachelmeier, Limberg &

Schadewald, 1991; Evans, Heiman-Hoffman & Rau, 1994; Lindquist, 1995;

Moser, Evans & Kim, 1995; Luft & Libby, 1997). However, none of these accounting studies investigates the voluntary behaviour that distributes wealth to others. Also, probably only Luft & Libby ( 1997) has examined the effect of fairness on the decision-making processes of a manager.

6 A manager has substantial direct interaction with accounting information. Furthermore, a manager's role in the organisation is unique and the scope of his or her decision is more diversified than many other users of accounting information. Thus, the manager's utility function has important bearings on the use and interpretation of accounting information.

To investigate if the manager suboptimises wealth to resist a distribution perceived to be unfair, the study examines a capital budgeting decision in a joint investment opportunity involving the manager and another party. An experiment was conducted to study the manager's chosen level of investment

(in a risky project yielding a positive expected return to the manager) in response to relative differences in the other party's (i) expected project return and (ii) prior contribution to the project. As the effect of these two factors on the investment's potential to maximise the manager's wealth was controlled, the wealth-maximisation hypothesis does not expect the manager to vary investment in response to the two factors. However, considerations of fairness or equity may cause the manager to reduce investment ( thus suboptimising wealth) when unfairness is perceived from the comparison of the two factors among the two parties.

As the manager's prior contribution to the project could have induced an escalated commitment effect, the chosen level of investment might have been confounded. Also, the risky nature of the investment might have caused

7 ambiguity in the results. As sue~ the study conducted another experiment in a joint investment context. This time, instead of the level of investment, the dependent variable was the choice of project return for the other party, from three different alternatives. The experimental treatment was the relative prior contribution by the other party to the development of the projects. Concerns for fairness may induce the manager to choose project returns for the other party according to the other party's relative prior contribution to the projects. As the manager's commitment to the investment was limited to one, and only one, project, it was unlikely that the escalated commitment effect could have influenced the decisions. Also, the projects had a fixed (riskless) return to the manager, thus excluding the possible effect of risk preference.

To investigate if the manager volunteers to distribute wealth to others, the study examines resource sharing decisions in a bargaining situation involving the manager and another party sharing a common resource. An experiment was conducted to study the level of cost and windfall benefit of the common resource that the manager intended to allocate to the other party. The notion of wealth-maximisation expects that the manager will exploit his or her bargaining position to allocate the maximum cost and minimum benefit to the other party. In contrast, the utility for fairness may urge the manager to consider fairness to others and not exploit his or her bargaining capacity to the fullest.

8 Some recent studies on reciprocal fairness suggest that the manager's consideration of fairness to others may be a function of the fairness ( or unfairness) perceived in prior treatment from others. The notion of reciprocal fairness advises that an individual tends to treat others the way he or she has been treated by these others (Rabin, 1993; Berg et al., 1995). As such, the consideration of fairness to others may be a function of the level and the source of perceived fairness or unfairness in prior treatment received. Hence, the resource sharing experiment also examines the manager's level of windfall benefit allocated to another party with respect to different levels of perceived unfairness in prior treatment from different sources.

The motivation of the present study is therefore fourfold. First, it attempts to investigate possible violations of the basic utility model based on wealth-maximisation. Second, it intends to test explanations to possible violations of wealth-maximisation with respect to the utility for fairness in the hope to improve the utility model. Third, it aims to expand the literature on the notion of fairness by studying managerial decisions, with specific regard to capital budgeting and resource sharing decisions. Fourth, it seeks to add to our understanding of the role of perceived fairness by considering subcomponents such as relative expected return and prior contribution, level and source of perceived unfairness in prior treatment received.

9 The study is organised as follows: Chapter II provides a review on the relevant literatures. Chapter III discusses the hypothesis development. Chapter

IV describes the experimental design. Chapter V contains the results and discussion. Chapter VI presents the conclusion, implications and limitations of the study.

10 Chapter II: Literature Review

The concept of fairness3 or justice entails the evaluation of distribution with respect to a standard or rule of fairness (Cohen, 1987). Drawing on theories of social comparison processes4 (Festinger, 1954) and cognitive dissonance5 (Festinger, 1957; Brehm & Cohen, 1962), the notion of fairness suggests that an individual compares intra-group distribution with norms and perceives (un)fairness when the distribution (dis)obeys the norms. Perceptions of unfairness cause discomfort and urge the individual to respond in various ways to reduce the discomfort (Adams, 1965; Walster, Walster & Berscheid,

1978).

Of the vanous norms of fairness, it is suggested that economically oriented coalitions usually invoke the equity norm of distribution (Deutsch,

1975). This norm of distribution advocates allocation of group output in proportion to each member's input to the group output, and factors used to assess input include contribution, investment, achievement and ability (Mannix,

Neale & Northcraft, 1995). The equity norm of distribution for a dyad of two members, say A and B, can be generally represented as:

Output (A) Output (B)

3 This concept of fairness is usually referred to as distributive fairness in the fairness literature, as a differentiation from procedural fairness and other forms of fairness. 4 The theory of social comparison holds that an individual has a drive to compare his or her beliefs and abilities with those of another individual who is socially close. 5 The theory of cognitive dissonance maintains that inconsistency (i.e. dissonance) between an individual's belief and behaviour is psychologically uncomfortable and motivates the individual to reduce the dissonance.

11 = Input (A) Input (B)

Leventhal & Michaels ( 1969) give empirical support to this equity model. They paired individuals into two-member teams to work separately on an identical task for different durations. Thereafter, a member of each team was selected to allocate the team's monetary rewards among the two members. The researchers observe that the duration and quantity performed (i.e. input) of both members were considered in the division of monetary rewards.

Such a notion of equity or fairness is not included in most conventional economic analysis (Kahneman, Knetsch & Thaler, 1986a). However, in recent years, many researchers have begun to reexamine the relevance of fairness in the utility function, primarily through the use of the ultimatum game. The game basically asks a player 1 to propose a division of a "cake" (usually a sum of money) to a player 2, who then chooses whether to accept the proposal or otherwise both players receive nothing. Game theory, under the assumption that the monetary payoff is everything to the bargainers' utilities, predicts that player 2 will receive no more than the smallest monetary unit allowed (Stahl,

1972; Rubinstein, 1982). Guth, Schmittberger & Schwarz ( 1982), however, first observe that the average offer to player 2 was above 30 % and about 20 % of offers were rejected. They note:

12 The typical consideration of a player 2 ... seems to be as follows: 'If player 1 left a fair amount to me, I will accept. If not and if I do not sacrifice too much, I will punish him ... (p. 384)

Thus, they conclude that

. . . subjects often rely on what they consider a fair or justified result. Furthermore, the ultimatum aspect cannot be completely exploited since subjects do not hesitate to punish if their opponent asks for "too much". (p. 384)

Binmore, Shaked & Sutton (1985) extended the ultimatum (i.e. one period) game to include another period of bargaining with alternate roles for the players and a discount factor of 0.25 on the size of the cake. Thus, if player 2 had chosen to reject player 1's proposal, the cake would "shrink" by the discount factor and player 2 could counterpropose a division of the remaining cake to player 1. This time, player 1 would then choose whether to accept the proposal or otherwise both players would receive nothing. The authors notice a

shift of the bargainers' decisions towards the subgame perfect equilibriu.m6 and

conclude:

Our suspicion is that the one-stage ultimatum game is a rather special case, from which it is dangerous to draw general conclusions. In the ultimatum game, the first player might be dissuaded from making an opening demand at, or close to, the "optimum" level, because his opponent would then incur a negligible cost in making an "irrational" rejection. In the two-stage game, these considerations are postponed to the second stage, and so their impact is attenuated. (p. 1180)

6 The subgame perfect equilibrium is game theory's "solution" for the game (Selten, 1975). It can be computed by working backward from the last (i.e. second) period. In the last period, a wealth-maximising player 1 (who will receive nothing if he/she rejects the offer) should accept any noMegative offer. Hence, if the game continues to the last period, player 2 (who gets to propose in the last period) should receive almost the whole remaining cake (i.e. 0.75 of the cake in the previous period). Therefore, prior to the last period (i.e. the first period), player 2 should reject any offer of less than what he or she should get if the game continues to the last period, but accept any offer of more. The same principle of computation applies to games that go beyond two periods.

13 Despite this caveat, the bargaining game has been extended on different aspects by subsequent studies. Thaler ( 1985) and Kahneman et al. ( 1986b) adapted the ultimatum scenario onto different realistic market situations.

Neelin, Sonnenschein & Spiegel ( 1988) extended the game to two, three and five periods. Guth & Tietz ( 1988) used different discount factors for the two­ period game. Roth, Prasnikar, Okuno-Fujiwara & Zamir (1991) repeated the game using subjects in four different countries: Israel, Japan, the United States, and Yugoslavia. Guth et al. (1993) used an increasing instead of a shrinking cake. Bolton ( 1991) allowed players to accumulate experience from repeated plays. Knez & Camerer ( 1995) extended the bargaining to three players instead of two. 7 Hoffman, McCabe & Smith ( 1996) tested the game using higher stakes of $100 instead of the usual $10. Again and again, studies observe individuals violating game theoty predictions under the wealth-maximising assumption. 8

Gale, Binmore & Samuelson ( 1995) note that:

. . . game theorists cannot ignore experiments that persistently refute their predictions ... In the case of the Ultimatum Game, the relevant experiments have been replicated too often for doubts about the data to persist. A theory predicting that real people will use the subgame-perfect equilibrium in the Ultimatum Game is therefore open to question. (p. 58)

7 In Knez & Camerer's (1995) game, a player 1 made simultaneous offers to two player 2s. 8 Observed violations of game theory include the high frequency of "disadvantageous counterproposals" in two-party alternating offer bargaining with discounting (Ochs & Roth, 1989). A disadvantageous counterproposal takes place when a player rejects a proposal and then make a counterproposal that gives him or her less cake (than what is offered in the rejected proposal), even though the share of the cake may be larger (than what is offered in the rejected proposal). The cake can be less even though the share of cake is larger because of the discount that takes place each time an offer is rejected.

14 Numerous authors have attempted to explain the game-theoretic violations. Thaler ( 1988) indicates that "subjects' utility functions have arguments other than money" (p. 202) and "notions of fairness can play a significant role in determining the outcomes of negotiations" (p. 205). Ochs &

Roth ( 1989, p. 3 79) justify that players "try to estimate the utilities of the player they are bargaining with" and "at least some agents incorporate distributional considerations in their utility functions." Guth & Tietz (1990) argue that subjects shift between strategic and equitable considerations in a hierarchical way so that they are concerned with only one aspect of the problem at a time. Bolton (1991) proposes that the bargainer's utility function includes both income and fairness elements. Roth (1995, p. 264) advises that "utility is not measured by its (their) monetary payoff, but must include some nonmonetary component". Collectively, these studies suggest that some form of concern for fairness is operating in the strategic decision process.

In particular, some authors suggest that the violations of game-theoretic predictions are due to player 1s "trying to be fair" (Roth, 1995). This suggestion is based on the belief that the individual has a preference to achieve a fairer distribution to others. To explore this "fairness hypothesis"9, Forsythe,

Horowitz, Savin & Sefton (1994) compared ultimatum and "dictator" games. A dictator game is similar to an ultimatum game except that player 2 does not have the opportunity to reject player 1's proposal. As such, the players will

9 Also referred to as the "radical hypothesis" in Kahneman et al. (1986a).

15 split the cake according to player 1's "dictation". Thus, if the significant offers in ultimatum games are due to player 1s trying to be fair, the offers should be as much in the dictator games. Forsythe et al. find evidence that "players are more generous in the ultimatum game than in the dictator game" (p. 357) and so they reject the hypothesis that game-theoretic violations in ultimatum games are due to player ls trying to be fair. However, they also observe that more than

60% of the dictators gave away portions of their cakes, which is inconsistent with the wealth-maximising prediction. Hence, they also conclude:

If a taste for fairness, by itself, cannot explain the outcomes of ultimatum games, how can they be explained? One possibility is to treat the ultimatum game as one in which there are different types of players, rather than one of complete information. In this incomplete information ultimatum game, some proposers are pure gamesmen, and others are concerned (to varying degrees) with fairness. (p. 362)

Hoffinan, McCabe, Shachat & Smith (1994) suspect that dictator players can be influenced by the availability of their decisions to the experimenter.

Hence, the researchers added "double-blind" experimental procedures to the dictator game guaranteeing the dictator player anonymity with respect to both the dictatee player and also the experimenter. The study detects high incidence of wealth-maximising behaviour, and suggests that fairness behaviour may not be due to utility for fairness per se but rather other social concerns such as reputation and threat of punishment.

Both Van Huyck, Battalio & Walters (1995) and Berg et al. (1995) included double-blind procedures in their studies on dictatorship. Both studies

16 involved a strategy game whereby a player (the investor) decided the portion of his or her endowment to invest for a fixed, higher return while another player

(the dictator) dictated the distribution of the investment and its return between the two players. Van Huyck et al. (1995) compared effects when the investor moved first and when the dictator moved first. They reason that the fairness hypothesis expects the dictator's behaviour to be independent of the order of moves. They find support against the fairness hypothesis. Berg et al. ( 1995), however, analyse the behaviour of the dictator, who moved after the investor.

They find support for the fairness hypothesis and explain that the dictator's behaviour is a reciprocation of the trust by the investor.

There are also those who interpret the failure of the game-theoretic predictions in bargaining games as a result of player 2s' "resistance" to unfaimess10 (Kahneman et al., 1986a & b). Rabin (1993) describes the behaviour as "sacrifices to hurt" those player ls who were being unfair. He explains that people reciprocate fairness and hence they "hurt those who are hurting them" (p. 1281). Bolton & Zwick (1995) address the action as

"punishment" for unfair treatment. They examined an "impunity" game, which is similar to an ultimatum game except that player I will receive his or her proposed share of the cake even if player 2 rejects the proposal. As such, the player 2 in the impunity game 11 is not able to "punish" the player I when the proposal is "unfair". The experimenters note strong evidence for perfect

10 Referred to as the "alternative hypothesis" in Kahneman et al. (1986a).

17 equilibrium plays in the impunity game and accrue the game-theoretic violations in the ultimatum game to the "punishment hypothesis".

As it stands, the existing economics-based game theory literature casts considerable doubt on the empirical validity of the traditional wealth­ maximisation model. Players are consistently observed to deviate from wealth­ maximisation predictions. Two explanations received significant attention from the literature. One attributes the behaviour to players "trying to be fair''.

Observations that support this explanation include the generous proposals of player 1s in dictator games. The other explanation attributes the behaviour to players' desire to punish unfair conduct. Observations that support this explanation include the rejection of positive offers by player 2s in ultimatum games. Both explanations are based on the notion of fairness.

While the body of literature on the notion of fairness is reasonable large, we know relatively little about the role and effects of perceived fairness on economic choices. The range of decision contexts studied also remains small. It is not clear if the observations in strategic games are generalisable to other economic decisions. As such, there is scope for extending the type of decision studied.

11 In substance, an impunity game is very much similar to a dictator game.

18 This is especially so given that the amount of research on the notion of fairness in accounting is also small. Kachelmeier et al. ( 1991) investigate the consumer's response to perceptions of fairness. The study gives support to the

"principle of dual entitlements", which posits that the consumer considers both the economic utility of the good and also the perceived fairness of the negotiated price. Evans et al. (1994) studied the significance of information to the firm owner's choice of internal control system. The writers draw on the concept of equity to propose an accountability demand for information by the firm owner. Lindquist (1995) analyses the effects of the worker's perceptions of fairness in the budgeting process on his or her job satisfaction and performance. The author suggests that fairness is an antecedent to participative budgeting. Moser et al. ( 1995) demonstrate that equity concerns affect the taxpayer's decision on the amount of income to report. Luft & Libby (1997) find that experienced managers expected the negotiated transfer price to deviate from the market price, when the profits to the buying and selling parties were unequal. The authors attribute this behaviour to concern for relative outcomes and aversion to unequal profits.

There 1s some non-empirical accounting work advocating the consideration of fairness in various accounting applications. For instance,

Young ( 1985) discusses different cost allocation methods from a fairness standpoint and Williams ( 1987) argues that there is a need for accountants to

19 consider the concept of fairness from a broader perspective. Luft ( 1997) applied the notion of fairness to explain various product costing practices.

The present study examines the relevance of fairness considerations in capital budgeting and resource allocation bargaining. The extant capital budgeting literature documents various investment evaluation techniques that emphasise mainly the wealth-maximising selection criterion, e.g. return on investment, internal rate of return, required rate of return, residual income and net present value. Variables relevant to an investment decision are the investor's expected return, expected risk, and attitude to risk. Northcott (1991) points out that

( c )oncepts of discounted cash flow analysis (DCF) have permeated the normative literature on capital budgeting analysis ... (p. 220) The tendency of (capital budgeting) theorists has often been to seek better ways of attaining 'optimum' decisions, given the presupposed objective of maximising shareholder wealth. (p. 229)

Cheung (1993) also notes:

A central result from the theory of the firm is that corporate investment decisions should be guided by the rule of net present value (NPV) maximization. (p. 29)

In contrast, non-wealth selection criteria have not received much attention in the literature.

20 Similarly, in the resource sharing literature, there is an abundance of documentation of different cost allocation methods using wealth-maximisation as a criterion, e.g. Shapley value, Moriarity method and Ramsey pricing

(Biddle & Steinberg, 1984; Young, 1985). Wealth-driven bargaining behaviour is also highlighted in some experimental studies on transfer pricing (DeJong et al., 1989; Chalos & Haka, 1990; Ravenscroft, Haka & Chalos, 1993).

Nevertheless, fairness is also discussed as a basis for cost allocation in some non-empirical research (Young, 1985; Lensberg, 1985). However, I am not aware of any empirical study investigating the effect of fairness on managerial behaviour in resource sharing.

Overall, the literature review shows that there is a large and still growing literature on the concept of fairness or justice or equity. Early studies, such as

Adams ( 1965), already note that individuals display various ,considerations for fairness. Since then, there has been substantial development of research in the social psychology literature in this area. This branch of literature, however, studies more an individual's social behaviour. There is less focus on economic decision-making.

Greater interest in the relevance of fairness in economic decision-making began in the games theory literature after Guth et al. ( 1982). Initially, studies contrasted the players' strategic choice between wealth and fairness

considerations. They consistently reported refutations to predictions based

21 solely on wealth considerations. Thereafter, studies investigated the mechanisms of fairness considerations in an attempt to provide a more comprehensive theory. At present, this branch of literature generally holds that strategic decisions involve both wealth and fairness considerations. However, there is still much diversity as to how and when fairness considerations operate.

The findings of the game theory literature have been introduced to the accounting literature recently. Some studies have begun to reexamine traditional accounting theories that do not regard fairness considerations as relevant. However, the amount of effort is still insufficient and many decision contexts remained to be investigated.

22 Chapter III: Hypothesis Development

The role of perceptions of fairness in capital budgeting environments

The discussion in the previous chapter identifies several inconsistencies between the notions of fairness and wealth-maximisation. One of these is behaviour which suboptimises wealth in order to resist a distribution perceived to be unfair. A significant number of players in bargaining experiments were observed to make disadvantageous counterproposals and to reject positive proposals at the final period (Guth et al., 1982; Ochs & Roth, 1989). These players seemed to prefer a "fairer" distribution arrangement that resulted in lower wealth than to accept an "unfair" option yielding greater end-of-game wealth. These observations suggest that failure to consider the role of perceptions of fairness may result in the omission of an important input to many decisions traditionally viewed as being governed purely by wealth­ maximisation.

Such considerations of fairness have implications in a capital budgeting context involving more than one party. Consider a scenario where a manager of a firm (hereafter, the manager and the firm are collectively referred to as 'the manager') is considering investing in a joint project which requires the participation of another firm (hereafter referred to as 'the other party').

23 Applying the traditional capital budgeting model, the manager is concerned exclusively with maximising "his" or "her" own wealth. As such, the variables relevant to the manager's investment decision are the manager's expected return, expected risk, and attitude to risk.

However, the notion of equity expects the manager to compare the distribution of output and input12 factors between himself or herself and the other party and respond to any perceptions of inequity13 that arise from the comparison. As such, equity considerations expand the set of decision-relevant variables considerably. Specifically, the roles of an output factor (i.e. expected return) and an input factor (i.e. prior contribution14) are considered.

According to the equity model, equity is in equilibrium when group members' output to input ratio is held constant (Leventhal & Michaels, 1969;

Walster, Berscheid & Walster, 1973). Hence, perceptions of inequity are less likely to arise when the other party receives a relatively higher expected return and also made a relatively greater prior contribution to the investment.

Similarly, perceptions of inequity are less likely to arise when the other party

12 The significance of input has also been noted in the ultimatum literature. Hoffman et al. ( 1994) observe that offers in ultimatum games were lower when subjects had to earn the right to be player I through better perfonnance in a quiz. 13 I have tried as much as possible to define notions in terms of equity/fairness instead of inequity/unfairness. However, for clarity sake, it is necessary to use the terms "inequity" and "unfairness·• instead of "equity" and "fairness" sometimes. 14 Usually, some prior effort has been incurred to develop an investment opportunity before further investment is considered. Such prior effort towards the development of the joint project opportunity is referred to as 'prior contribution' in this thesis.

24 receives a relatively lower expected return and also made a relatively smaller prior contribution to the investment.

Conversely, perceptions of inequity are more likely to arise when the relative expected return does not reflect the relative prior contribution. Such a situation can arise in two ways: one, when the other party receives a relatively higher expected return and made a relatively smaller prior contribution to the investment; and two, when the other party receives a relatively lower expected return and made a relatively greater prior contribution to the investment.

To illustrate these points more concretely, imagine that initially, the manager is faced with a project that does not involve another partner. The manager learns the expected payoffs in the various possible states of nature and the probabilities of each of these states. The manager uses this information along with knowledge of his utility function and his level of risk aversion to choose a level of investment that maximises his expected utility. Now consider the effect of introducing a second party to the project but continue to assume that the project payoffs, states, and probabilities presented to the manager remain unchanged. In the light of the previous discussion of the 'output to input' equity model, how might the manager's optimal level of investment be affected?

25 Traditional capital budgeting would not predict any change in the level of the manager's investment as all the relevant factors remain unchanged.

However, consider the case where the expected return offered to the other party is greater than that offered to the manager. Further, imagine that the manager and not the other party had been responsible for the project's initial development. It seems reasonable to argue that the output ( distribution of expected returns) to input (prior contribution) ratio is now 'out of balance'. The party with the greater input (the manager) has the lower relative output. Note that the key idea here is relative output rather than absolute output. The absolute expected return offered to the manager has not altered.

In such a situation, it is argued, the manager is likely to perceive the distribution of returns between the two parties as inequitable. If the manager values equity ( or has disutility for inequity), then, all other things being equal, his or her optimal level of investment in the joint project should decrease. The predicted effects of (i) the expected return available to the other party relative to the manager's expected return, and (ii) relative prior contribution are summarised as hypothesis 1.

Hypothesis 1: Holding the expected risk and return to the manager constant, the manager's level of future investment in a joint investment depends upon the interaction between both the relative expected return and the relative prior contribution of the other party. Specifically,

26 • When the other party receives a higher expected return than the manager, the manager's level of future investment is less (more) when the other party has less (more) prior contribution to the investment than the manager.

• When the other party receives a lower expected return than the manager, the manager's level of future investment is less (more) when the other party has more (less) prior contribution to the investment than the manager.

Figure 1 illustrates the hypothesis. Note that the level of investment by the manager is expected to be lowest when the manager made the greater prior contribution but the other party receives a relatively higher expected return.

The figure also shows that the manager's level of investment is expected to be relatively greater in the two 'equitable' cases - the party with higher contribution also has the higher relative expected return. Notice also the asymmetry illustrated in Figure 1. It is theoretically unclear what should be the correct prediction when the manager is the beneficiary of inequity - the manager has the higher expected return while the other party has the greater prior contribution. The figure has been drawn to reflect the assumption that the level of investment will be reduced to some extent as a consequence of this

27 inequity but that the reduction will be less than when the manager 1s the

'victim' of inequity.

Figure I (not drawn to scale) Level of future investment by Relative expected return to the other party (higher or lower than the manager) Relative prior contribution by the other party (more or less than the manager)

Level of future investment

More prior Less prior contribution contribution by the other by the other party party

--Higher expected return to the other party ------Lower expected return to the other party

It is noted that when the pnor contribution by the manager to the investment is significant, escalated commitment theory15 expects the manager to develop greater commitment towards the investment. Hence, the effect of commitment is expected to induce the manager to invest more in the joint investment when significant prior contribution has been contributed by the manager. As such, Figure I will look different when the effect of commitment is included. That is, the level of investment will be higher as the prior

28 contribution by the manager increases, i.e. as the relative prior contribution by the other party becomes less (see Appendix A). However, the interaction effect outlined in hypothesis 1 is still expected to hold despite the commitment effect.

In an attempt to gain a clearer insight into the role of the relative prior contribution by the other party without the commitment effect, the following scenario is developed.

Instead of having only one joint project with a manager choosing his or her level of investment, consider a situation where a manager has the opportunity to invest in three different joint projects, each involving the same other party, and is required to choose only one. The projects offer identical returns to the manager but differ with respect to the return offered to the other party. Specifically, one project offers a larger return to the other party, another offers an identical return, and the third offers a lower return. All the three projects are either developed by the manager or the other party.

Thus, the manager in this scenario is allowed to choose what would be considered as a "fair" outcome. This is different from the previous scenario, where the manager is allowed to respond to perceptions of unfairness invoked.

15 Escalated commibnent theory asserts that prior efforts induce greater commibnent (Staw, 1981 ).

29 The notion of equity expects the manager to choose a higher (lower) project return for the other party when the project opportunity is developed by the other party (the manager). Since the return to the manager is independent of which project is actually chosen, the wealth-maximisation hypothesis offers no prediction in this context. As the prior contribution of the managers in the two conditions will still be different, it is still likely that the level of commitment is not similar in the two conditions. However, as all managers will be required to choose one, and only one project, it is unlikely for the potential difference in commitment to be manifested. That is, those managers with potentially higher commitment will not be able to invest in more than one project. Despite the level of commitment, all managers must still choose one project and could only choose one project. Hence, it is unlikely for potential commitment effects to influence the dependent variable. This leads to the next hypothesis.

Hypothesis 2: Holding the expected wealth to the manager constant, the manager's choice of return offered to the other party in a joint project is a function of the relative prior contribution by the other party to the project development. Specifically, the manager chooses a higher (lower) project return for the other party when the project opportunity is developed by the other party (the manager).

This, however, is a weaker hypothesis than hypothesis 1 as it does not involve any sacrifice of wealth by the manager.

30 The role of perceptions of fairness in allocative decisions

Another inconsistency between the notions of fairness and wealth­ maximisation identified in the previous chapter pertains to voluntary actions aimed at achieving a fairer distribution to others. Significant allocations of wealth to other players have been observed in ultimatum and dictator games, contradicting the wealth-maximisation prediction (Forsythe et al., 1994;

Hoffman et al., 1994). Although studies find that the phenomenon of the ultimatum game cannot be completely explained by the fairness hypothesis, they also find evidence of dictator players behaving in a fair manner that cannot be completely explained by the wealth-maximisation hypothesis.

The ultimatum and dictator games can be found in many realistic managerial decision contexts. For example, responsibility centres in decentralised firms often share resources and negotiate on the basis of cost sharing of these resources. Consider a situation where one centre gets to propose a basis of cost sharing and the other centre can only either accept or reject the proposal. Such a mode of bargaining gives rise to an ultimatum scenario. Also, consider the situation where one of the centres receives a windfall (i.e. unexpected) benefit from the shared resources. In the absence of a prior arrangement to distribute the benefit between the centres, the centre receiving the benefit may be left in a position of being able to dictate the allocation of the benefit, giving rise to a dictator game.

31 In a multi-period environment, long-term wealth effects play an important role and the relationship between notions of fairness and wealth­ maximisation becomes less clear. Failure to maximise short-term wealth may be due to considerations of either fairness or strategic wealth-maximisation, i.e. a sacrifice of short-term gain in return for a greater long-term payoff. However, when long-term wealth effects are absent, the contrast between the predictions becomes more visible. Wealth-maximising analyses anticipate the centre's manager will take full advantage of the centre's bargaining position to allocate as much cost as possible and also to retain as much benefit as possible. On the contrary, the notion of fairness expects the manager to try to be fair to another centre by not fully exploiting his or her bargaining position. This leads to hypothesis 3.

Hypothesis 3: The manager's resource sharing decisions are not necessarily wealth-maximising subgame perfect equilibria16, even in the absence of long-term wealth effects.

A manager's actions can also be affected by perceptions of previous distributive treatment by others. The notion of reciprocity or reciprocal fairness argues that an individual tends to treat others the way he or she has been treated by these others. Rabin (1993, p. 1281) notes that "people like to help those who

32 are helping them, and to hurt those who are hurting them". Equity theorists, e.g.

Walster et al. ( 1978), also argue that people perceiving injustice received may retaliate to restore equity.

An implication of reciprocal fairness is the greater the perceived unfairness, the greater the need to restore fairness. In this thesis, I examine the role of reciprocal unfairness on a manager's decision to share an unexpected windfall benefit with another department. The degree to which the manager has been treated unfairly in a prior distributive arrangement was manipulated. The notion of reciprocal unfairness suggests that perceptions of unfair treatment received will decrease the amount of the windfall benefit allocated by the manager to the other department, specifically,

Hypothesis 4: A manager allocates less (more) of a windfall benefit when he or she has been treated more (less) unfairly in prior distributive arrangements.

The notion of reciprocal unfairness also suggests that the source of unfairness plays an important role. Consider a scenario with three parties X, Y and Z. Assume X perceives unfair treatment from Y in the past. Reciprocal unfairness implies that X will now feel a need to restore equity with respect to

Y. However, it is less likely that X will feel a need to restore equity with

16 These are game theory's "solutions" to the strategic situation identified. For their

33 respect to Y, if unfair treatment is perceived to arise from actions taken by Z in the past. Actions motivated by notions of reciprocal unfairness are source dependent. Such considerations motivate the following hypothesis.

Hypothesis 5: The amount of windfall benefit allocated depends upon the source of any perceived unfairness in prior distributive arrangements.

Specifically, when the source of unfairness is the potential beneficiary, the manager will allocate less to the beneficiary than when the source of unfairness is a third party.

computation, please refer to footnote 6.

34 Chapter IV: Experimental Design

In this study, three consecutive laboratory experiments were conducted, in the order of 1, 3, 2, for seven separate sessions. This was because among the experiments, 1 and 2 were of a similar context (i.e. capital budgeting) while 3 was of a different context (i.e. resource sharing). Experiment 3 was conducted after experiment 1 to allow a longer time gap between experiments 1 and 2.

This was to reduce any potential effect that decisions in experiment 1 would have on the decisions in experiment 2. The payment to subjects was dependent on subjects' response in experiment 1 but independent of their response in experiment 3. This is because subjects received a fixed project return in experiment 3 regardless of their decision. As such, experiment 3 was placed as the last experiment to facilitate the administration of payment which was made at the end of every experimental session. The same order was used in all the experimental conditions. Given this a few comments on the potential of order effects to influence the results need to be made. First, the allocation of students to treatments within each experiment was independent across experiments.

Second, the existence of order effects was tested by partitioning each dependent variable on prior experimental conditions. For example, the ability of experiment 1 treatments (level of prior contribution and relative expected return) to predict subjects' cost allocation decision in the second experiment was examined. In no cases did such analyses reveal the existence of significant order effects in the data.

35 Subject

106 undergraduates with management accounting background at the

University of New South Wales volunteered to participate in the study. They were told before volunteering that they would receive at least A$ I O and have the opportunity to receive "substantially" more. All subjects participated in all three experiments in a single session.

Procedure

Subjects first assembled in a common area. At the beginning of each session, they were randomly allocated into two groups. After the allocation, each group of subjects was led by an experimenter to a separate room. Later during the session, subjects were told that each of them was paired with other subjects in a different room. The purpose of assembling the subjects and then allocating them into to two different rooms was to convince the subjects that there was another room of subjects.

Subjects were told to choose their own seat. On each desk was an instruction sheet headed "General Instructions" and three different sets of instructions enclosed in three envelopes, one for each experiment (see

36 Appendix B). 17 The instructions for experiments I and 2 were random combinations of the various experimental conditions in these two experiments.

The experimental conditions of experiment 3 were assigned later during experiment 3 itself. The allocation across treatments was independent across experiments. The experimenter in each room read the instructions aloud and answered questions.

Subjects were told they would participate m three completely independent experiments involving monetary decisions m business organisations. All monetary amounts were denominated m 'experimental dollars' called lira, which would be converted into Australian dollars at a rate of $1 = 250,000 lira at the end of the session. Total payment to each subject ranged between A$22 to A$27. Subjects were told that each of them was paired with other subjects in another room for some parts of the experiments. During the second and third experiments, they were reminded that the experiments were completely independent of one another.

In the overall design of the experiments, timing was carefully considered to avoid fatigue effects. Each actual session took approximately 1.5 hours.

Fatigue effects did not appear to be likely as it is relatively common for

17 Subjects were told to open the envelopes only upon specific instructions by the experimenter. As such, subjects had access to the instructions of an experiment only when that particular experiment commenced.

37 experiments to be run for this length of time. Furthermore, there was no report of fatigue.

To avoid wealth-suboptirnising behaviour owing to social concerns other than fairness (e.g. reputation and threat of punishment), the experiment included additional double-blind procedures to assure subjects that their identity would be unknown to both the experimenter and other subjects. At the same time, these procedures allowed the experimenter to reward the subjects according to their decisions, even though their identity was unknown.

Before the commencement of experiment 1, each subject drew an identification number from a bag. Subjects were told to indicate their number, instead of their name, on their responses for all three experiments. The experimenter reimbursed the subjects by putting the cash ( computed based on the decisions) in an envelope with the subject's identification number written on top. Each subject collected his or her own envelope, which was spread out with other envelopes on a row of tables in front of the room. As such, the experimenter did not know the identity of the subject as all decisions were identified by numbers. Yet, the experimenter was able to reimburse the subjects according to their decisions, as the subjects identified their own payment according to the number on the envelopes.

Experiment I

38 Experiment 1 was designed to test hypothesis 1. Subjects were presented with a risky investment opportunity (hereafter referred to as 'the project') and

required to decide the amount they wished to invest. Subjects were informed

that the project required the participation of another party. The independent

variables were the relative expected return available to the other party (higher

or lower than the subject) and the relative level of prior contribution by the

other party (more or less than the subject). The experiment was a 2 x 2

between-subjects design yielding four experimental treatments as shown in

Table 1.

Table 1 Experiment 1 - Experimental treatments

Treatment Independent variable Relative expected return available to Relative level of prior contribution by the other party the other party HM Higher More LM Lower More I-Il, Higher Less LL Lower Less

Specifically, subjects were told they were the CEO of a large business

firm, Alpha. They were presented with a joint investment opportunity which

required the participation of another firm, Beta. The investment had a 60

percent chance of a good outcome and a 40 percent chance of a poor outcome.

The return to Alpha depended upon the outcome of the investment: 25 percent

in the advent of good outcome and -10 percent otherwise. Thus, the expected

return to Alpha across all four treatments was 11 percent.

39 Each subject had an initial investment account balance of 1,000,000 lira.

To participate in the project, the subject was required to invest at least 100,000 lira up to a maximum of 1,000,000 lira. The dependent variable was the amount invested by each subject. It is expected that subjects' perceptions of equity or inequity, i.e. their return relative to prior contribution, will influence their level of interest, and hence, investment in the project. The investment outcome (good or poor) of each subject was determined after the investment decision was completed. Each subject chose a card from a shuffled deck of 10 cards where six of the cards represented a good outcome and the remaining four cards represented a poor outcome. Each subject's investment account was then adjusted to reflect the amount invested and the realised return. At the end of the experimental session, the balance of the investment account was converted into

Australian dollars at an exchange rate of A$1 = 250,000 lira and paid out in cash.

The first independent variable, relative expected return, was manipulated by varying the expected return available to the other party. The expected return to the subject was held constant across all treatments. In the 'higher return to the other party' treatment, subjects were informed that Beta would earn a return of either 60 percent (good outcome) or 25 percent (poor outcome). This gave an expected return of 46 percent to Beta ( compared to an expected return of 11 percent to the subject). In the 'lower return to the other party' treatment, Beta

40 would earn a return of either 20 percent (good outcome) or -15 percent (poor outcome) giving an expected return of 6 percent.

The second independent variable, relative level of prior contribution, was manipulated by informing subjects whether Alpha or Beta had developed the project. Subjects in the 'less prior contribution by Beta' ['more prior contribution by Beta'] treatment were told, specifically:

'After extensive work and planning your firm Alpha [another firm Beta] has developed a new business opportunity. This plan was developed by your [another] firm but requires the participation of another firm, Beta [your firm, Alpha], to be put into effect. Beta [Alpha] was not involved in the development of the new investment, but its participation is necessary for the investment to go ahead.'

As discussed in the previous chapter, the argument for the importance of equity does not imply that traditional variables such as absolute returns, states of nature, probabilities of these states, and risk aversion are not important.

Rather, equity is viewed as potentially possessing incremental explanatory power. Thus, in order to examine equity effects, it is important to control as much as possible the effects of these other variables. In this experiment, the vectors of returns, states, and associated probabilities were held constant across all treatments. However, variations in risk aversion are not explicitly controlled for. Some discussion of this point is necessary.

41 The approach taken in this experiment is to control for variations in risk aversion by the random assignrnent18 of subjects across the four experimental treatments. It seems unlikely that average levels of risk aversion should be systematically different across the four groups. It is even more unlikely that any pattern of differences could cause investment level differences across groups that match the pattern presented in Hypothesis 1. However, a few further comments may be made to justify this approach. First, an alternative approach is to attempt to measure underlyirlg risk attitudes in a prelimirlary stage, and then sort subjects on the basis of revealed risk attitudes19. However, it is difficult to elicit detailed information regardirlg preferences and this would have substantially increased the time required to complete the experiment. As each experimental session already required on average of 1.5 hours, this approach was deemed to be impractical.

Another approach is to attempt to manipulate subjects' risk preferences directly. An example is the two-stage lottery procedure suggested by Smith

( 1961 ). However, this approach adds substantially to the complexity of the mechanism for rewarding subjects and again adds to the time required to complete the experiment. In addition, there exists some concerns over its effectiveness (see Davis & Holt, 1993, chapter 8 for a discussion).

18 This statement needs to be qualified. Assignment of subjects to treatments was not completely random as a few subjects assigned to the same room appeared to know one another. However, within each room they were not necessarliy assigned to the same treatment. It seems unlikely that this variation to complete random assignment would have resulted in systematically different risk aversion across treatments.

42 Consequently, neither of these alternatives was chosen in preference to random assignment.

However, attitude to risk could have a second and potentially more serious confounding effect. If subjects viewed the investment as too attractive for the risk borne, then high levels of investment would be expected, regardless of issues related to perceptions of fairness. It would be possible for this risk effect to swamp the experimental manipulations. This effect could also occur if subjects viewed the project as too unattractive.

Ideally, the expected return and risk should be set such that most subjects would find the investment attractive enough to encourage some investment and yet not too attractive as to lead to full investment. Choosing these investment parameters was essentially a question of judgment. It was felt that the parameters detailed above would satisfy these requirements.20

Experiment 2

Experiment 2 was designed to test hypothesis 2. Recall the purpose of this second experiment was to provide a clear examination of the role of relative prior contribution. Subjects were told they were the CEO of a large

19 This approach has been used by Mumighan, Roth & Shoumaker (1988) and Millner & Pratt (1990, 1991). . 20 The return and risk parameters were tried out in a pilot study consisting of 8 subjects. The chance of a good outcome was set at 80 percent with other parameters as described above. The consistently high levels of investment from all subjects led to the conclusion that the project

43 business firm, Orange, and presented with a choice of three independent projects. All the three projects were joint projects involving another firm,

Apple. Subjects were told that Apple would agree to participate in whichever project Orange (i.e. the subject) selected. The independent variable was the relative level of prior contribution by the other party (more or less than the subject). Note that in each treatment, the level of prior contribution was the same for all three projects. The experiment was a 2 x I between-subjects design.

The dependent variable was the project selected by the subject. Each project earned a fixed (i.e. riskless) return of 20 percent for Orange but differed in the return to Apple. Project I offered a fixed return of 22 percent for Apple, project 2 offered 20 percent and project 3 offered 18 percent. Thus, project I

(3) offered a relatively higher (lower) return to the other party while project 2 offered equal returns.

Subjects were required to choose only one project. They were also given the choice of indicating no preference, as a wealth-maximising subject might not have preference over any of the project, given that all three projects gave the same return to the subject. Each subject had an initial investment account balance of 500,000 lira. After subjects had made their project choice, the final balance of their account was adjusted to include the realised project return. At was too attractive. Hence, the chance of a good outcome was reduced to 60 percent in the

44 the end of the experimental session, this balance was paid out to subjects as described in experiment 1.

As in experiment 1, the relative level of prior contribution by the other party was manipulated by informing subjects whether their own firm, Orange, or the other party, Apple, had developed the projects. Specifically, subjects were informed that:

'Each of these projects were developed by your firm Orange [another firm, Apple], but each requires the participation of another firm, Apple [your firm Orange], to put into effect. Apple [Orange] was not involved in the development of any of these projects, but its participation is necessary for them to go ahead.'

The experimental design removed subject risk preference as a possible confounding variable. It also, as discussed in the previous chapter, removed any possible commitment effect.

Experiment3

Experiment 3 was designed to test hypotheses 3, 4 and 5. The experiment consisted of two parts. In the first part, subjects were told they were the manager of a strategic business unit (SBU) X in a large firm, which consisted of top management and two SBUs - X and Y. The SBUs were under the ultimate control of top management but each possessed substantial

experiment.

45 autonomy over its own operations. Specifically, each SBU made its own decisions but were subject to top management's regulations. Each subject had an initial account balance of 1,000,000 lira.

The first part of the experiment was designed to test hypothesis 3. Each subject was informed that other subjects were playing the roles of top management and the manager of SBU Y. They were also informed that they had been matched with a subject playing the role of the manager of SBU Y in a different room. It was stressed that each member of a subject pair would be unable to identify his or her partner. In reality, subjects were not matched and all subjects played the role of the manager of SBU X.

Subjects were then presented with the following scenario:

'SBU Y is in need ofa particular type of computer software. Your SBU (SBU X) has previously acquired a licence to use this software from the software manufacturer at a fee of 1,000,000 lira (other costs are negligible). The licence agreement permits unlimited access to the software across the firm. As such, SBU Y can request your SBU duplicates an identical copy of the software at negligible additional cost to the firm. Alternatively, SBU Y can obtain the software from the software manufacturer at a price of 1,000,000 lira. SBU Y has no other way to obtain the software. As your SBU has solely incurred the licence fee for the software, top management asked you to propose a basis to allocate the licence fee to SBU Y, i.e. how much of the 1,000,000 lira will SBU Y bear. Top management has also asked SBU Y to decide whether to accept your proposed allocation. If SBU Y accepts the proposed allocation, your SBU will duplicate a copy of the software for SBU Y, which in tum pays for its allocated share of the licence fee to your SBU. In addition, top management allows SBU Y the discretion to reduce your proposed allocation up to a maximum of 100,000 lira. If SBU Y rejects the proposed allocation, it will purchase the software from the manufacturer and your SBU will not receive any payment from SBU Y. If SBU Y decides to copy the software from your SBU then your account will be increased by an amount equal to the agreed upon payment.'

46 After reading the above scenario, subjects were required to decide how much of the cost they proposed to allocate to SBU Y. This allocation proposal

(hereafter referred to as 'cost proposed') was the dependent variable in the first part of experiment 3. It was stressed that each subject's account would be increased by an amount equal to the subject's cost proposed after any adjustments. Thus, the wealth-maximisation prediction was that subjects would propose to allocate the full cost to SBU Y.

After the subjects made their decisions, an experimenter left the room with all the responses to simulate the transmission of the cost proposed to the other parties. The experimenter returned after a few minutes with envelopes containing the experimental instructions of the second part of the experiment

(see Appendix C). Subjects collected their individual envelope by their identification number.

The second part of experiment 3 was designed to examine hypotheses 4 and 5. The independent variables were the level of perceived fairness in prior distributive arrangements (fair or unfair) and the source of any perceived unfairness (SBU Y or top management). These variables were manipulated as follows. In the instructions for part 2 of the experiment, subjects were informed that their cost proposal had been either ( 1) accepted with no change, (2) reduced by SBU Y, (3) reduced by top management, and (4) reduced by both

SBU Y and top management. In all cases, SBU Y accepted the cost proposal

47 subject to the adjustments. SBU X was not provided with the opportunity to renegotiate. The four experimental treatments are shown in Table 2.

Table 2 Experiment 3 - Experimental treatments

Cell I 2 3 4 Treatment (lira): Reduction by SBU Y 0 0 100,000 100,000 Reduction by top management 0 100,000 0 100,000 Total reduction 0 100,000 100,000 200,000

The reductions by the two parties were either 0 lira or 100,000 lira, and the total reduction could be as much as 200,000 lira. The subjects' proposed allocation could range between 0 lira to 1,000,000 lira. If a subject's proposed allocation was less than 200,000 lira, and the total reduction was 200,000 lira, then the actual allocation would become negative, rendering it invalid.

However, it is relatively unlikely for a proposed allocation to be less than

200,000 lira.

If the level of reduction by each of the two parties was not set at 100,000

lira but, say 200,000 lira, then the total reduction could be as much as 400,000

lira. In this case, any proposed allocation less than 400,000 lira would give rise

to an invalid actual allocation. The higher the level of reduction, the more

probable a proposed allocation became invalid. To keep the probability of

invalid allocations low, the reduction level was set at only 100,000 lira.

48 Subjects were told specifically that SBU Y had the discretion to reduce their proposed allocation before they made the proposed allocation decision. If this was not done, and subsequently, a reduction was made by SBU Y, the manipulation of perceptions of inequity could be more effective. However, such withholding of information from the subjects might lead to a breach of ethical duty of the experimenter. To avoid such a situation, the scenario informed subjects of the possible reduction by SBU Y. As for the reduction by top management, subjects were told they were "under the ultimate control of top management" and that they were "subject to top management's regulations".

Having been informed of the outcome, subjects were presented with the following scenario:

'You have duplicated a copy of the software for SBU Y, and the respective accounts of the two SBUs have been adjusted to reflect the transaction. Subsequently, the software manufacturer informed your firm that serious faults were detected in the software. These faults cannot be repaired so the supplier has decided to replace the software with a more advanced version. This advanced version has been proven to be suitable for both SBU X and Y. Although not provided by the licence agreement, the manufacturer has agreed to pay additional compensation of 500,000 lira to you, the licensee. Therefore, your investment account has been increased by 500,000 lira. SBU Y did not receive any compensation from the manufacturer.'

Subjects' task was to decide how much, if any, of this 500,000 lira windfall benefit would they share with SBU Y. This judgment (hereafter referred to as the 'benefit allocated') constituted the dependent variable for the second part of the experiment. Subjects were informed that any allocation

49 would result in a reduction in their account by an amount equal to the benefit allocated and a corresponding increase in SBU Y' s account. Each SBU account was adjusted for the decisions made and the balance paid out to subjects at the end of the session.

Understanding check

In all the three experiments, participants were required to attempt questions designed to reveal whether they had understood the experimental instructions.

50 Chapter V: Results and Discussion

Before testing the hypotheses, the subjects' response to the understanding check questions were examined. A minority of subjects did not appear to fully understand the instructions: 8 percent for experiment l, 21 percent for experiment 2, and 7 percent for experiment 3. The misunderstanding in experiment 2 was mainly caused by subjects in the 'less prior contribution by the other party' condition (i.e. Orange developed the projects) failed to recognise that their firm had contributed more effort to the development of the projects than the other firm. All the hypotheses were tested based on data sets both including and excluding subjects who failed to demonstrate an adequate understanding. In the interests of clarity, only the results based on the subset of subjects who successfully answered all understanding check questions are presented below. Results based on the entire sample are included in the Appendices D to J. Comments based on these full sample results are restricted to those instances where they differ from those obtained from the reduced sample.

Experiment I

Table 3 presents the means and standard deviations of the amount invested by the subjects in the joint project.

51 Table 3 Experiment l - Mean and Standard deviation of Amount invested by treatment

Relative expected return to the other party HiJdier Lower Relative prior contribution by the other party More

Amount invested (lira): Mean 628,261 714,000 Standard deviation 283,976 266,349

N 23 25 Less

Amount invested (lira): Mean 633,929 742,857 Standard deviation 365,162 214,059

N 28 21

Recall the expected risk and return to the subject were held constant

across all four treatments. Differences in risk preferences between subject were

assumed to be randomly distributed across these treatments. The results

indicated that, on average, subjects found the project to be neither

overwhelmingly attractive or unattractive. Only 31 percent of subjects invested

the entire available amount of 1,000,000 lira and only 2 percent chose to invest

0 lira.

The results of a two-way between-subjects ANOVA are presented in

Table 4. Hypothesis 1 predicts an interaction between the two main effects of

relative expected return and relative prior contribution. The results in Table 4

provide no evidence in support of such an interaction (F = 0.038, p < 0.847).

This lack of significant results could be due to low power in the experiment.

52 Nevertheless, it could also be due to the investment decision not directly reflecting the subjects' perceptions of equity. The explanations provided by subjects were reviewed. It was observed that out of 97 subjects, 5 did not give an explanation for the amount invested. Of the remaining 92 subjects, 19 (21 percent) attributed their decisions to comparison of expected returns and prior contribution of the other party. All 92 subjects related their decisions to the attractiveness ( or unattractiveness) of the expected outcome. This suggests that subjects' investment decisions were driven considerably by the expected outcome and the subjects' risk preferences.

Table 4 Experiment I - 2 x 2 Analysis of variance on Amount invested by Relative expected return and Relative prior contribution

Source of variation OF F Sig of F (2-tailed)

Relative expected return• I 2.643 0.107 Relative prior contributionb I 0.083 0.774

2-way interaction I 0.038 0.847

Explained 3 0.899 0.445 Residual 93 Total 96 • Manipulated at two levels: The other party's expected return was either higher or lower than the subject's expected return. b Manipulated at two levels: The other party's prior contribution was either more or less than the subject's prior contribution.

The ANOVA results indicate a p-value of 0.107 for the relative expected return main effect.21 This result does not allow rejection of the null of no effect

An examination of the standard deviations in Table 3 reveals large within cell variation substantially reducing the ability of the statistical test to detect any

21 The relative expected return main effect was insignificant for the entire sample (see Appendix E).

53 potential between cell effects. In retrospect, a more powerful design would be to have restricted subjects' level of investment choice to a small number of discrete choices, e.g. low, medium, or high investment levels. This observation is made because despite the relatively small sample size and the high within cell variation, the p-value for the relative expected return main effect is suggestive of a potentially interesting effect.

If both parties made equal contributions to the project, the notion of equity predicts that the manager perceives greater unfairness when the other party receives a relatively higher expected return. This greater unfairness perceived in tum leads to less (more) investment when the expected return to the other party is higher (lower), which was the direction observed in Table 3.

However, this prediction could not be tested in this experiment as the experiment did not include an equal prior contribution treatment (i.e. the relative prior contribution by the other party was either more or less, but not equal). Nonetheless, the results of this study suggest an opportunity to test this prediction in the future.

Experiment 2

Results for experiment 2 are presented in Table 5.

54 Table 5 Experiment 2 - Choice of project by Relative prior contribution by the other party

Choice of pro· ect Project 1 2 3 Total Return to the ~er 20% 20% 20% Return to the other party 22% 20% 18% Relative prior contribution by the other party Cell A Cell B More" N 37 9 7 53 Expected 28.4 7.1 17.5 64.6% Cell C Cell D Lessb N 7 2 20 29 Expected 15.6 3.9 9.5 35.4% Total N 44 11 27 82 Exoected 53.7% 13.4% 32.9% 100.0% • 2 subjects indicated no preference. b None indicated no preference.

Hypothesis 2 predicts that the subjects (i.e. Orange) would choose a

higher (lower) project return for the other party (i.e. Apple) when the projects

were developed by Apple (Orange). Such behaviour, which would be in

accordance with equity considerations might not necessary take place. Based on

conventional capital budgeting approaches, subjects should choose projects that

offered the highest return. Since all three projects offered identical returns, it

should not matter which project was chosen. The null hypothesis is therefore an

equal choice of the three projects. To test this prediction, a Pearson Chi­

Squared test was first performed. The results indicate that the likelihood that

any given project would be chosen was related to relative prior contribution in

the direction expected [/(2) = 26.406, p < 0.00001, n = 82]. However, it

should be noted that this choice did not involve any sacrifice of wealth on the

part of the subjects. This, however, does not imply that the findings are not

55 relevant. The experiment examines a situation where subjects were given an opportunity to bring about an equitable outcome rather than a situation of merely reacting to equity imbalances, which can be found in most other experiments on equity. As such, the experiment did not ask subjects to choose between equity or wealth. Rather, the experiment tests if subjects would effect equity when wealth-based theories would predict otherwise. The wealth-based prediction of random selection is rejected by the experiment.

Examination of Table 5 indicates that when the projects were developed by Apple, 70 percent of the subjects chose the project offering a higher return to Apple ( cell A in Table 5) while only 13 percent chose the project offering a lower return (cell B). The results of a Wald Chi-Squared test (adjusted for multiple comparisons) indicate that this difference was significant [x2( 1) =

16.318, p < 0.05; see Table 6]. In contrast, when the projects were developed by Orange, only 24 percent of the subjects chose the project offering a higher return to Apple ( cell C) but 69 percent chose the project offering a lower return

(cell D). Again, a Wald Chi-Squared test was performed. However, this time the results only indicate a marginally significant difference [x2(I) = 5.715, p <

0.10; see Table 6]. Results for the entire sample do not provide support for a difference between cells C and D (see Appendix G).

Table 6 Experiment 2 - Wald Chi-Squared test

Comparison F

56 Cell A versus cell B 16.318. Cell C versus cell D 5.715b Difference between cells A and B versus difference between cells C and D 20.318. • p < 0.05] Adjusted significance levels b p < 0.10] to control for multiple comparisons.

The asymmetry revealed by these two contrasts is interesting. A Waid

Chi-Squared test on these two contrasts indicates that the difference was significant [/(I)= 20.318, p < 0.05; see Table 6]. Examination of Tables 5 and

6 suggests that subjects were quite willing to reward Apple with a higher return when the projects were developed by Apple. However, when the projects were

developed by themselves (i.e. Orange), they appeared to be less willing to offer

a lower return to Apple. Given the much smaller sample size for the 'less prior

contribution' treatment (i.e. Orange developed the projects), this result should

be interpreted with caution. Nonetheless, the results provide some evidence that

subjects were more willing to give a higher return to the other party when the

other party had made more prior contribution than to give a lower return when

the other party had made less prior contribution. However, it should be noted

that there was no actual cost to the subjects in giving either a higher or a lower

return. Their own wealth is unaffected by their allocations to the other party,

Apple.

Experiment 3

In this experiment, there were two dependent variables: cost proposed

and benefit allocated. Cost proposed was measured before the experimental

treatments were administered whereas benefit allocated was measured after.

57 Tables 7 and 8 show the descriptive statistics of cost proposed and benefit allocated (by cell) respectively.

Table 7 Experiment 3 - Descriptive statistics of Cost proposed

Descri tive statistics = 99 Cost ro osed lira Mean 658,061 Standard deviation 184,575 Mode 600,000 95% Cl (lower) 621,248 95% Cl u er 694,874

Table 8 Experiment 3 - Descriptive statistics of Benefit allocated by cell

Cell 1 2 3 4 Total Treatment (lira): Reduction by SBU Y 0 0 100,000 100,000 Reduction by top management 0 100,000 0 100,000 Total reduction 0 100,000 100,000 200,000 Benefit allocated (lira): Mean 74,074 46,565 108,696 45,962 68,343 Standard deviation 103,190 80,541 106,229 73,607 93,979 Mode 0 0 0 0 0 95% Cl (lower) 33,254 11,737 62,759 16,231 49,600 95% Cl (upper) 114,895 81,394 154,633 75,692 87,087

N 27 23 23 26 99

In the experiment, the manager could maximise his or her own wealth by proposing a cost allocation of 1,000,000 lira and not allocating any benefit.

There was no long-term wealth benefit for the manager to sacrifice short-term gain. Therefore, the wealth-maximising subgame perfect equilibria were

1,000,000 lira for the cost proposed and 0 lira for the benefit allocated.

The potential for SBU Y to reject an offer does not change the traditional game theoretic prediction. Denote the amount proposed by the SBU

58 X manager (i.e. the subject) by Z. Any level of Z less than 1,000,000 lira will be accepted by a wealth-maximising SBU Y manager because the only alternative is to purchase the licence from an external vendor for 1,000,000 lira.

The SBU X manager knows this to be the case and therefore will not offer any level of Z less than 1,000,000 lira. When Z equals 1,000,000 lira, the SBU Y manager is indifferent between accepting or rejecting the proposal. The traditional game theory approach is to assume that SBU Y will not reject the offer in such circumstances. Of course, equity considerations alter this analysis as discussed below.

Hypothesis 3 expects the manager's resource sharing decisions (i.e. cost proposed and benefit allocated) to deviate significantly from the wealth­ maximising subgame perfect equilibria. By examining Tables 7 and 8, hypothesis 3 is supported as the subgame perfect equilibria were both outside the 95% confidence intervals of the respective dependent variables.

In addition, the following observations are made:

( 1) The modal cost proposed ( 18 percent of subjects) was 600,000 lira. This appeared to be the equal split offer observed in most ultimatum games (Roth,

1995) adjusted for the anticipated reduction of 100,000 lira by SBU Y (the maximum amount that it was allowed discretion to reduce). There was also a high concentration (14 percent) of cost proposed at the equal split level too,

59 despite the discretion allowed to SBU Y to reduce the cost proposed. Such behaviour is supportive of hypothesis 3.

(2) The modal benefit allocated (56 percent) was O lira. This behaviour, however, is supportive of wealth-maximisation.

The deviation from the wealth-maximising prediction in the cost proposed could not be attributed solely to the desire of subjects to volunteer a

"fairer" distribution to SBU Y. This was because SBU Y might have rejected the subject's cost proposed if it was perceived as unfair. Hence, the subjects' deviation from the wealth-maximising prediction in the cost proposed might have been an effort to encourage SBU Y to accept the cost proposed. However, the deviation from wealth-maximising prediction in the benefit allocated was more likely to be voluntary actions of subjects to achieve a "fairer" distribution to SBU Y, as SBU Y could not alter the decision even if it perceived the decision as unfair.

Analysis was conducted to determine whether the cost proposal decision differed across the four cells. Recall that the cost proposal decision was made prior to allocation of subjects to the different treatments and no difference is anticipated. However, such differences may arise purely by chance. If such a result occurred, it would have a confounding influence of the subsequent benefit allocation decision. The mean and standard deviation of cost proposed

(lira) by cell are as follows: cell 1 (688,889; 193,815), cell 2 (639,304;

60 196,953), cell 3 (622,565; 178,362) and cell 4 (674,038; 171,971). A one-way

ANOVA performed on the cells indicates that there was no significant difference among the cells (F = 0.672, p< 0.571).

Hypotheses 4 and 5 investigate the effects of the level and source of perceived unfairness in prior distributive treatment received respectively.

Hypothesis 4 expects less (more) benefit allocated when the subject was treated more (less) unfairly in prior distributive arrangements. In terms of Table 8, the hypothesis implies that the benefit allocated in Cell 1 (no reduction to cost proposed) should be greater than Cell 4 (two reductions of 100,000 lira, once by SBU Y and once by top management).

Hypothesis 5 expects less benefit allocated upon unfairness perceived in prior treatment from SBU Y than from top management. In terms of Table 8, the hypothesis implies that the benefit allocated in Cell 2 ( one reduction of

100,000 lira by top management) should be greater than Cell 3 (one reduction of 100,000 lira by SBU Y).

It was discussed earlier that subjects were observed to propose cost allocations that anticipate reductions by SBU Y. Such behaviour might introduce a confounding effect to the testing of hypotheses 4 and 5. This is because it could become unclear as to whether reductions were being perceived as unfair by subjects. For example, assume a subject privately believed a 50/50

61 split to be fair but decided to be opportunistic and offered 80/20. SBU Y then reduced the allocation by 100,000 lira leading to a final allocation of 70/30.

Would the subject perceive SBU Y's reduction as unfair? The answer is indeterminable.

Such opportunistic behaviour could weaken the power of tests of hypotheses 4 and 5. However, it should not change the directional expectation of the hypothesised effects. To illustrate, consider the distribution of opportunistic subjects across the treatments. Based on the analysis of the cost proposed across treatments earlier, the distribution of opportunistic subjects across treatments can be considered to be random. This is because the cost proposals did not differ significantly across the four cells. As such, it could be assumed that all four treatments have an almost similar cost proposed of approximately 650,000 lira. Hence, it could be assumed that subjects' perceptions of relative need of software by the two SBU s were indifferent across the treatments. Similarly, it could be assumed that the differential impact of an absolute 100,000 lira reduction to be equivalent across the treatments.

Further, continue to assume the distribution of opportunistic subjects as random across treatments. In one cell, such opportunistic subjects had their proposals reduced by SBU Y and in another cell, SBU Y left the allocation unchanged. The original direction of the prediction contained in hypothesis 4 remains unchanged but the ability to detect any difference may be reduced.

62 Opportunistic subjects who increased their proposal from the equitable level by

100,000 lira in anticipation of a reduction by SBU Y and subsequently had their proposal reduced were likely to consider the overall situation equitable with neither party having an advantage over the other. In contrast, if their proposal was not reduced the SBU X managers were in a relatively advantageous position and would likely be prepared to offer a higher benefit allocation. Thus the directional prediction of the effect of a reduction by the

SBU Y manager remains unchanged. However, the correct interpretation of this effect is problematic for the reasons discussed above.

To test the two hypotheses, two a priori orthogonal contrast tests (one between cells 1 and 4 and another between cells 2 and 3) were performed. Such contrasts have the advantage of minimising the family-wise error rate while still allowing multiple questions to be asked of the data. However, there is a limitation to the number of contrasts and not all possible comparisons can be included in such a test. Thus, there is a need to include only the most essential contrasts. When there are 4 cells, it is only possible to test one set of three such contrasts and still control for the family-wise error rate. The simultaneous comparisons of cells I and 4 and cells 2 and 3 are orthogonal and so were chosen as the primary tests of hypotheses 4 and 5. In addition, the concerns about the perception of a reduction by SBU Y raised earlier suggest that the comparison of cells I and 2 will have low power. The comparison of cells I and 4 has the greatest power. Hence, although hypothesis 4 suggest a contrast

63 C I < C2, C3 < C4, only C I < C4 is included in the orthogonal contrast test.

Still, all pair wise comparisons were also performed and reported in the following section.

The results of the first contrast fail to support hypothesis 4 [t(95) =

I. I 13, p < 0.135 (I-tail)]. The results of the second contrast find a significant difference between cells 2 and 3 [t(95) = -2.291, p < 0.012 (I-tail)]. However, examination of cell means in Table 8 shows that this difference between cells 2 and 3 was not in the expected direction.

To investigate the results further, a Tu.key HSD multiple comparison was performed. The results, presented in Table 9, indicate that only the difference between cells 3 and 4 was marginally significant (p < 0.087). The significant difference reported between cells 2 and 3 from the a priori contrasts was not supported by the Tu.key HSD test. This was probably due to more stringent significance levels in the Tu.key HSD test after adjustment for multiple comparisons.

Table 9 Experiment 3 - Significance level (adjusted for multiple comparisons) ofTukey HSD test on Benefit allocated by cell

Cell l 2 3 4 l - 2 0.718 - 3 0.548 0.107 - 4 0.683 1.000 0.087 -

64 Thus, the results support neither hypothesis 4 nor 5. Furthermore, the results for the source hypothesis were in the opposite direction to that expected.

When SBU Y alone reduced the subject's cost proposed, the subjects were willing to allocate a mean benefit of 108,696 lira. This was the largest benefit allocated in any of the experimental manipulations. In contrast, when a third party - top management - reduced the proposed cost allocation, subjects were only willing to allocate 46,565 lira. This appears to suggest that subjects were willing to punish22 SBU Y because of actions taken by top management. Thus, the results suggest that the source of unfairness matters, but in an unexpected manner.

A review of the explanations provided by subjects to their benefit allocation decision indicates the following. Out of 55 subjects who did not allocate any benefit, 20 (36 percent) reasoned that SBU Y should not be entitled to the benefit, 17 (31 percent) indicated that SBU X was not obliged to share the benefit, 11 (20 percent) explained that SBU Y would not be aware of the decision, 9 (16 percent) reflected that SBU Y already had a good bargain, 6

( 11 percent) expressed dissatisfaction to the responses of SBU Y and top management, and 10 (18 percent) gave other reasons. Out of the 44 subjects who allocated benefit to SBU Y, 32 (73 percent) cited fairness or ethical reasons, 9 (20 percent) justified it as a means of goodwill, and 3 (7 percent) gave other reasons. These explanations showed that subjects who allocated

22 Strictly speaking, subjects were not punishing SBU Y. A more accurate description is they

65 benefit were mainly driven by equity considerations. As for those who did not allocate any benefit, a large portion were also driven by equity reasons, such as

SBU Y not "entitled" to the benefit, SBU Y already had a good bargain, and

SBU Y's responses were not satisfactory. This gives support to the effectiveness of the experimental manipulations. Most subjects, however, did not give more detailed explanations on how they arrived at their figures. As such, it is difficult to further analyse the explanations.

From a wealth perspective, cells 2 and 3 were identical. In both treatments, the subjects' wealth was reduced by 100,000 lira. Why would subjects react strongly to a reduction by top management? The following tentative explanation is offered. Subjects were made aware that SBU Y had the option of reducing the cost proposal by 100,000 lira. As noted earlier, many subjects appeared to 'insure' themselves against this possibility by proposing an equal split of 500,000 lira plus 100,000 lira as 'insurance'. Subjects were not told that top management might reduce the cost proposal. Thus, the reduction by SBU Y (cell 3) was anticipated whereas the reduction by top management

(cell 2) was unanticipated.

It is important to note that if the subjects were attempting to insure themselves by adding 100,000 lira to their cost proposals, then the source of any single reduction should be irrelevant from a wealth perspective. Subjects

were less willing to reward SBU Y. However, the tenn 'punish' is used for brevity.

66 were insured against a reduction of 100,000 lira. However, the results suggest that subjects did not perceive themselves to be insured for 100,000 lira from any source. Rather, they suggest that subjects saw themselves as insured against a 100,000 lira reduction by SHU Y. Subjects did not see themselves as insured against an equivalent reduction by top management.

This explanation is further supported by the fact that the mean benefit allocated for cell 2 (top management reduction only) and cell 4 (reduction by both top management and SBU Y) were almost equivalent: 46,565 lira versus

45,962 lira for cells 2 and 4 respectively. This suggests that in both these cells, subjects were reacting primarily to the uninsured reduction by top management and did not react to the reduction by SBU Y against which they considered themselves insured.

This explanation also implies that the mean benefit allocated in cell I

(no reduction by both) to be equivalent to cell 3 (reduction by SBU Y only).

This is because the subject had either no damage ( cell 1) or an insured damage

(cell 3). Hence, no unanticipated damage was suffered in both cases. The expectation is supported as there was no significant difference in the mean benefit allocated between cells 1 and 3 (p < 0.548; see Table 9).

67 The explanation is further supported by the rules of fairness outlined in

Kahneman et al. ( 1986a &b ). The following examples are listed in Kahneman et al. (1986b, p. 732-3):

A landlord owns and rents out a single small house to a tenant who is living on a fixed income. A higher rent would mean the tenant would have to move. Other small rental houses are available. The landlord's costs have increased substantially over the past year and the landlord raises the rent to cover the cost increases when the tenant's lease is due for renewal. (N= 151) Acceptable 75% Unfair 25%

Suppose that, due to a transportation mixup, there is a local shortage of lettuce and the wholesale price has increased. A local grocer has bought the usual quantity of lettuce at a price that is 30 cents per head higher than normal. The grocer raises the price oflettuce to customers by 30 cents per head. (N = 101) Acceptable 79% Unfair 21%

A small company employs several people. The workers have been receiving a I O percent annual bonus each year and their total incomes have been about average for the community. In recent months, business for the company has not increased as it had before. The owners eliminate the workers' bonus for the year. (N = 98) Acceptable 80% Unfair 20%

A small photocopying shop has one employee who has worked in the shop for six months and earns $9 per hour. Business continues to be satisfactory, but a factory in the area has closed and unemployment has increased. Other small shops have now hired reliable workers at $7 an hour to perform jobs similar to those done by the photocopy shop employee. The owner of the photocopying shop reduces the employee's wage to $7. (N = 98) Acceptable 17% Unfair 83%

In the first three examples, the tenant, customers, and workers were penalised for others' actions and yet the owners' behaviours were perceived as acceptable and not unfair. However, in the fourth example, the owner's

behaviour was perceived as unfair. Why?

Kahneman et al. ( 1986a) reconcile the difference by theorising that it is

acceptable for the owner to maintain his or her profit at a "reference level"

68 (examples I to 3) but not acceptable for the owner to exploit his or her power to alter the reference level ( example 4 ).

Applying this rule of fairness to cells 2 and 4, the reduction by top management would affect subjects' "reference level" as the reduction was unanticipated and "uninsured". Thus, subjects maintain their reference level by reducing the benefit allocated to SBU Y, which was the only party they could

"recover" from. Hence, SBU Y was penalised even for top management's actions. According to the rule of fairness outlined in Kahneman et al. ( 1986a & b), such behaviour is acceptable. However, in cells 3 (and 4), the reduction by

SBU Y would not affect subjects' reference level as the reduction was already anticipated and "insured". Applying the rule of fairness, adjustment of the reference level will be perceived as unfair. Thus, subjects were willing to allocate more benefit to SBU Yin cell 3 than, say, cell 2.

The results of all the hypotheses tested are summarised in Table 10.

Table 10 Summary of results

Hypothesis Effect Results l Interaction between relative expected return Not supported. to the other party and relative pnor contribution bv the other party 2 Relative prior contribution by the other Supported. party 3 Non wealth-maximisin~ Sunnorted. 4 Level of perceived unfairness ID pnor Not supported. treatment 5 Source of perceived unfairness in pnor Not supported. treatment

69 Chapter VI: Conclusion, Implications and Limitations of the study

Overall, the study provides some evidence to suggest that managers in capital budgeting and resource sharing contexts take into account considerations of fairness or equity. Some of these considerations even lead to wealth-suboptimising behaviour.

Set in a capital budgeting context, experiment 1 examines subjects' level of investment in a joint project in response to relative differences in the other party's expected project return and prior contribution to the project. No evidence was obtained for the expected interaction effect.

Also set in a capital budgeting context, experiment 2 examines the effect of relative prior contribution by the other party alone. The experimental design removed subjects' risk preference and commitment as possible confounding effects. The relative prior contribution effect was found to be significant.

Subjects chose a higher (lower) project return for the other party in a joint investment when the other party made more (less) prior contribution to the project development. However, it is noted that the wealth effect for subjects was controlled in this experiment.

Set in a resource sharing context, experiment 3 finds subjects allocating significantly less cost and more benefit to another party than their bargaining

70 position would allow, providing evidence of consideration of fairness among the parties. However, the experiment was not able to obtain evidence for the effect of the level of perceived unfairness in prior distributive treatment. In addition, the experiment found a significant effect for the source of prior distributive treatment, but in an unexpected direction.

The study has a number of practical implications. Applying the notion of fairness to a capital budgeting context, the study suggests that unfairness perceived in the arrangement of project returns in relation to project contribution may lead to underinvestment in a joint project with a positive expected return. As such, promoters of joint projects may have to consider the perceptions of investors towards the overall distribution of output and input factors among parties involved in the project.

Also, the study suggests that the hazard of autonomous units pursuing short-term wealth effects for themselves and impairing organisational goal congruence may be overemphasised. Managers do not always maximise individual wealth effects even in the absence of long-term wealth effects. They also have a tendency to attempt to pursue actions that lead to equitable or fair outcomes. Thus, organisational planners may have to make adjustments to basic assumptions about managerial behaviour in order to achieve a more realistic design of organisations.

71 This study has a number of limitations. Firstly, the findings were drawn from data collected from students playing the role of managers. Thus, the external validity of the experiments is an issue. To overcome this limitation, it is suggested that future research considers employing managers as subjects.

Secondly, as subjects were volunteers, there might be a self-selection bias in the sample. In particular, it was noted that the sample had a higher ratio of Asian females than that in the subject population. No explanation is provided for the phenomenon. It is also not very clear how this phenomenon would have affected the results of the study. However, it is argued that even if the phenomenon might have caused the sample to be "fairer", it would have been mitigated by the possible bias that the volunteers could have been motivated by wealth to participate in the study.

As the experiment involved two experimenters conducting the experiment consecutively in two different rooms, a third limitation of the study is the bias that could be introduced by experimenter differences. Such differences, however, would have been reduced through the use of controlled experimental procedures.

In experiment 1, it is assumed that there was no systematic difference in the subjects' risk preferences across the experimental conditions as subjects were randomly assigned to the conditions. To obtain greater assurance for the

72 assumption, the experiment should have included an instrument to measure the risk preference of the subjects.

Despite these limitations, it is argued that this study has been beneficial in several ways. Firstly, it contributes to the accounting literature by attending to a concept (fairness) that has not been well studied. Secondly, it extends the decision contexts studied by investigating allocative decisions within a capital budgeting and resource sharing context. Last but not least, it obtains results that pave the way for fruitful research in the future.

73 Appendix A (Not drawn to scale)

Level of future investment (effect of escalated committnent included) by Relative expected return to the other party (higher or lower than the manager) Relative prior contribution by the other party (more or less than the manager)

Level of future investment

More prior Less prior contribution contribution by the other by the other party party

---Higher expected return to the other party - - - - • • Lower expected return to the other party

Note that this figure is different from Figure 1 (p. 25) in that the right-hand ends of the two lines are shifted upwards. There is no change to the left-hand ends of the two lines. This is because when the effect of escalated committnent is included, the level of investment will be higher as prior contribution by the manager increases from the left to the right on the x-axis.

74 Appendix B General Instructions

You are here to participate in a study on how people in business organisations make decisions. For your participation we will pay you $10 in cash at the end of the experiment. You can also earn additional money depending upon the decisions you make during the experiment.

Today you are actually going to participate in 3 different experiments. It is important that you realise that these 3 experiments are completely independent of one another. Your decisions in any of the experiments have no effect upon your performance in the other experiments. As you progress through the experiments you will be given detailed instructions of how to complete each step. Please read these instructions carefully. If you have any questions during the course of the experiment please raise your hand and an instructor will come over to assist you. Please do not talk to any other students at any time during the experiment.

Before you begin the experiments, we will arrange for everyone in the same room to draw a number from a bag consisting of numbers ranging from I to _. This is your identification number for this study. You are the only person who knows this number. Keep this number in a safe place in case you forget it. You will be asked to indicate this number on your response sheets. Please ensure that you indicate your identification number correctly in all response sheets so that we can process your pay correctly. Those with access to your response sheets can only identify a number. As such, your identity is unknown to both the instructors and the other students in this study.

For some parts of the experiments you will be paired with other students in a different room. You will never be paired with a student in the same room as yourself. Pairs of students will only be able to identify each other by their identification number. You will never know the true identity of your partner. The decisions of people in the same room will have absolutely no effect on you nor will any of your decisions affect them.

When you have completed all the experiments, please remain seated. We will then compute your remuneration. All remuneration will be paid out in sealed envelopes with the identification number written on top. We will also include in the envelope a tabulation showing the basis of computation. All envelopes for the room will be spread out in front of the room. Collect your own envelope, and only your own, according to your identification number. At that point, the session is over and you may leave the room.

In the experiment you will be asked to make a number of monetary decisions. All monetary amounts will be denominated in 'experimental dollars' called lira. At the completion of the experiment your account balance in lira will be converted into Australian dollars at an exchange rate of 250,000 lira= $1. This amount will then be paid to you in cash.

If you have any questions on any of the above material, please raise your hand now.

75 General Instructions For Experiment 1•

Your role

You are the chief executive officer of a large business firm called Alpha. You will be asked to make decisions on behalf of your firm Alpha.

Your remuneration

You begin with an investment account with a balance of 1,000,000 lira. Soon you will be presented with an opportunity to invest all or some of this money. After you have decided how much to invest the outcome of the investment will be revealed. The final balance of the investment account will thus depend on how much you choose to invest and the outcome of the investment. At the end of the experiment the final balance of the investment account will be converted into Australian dollars at the rate of 250,000 lira= $1. This money will then be paid to you in cash.

Your task

After going through this instruction page, read 'Case I'. It provides the information for this experiment. After reading the information, attempt the questions on 'Response I'. This document has 2 pages. The first page contains questions to check your understanding of this experiment. The second page provides space for you to record your decisions for this experiment. When you have completed the questions in 'Response I', place it face down and we will come to collect it. Kindly remain in your seat for the next experiment.

Please read 'Case l' on your own now.

Case t• . Page I of3

After extensive work and planning your firm Alpha [another firm Betat has developed a new business opportunity. This plan was developed by your [another] firm but requires the participation of another firm, Beta [your firm, Alpha], to be put into effect. Beta [Alpha] was not involved in the development of the new investment, but its participation is necessary for the investment to go ahead. To participate in this project, a firm must invest at least 100,000 lira. You can choose to invest more than this minimum amount up to a maximum of 1,000,000 lira. You can only invest in multiples of 50,000 lira. For example, you can invest 200,000 lira or 650,000 lira, but not 474,000 lira. If you wish to, you can choose to invest nothing which means that you do not want to participate in the investment at all.

Like all investments the outcome of the business opportunity is uncertain. There are two possible outcomes. There is a 60% chance that the investment will perform well and a 40% chance that it will perform poorly. The returns for these two possible outcomes for both Alpha and Beta are shown in Table I.

• This document was placed in the envelope for the first experiment. b Experimental manipulations are indicated in square brackets [ ] .

76 Table 1 . Fm11 Alpha f 1rm Bt:ta 1 Return on investment:

1,. -- Good outcome (60% chance) 25% 60% [20%] 1 -- Poor outcome (40% chance) -10% 25% L...... £-15%1 ...... : Expected return on investment 11 % 46% j

1...... [6%J...... 1

From Table I you can see that if the actual outcome is good the investment will earn your company a return of 25%. However, if the outcome is poor you will earn a negative return of 10%, i.e. you will lose 10% of the amount you invested. For Beta the good outcome return is 60% (20%] and the poor outcome return is 25% (-15%). Note that the type of outcome (good or poor) will be the same for both firms although the returns earned will differ.

Page 2 of 3

In the last row of the table is the expected return. For Alpha this is computed as (0.60 * 25%) + (0.40 * -10%) = 11%.

When everybody has completed their investment decisions, the actual project outcome will be determined by picking a card out of a stack of 10 cards (6 representing good outcome and 4 representing poor outcome), in your presence. The same outcome will apply to both firms. Hence, if you have chosen to invest x lira, where 100,000 :5: x :5: 1,000,000, and the project outcome is good, you will receive 1.25 * x lira in return. You have been provided with a schedule showing both the good and the poor return for each possible level of investment. This schedule is headed Table 2. Have a look at Table 2 now.

The closing balance of your investment account is computed as the initial balance of 1,000,000 lira less the amount you choose to invest plus the actual return earned. At the end of the experiment the ending balance of your investment account will be converted into Australian dollars and this amount will be paid to you in cash.

For example, if you choose to invest 600,000 lira in the project your investment account would immediately be reduced by 600,000 leaving a balance of 400,000 lira. If the project outcome was good examination of Table 2 reveals that your total return would be 750,000 lira. This is then added to your investment account leaving a final balance of 1,150,000 lira. At the end of the experiment this would be converted into Australian dollars and paid to you in cash.

You must now decide if your firm Alpha will participate in the project and the amount that you would like to invest. If you choose not to participate, you will not get the opportunity to participate in the project again.

Please answer the questions on 'Response I' now.

77 Page 3 of 3

Table 2 Project Outcome Aloha Beta Amount Invested Poor Good Poor Good 0 0 0 0 0 100,000 90,000 125,000 125,000 160,000 r85,ooo1 r120,0001 150,000 135,000 187,500 187,500 240,000 [127,5001 [180,0001 200,000 180,000 250,000 250,000 320,000 f170,000l r240,0001 250,000 225,000 312,500 312,500 400,000 r212,5001 r300,0001 300,000 270,000 375,000 375,000 480,000 r255,000l r360,000l 350,000 315,000 437,500 437,500 560,000 [297,5001 [420,000] 400,000 360,000 500,000 500,000 640,000 [340,0001 r480,0001 450,000 405,000 562,500 562,500 720,000 r382,500l r540,0001 500,000 450,000 625,000 625,000 800,000 H25,000l r600,0001 550,000 495,000 687,500 687,500 880,000 r467,500l r660,0001 600,000 540,000 750,000 750,000 960,000 [510,000] [720,000] 650,000 585,000 812,500 812,500 1,040,000 [552,5001 [780,0001 700,000 630,000 875,000 875,000 1,120,000 [595,0001 [840,000] 750,000 675,000 937,500 937,500 1,200,000 [637,500] [900,000] 800,000 720,000 1,000,000 1,000,000 1,280,000 [680,000] r960,0001 850,000 765,000 1,062,500 1,062,500 1,360,000 [722,500] r 1,020,0001 900,000 810,000 1,125,000 1,125,000 1,440,000 [765,0001 fl,080,0001 950,000 855,000 1,187,500 1,187,500 1,520,000 [807,5001 fl,140,0001 1,000,000 900,000 1,250,000 1,250,000 1,600,000 [850,0001 [1,200,000]

78 Response 11 Page I of2

Your identification nwnber: ____

Questions to check your understanding of Experiment I (Please circle either Yes or No).

I. The balance in my firm's investment account after my decision will be converted to Australian dollars at a rate of 250,000 lira = A$ I and paid out to me at the end of the experiment. Yes No

2. The instructor is able to trace my response to my name. Yes No

3. Regardless of the outcome, Beta will have higher investment returns than my firm. Yes No

4. The investment opportunity was developed by my firm and not by Beta. Yes No

When you have completed the questions above please tum the page, decide how much you wish to invest in the investment and record your decisions in the space provided.

Response I Page 2 of 2

Please read 'Case I' again and then make the following decisions:

I. Do you wish to invest in the project? Yes No

2. If you answered yes to question 1, how much do you wish to invest? (Give your answer as a multiple of 50,000 lira). _____ lira

3. Please explain your decisions in questions I and 2.

This completes the first experiment. Please place this document face down and we will come to collect it.

79 General Instructions For Experiment 2° d

Your role

In this experiment, you are the manager of a strategic business unit (SBU) in a large business firm called Pear. In the firm Pear, there are two SBUs - X and Y. You are the manager of SBU X. Both SBUs are under the ultimate control of top management but each possesses autonomy over its own operations to a large extent. In other words, the SBUs make their own decisions but are subject to top management's regulations. You will be asked to make decisions on behalf of your SBU.

In this experiment, there will be people playing the roles of SBU Y manager and top management. You are playing the role of the manager of SBU X. You have been matched with someone in a different room who is playing the role of the manager of SBU Y. You will not be told who you are matched with and they will not be able to know who you are.

Remember that this experiment is completely independent of Experiment 1 which you just completed.

Your remuneration

Each SBU keeps its own account. At this point, the opening balance in your account is 1,000,000 lira. (Remember that the balance of your investment account in this second experiment is independent of the final balance of your investment account in the first experiment). The balance may increase or decrease depending upon your decisions and those of top management and the manager of SBU Y. The balance of your SBU' s account at the end of this experiment will be converted to Australian dollars at a rate of 250,000 lira=$ 1. This amount, in addition to your account balance from Experiment 1, will be paid out to you at the end of the experiment.

Your task

There are two parts to this experiment. After going through this instruction page, read 'Case 2A'. It provides the information for the first part of this experiment. The information contained in Case 2A is also available to top management and to the SBU Y manager. After reading the information, attempt the questions on 'Response 2A'. This document has 2 pages. The first page contains questions to check your understanding of the first part of this experiment. The second page contains the decisions to be made for the first part of this experiment. This will complete the first part of Experiment 2. When you have completed the questions in 'Response 2A', place it face down and we will come to collect it. Kindly remain in your seat for the next experiment.

Your decisions in 'Response 2A' will first be made known to the SBU Y manager and then the top management. You will then receive an envelope marked 'Part 2 of Experiment 2'. As the contents of these envelopes are different for each individual in the room, the envelopes will be

c This document was placed in the envelope for the second experiment. d During the experimental sessions, experiments were conducted in the order of 1, 3, 2. Hence, the second experiment (or 'Experiment 2' in Appendix B and C) is actually experiment 3 in the study. Also, the third experiment (or 'Experiment 3' in this appendix) is actually experiment 2 in the study.

80 labeled with identification number. All envelopes for the room will be spread out on the row of tables in front of the room. When asked to do so please come up to collect your own envelope according to your identification number.

Please read 'Case 2A' on your own now.

Case 2Ac

SBU Y is in need of a particular type of computer software. Your SBU (SBU X) has previously acquired a licence to use this software from the software manufacturer at a fee of 1,000,000 lira (other costs are negligible). The licence agreement permits unlimited access to the software across the firm. As such, SBU Y can request your SBU duplicates an identical copy of the software at negligible additional cost to the firm. Alternatively, SBU Y can obtain the software from the software manufacturer at a price of 1,000,000 lira. SBU Y has no other way to obtain the software. As your SBU has solely incurred the licence fee for the software, top management asked you to propose a basis to allocate the licence fee to SBU Y, i.e. how much of the 1,000,000 lira will SBU Y bear. Top management has also asked SBU Y to decide whether to accept your proposed allocation. If SBU Y accepts the proposed allocation, your SBU will duplicate a copy of the software for SBU Y, which in tum pays for its allocated share of the licence fee to your SBU. In addition, top management allows SBU Y the discretion to reduce your proposed allocation up to a maximum of 100,000 lira. If SBU Y rejects the proposed allocation, it will purchase the software from the manufacturer and your SBU will not receive any payment from SBU Y.

If SBU Y decides to copy the software from your SBU then your account will be increased by an amount equal to the agreed upon payment.

Please answer the questions on 'Response 2A' now.

The role of the box below will be explained in a moment. i i

81 Response 2Ac Page I of2

Your identification number: ----

Questions to check your understanding on the first part of Experiment 2 (Please circle either Yes or No).

1. The balance in my SBU's account at the end of this experiment will be converted to Australian dollars at a rate of 250,000 lira= A$ 1 and paid out to me at the end of the experiment. Yes No

2. I know the names of the people assuming the roles of SBU Y manager and top management. Yes No

3. The people assuming the roles of SBU Y manager and top management know my name. Yes No

4. The instructor is able to trace my response to my name. Yes No

5. This experiment (Experiment 2) is independent of the decisions I made in Experiment 1. Yes No

Response 2A Page 2 of2

Please read 'Case 2A' again and then make the following decisions:

I. How much of the licence fee do you propose to allocate to SBU Y in return for providing a copy of the software it requires? (Please round off to the nearest thousand). -----lira

2. Please explain your decision in question I.

In addition, please record you answer to question 1, i.e. the amount of the licence fee you propose to allocate to SBU Y in the box at the bottom of the page headed 'Case 2A'. We will collect the response document but you will need to know the amount you propose to allocate when responding to the second part of the experiment.

This completes the first part of Experiment 2. Please place this document face down and we will come to collect it.

82 General Instructions For Experiment 3e

Your role

You are the chief executive officer of a large business firm called Orange. You will be asked to make decisions on behalf of your firm Orange.

Your remuneration

You begin with an investment account with a balance of 500,000 lira. Soon you will be presented with an opportunity to invest all or some of this money. After you have decided how much to invest the outcome of the investment will be revealed. The final balance of the investment account will thus depend on how much you choose to invest and the outcome of the investment. At the end of the experiment the final balance of the investment account will be converted into Australian dollars at the rate of 250,000 lira = $1. This amount, in addition to your account balance from Experiments I and 2, will be paid out to you at the end of the experiment.

Your task

There is only one part to this experiment. After going through this instruction page, read 'Case 3'. It provides the information for the experiment. After reading the information, answer the questions on 'Response 3'. 'Response 3' has 2 pages. The first page contains questions to check your understanding of this experiment. The second page contains space for you to record your decisions of this experiment. When you have completed the questions in 'Response 3 ', place it face down and we will come to collect it. Kindly remain in your seat while we arrange to pay you.

Please read 'Case 3' on your own now.

Your firm Orange is evaluating three different investment projects ()abeled 1, 2 and 3). Each of these projects were developed by your firm Orange [another firm, Apple], but each requires the participation of another firm, Apple [your firm Orange], to put into effect. Apple [Orange] was not involved in the development of any of these projects, but its participation is necessary for them to go ahead. All the projects require the two parties to each invest an initial amount of 500,000 lira in order to proceed. All the projects have equal time span and will complete before the end of this experiment. Note that you can only choose to invest in ONE of the three available projects.

The projects have a fixed return on investment for Orange and Apple as shown in Table 1.

Table 1

Return on investment

• This document was placed in the envelope for the third experiment.

83 For example, if you decide to invest in project I, you will earn a return of 20% on the 500,000 lira invested. This gives you a final balance of your investment account of 600,000 lira. Apple, on the other hand, will earn a return of 22% on its investment of 500,000 lira and thus will have a final balance of its investment account of 610,000 lira.

Regardless of which investment you choose Apple will always agree to participate. You must participate in one of the projects. Once your participation in any one is certain, the other two projects will not take off.

Please answer the questions on 'Response 3' now.

Response 3e Page I of2

Your identification number: ----

Questions to check your understanding of Experiment 3 (Please circle either Yes or No).

1. The balance in my firm's investment account after my decision will be converted to Australian dollars at a rate of 250,000 lira= A$ I and paid out to me at the end of the experiment. Yes No

2. The instructor is able to trace my response to my name. Yes No

3. Your firm Orange has contributed more than Apple towards the development of the projects. Yes No

When you have completed the questions above please tum the page.

Response 3 Page 2 of2

Please read 'Case 3' again and then make the following decisions:

1. Which project will your firm participate in? Please write the project number (1, 2 or 3 or no preference) in the space provided.

2. Please explain your decisions in question I.

This completes the experiment. Please place this document face down and we will come to collect it.

84 Appendix C General Instructions for Part 2 of Experiment la

This envelope contains three other documents headed: l. 'SBU Y's Reply to Your Proposal' 2. Case 2B 3. Response 2B

'SBU Y's Reply to Your Proposal' contains the response of the SBU Y manager and top management to your proposed allocation. 'Case 2B' contains the information for the second part of the experiment. This information is available to you only. 'Response 2B' has 2 pages. The first page contains questions to check your understanding of the second part of the experiment. The second page contains space for you to record your decisions with respect to the second part of this experiment. This will complete the whole of Experiment 2. When you have completed the questions in 'Response 2B', place it face down and we will come to collect it. Kindly remain in your seat for the next experiment.

Please read 'SBU Y's Reply to Your Proposal' on your own now.

SBU Y's Reply to Your Proposal"

The SBU Y manager has accepted/rejected your proposed allocation, and used his/her discretion to reduce [0 or 100,000t lira from your proposed allocation.

Then, top management reduced an additional amount of [0 or 100,000]b lira from your proposed allocation.

Therefore, the effective cost allocation is [0, 100,000 or 200,000]b lira less than that proposed by you. This allocation is final.

Please read 'Case 2B' now.

• This document was placed in the envelope for the second part of the second experiment. b Experimental manipulations were written in hand.

85 You have duplicated a copy of the software for SBU Y, and the respective accounts of the two SBUs have been adjusted to reflect the transaction.

Subsequently, the software manufacturer informed your firm that serious faults were detected in the software. These faults cannot be repaired so the supplier has decided to replace the software with a more advanced version. This advanced version has been proven to be suitable for both SBU X and Y. Although not provided by the licence agreement, the manufacturer has agreed to pay additional compensation of 500,000 lira to you, the licensee. Therefore, your investment account has been increased by 500,000 lira. SBU Y did not receive any compensation from the manufacturer.

Please answer the questions on 'Response 28' now.

Response 288 Page I of 2

Your identification number: ----

Questions to check your understanding on the second part of Experiment 2. l. I am not obliged by formal contract to share the compensation of 500,000 lira with SBU Y. Yes No

Response 28 Page 2 of 2

Please read 'SBU Y's Reply to Your Proposal' and 'Case 2B' again and then make the following decisions: l. Will you share the compensation of 500,000 lira with SBU Y? Yes No 2. If you answered yes to question l, how much do you wish to share? (Give you answer in a multiple of 1,000 lira). _____ lira 3. Please explain your decisions in questions l and 2.

This completes the second experiment. Please place this document face down and we will come to collect it.

86 Appendix D Experiment 1- Mean and Standard deviation of Amount invested by treatment (entire sample)

Relative expected return to the other oartv Hi~her Lower Relative orior contribution bv the other oartv More

Amount invested (lira): Mean 658,000 716,071 Standard deviation 290,718 267,725

N 25 28 Less

Amount invested (lira): Mean 637,931 729,167 Standard deviation 359,229 224,052

N 29 24

87 Appendix E Experiment l - 2 x 2 Analysis of variance on Amount invested by Relative expected return and Relative prior contribution (entire sample)

Source of variation OF F Sig of F (2-tailed)

Relative expected return" l l.715 0.193 Relative prior contributionb l 0.004 0.951

2-way interaction l 0.085 0.772

Explained 3 0.608 0.611 Residual 102 Total 105 • Manipulated at two levels: The other party's expected return was either higher or lower than the subject's expected return. b Manipulated at two levels: The other party's prior contribution was either more or less than the subject's prior contribution.

88 Appendix F Experiment 2 - Orange's choice of project by Relative prior contribution (entire sample)

Orange's choice of project Project l 2 3 Total Orange's return on investment 20% 20% 20% Aoole's return on investment 22% 20% 18% Relative prior contribution bv Apple Cell A Cell B More• N 37 9 7 53 Expected 29.6 6.8 16.6 52.0% Cell C Cell D Lessb N 20 4 25 49 Expected 27.4 6.2 15.4 48.0% Total N 57 13 32 102 Expected 55.9% 12.7% 31.4% 100.0% • 2 subjects indicated no preference. b 2 subjects indicated no preference.

89 Appendix G Experiment 2 - Wald Chi-Squared test (entire sample)

Comparison F Cell A versus cell B 16.318* Cell C versus cell D 0.553 Difference bet\veen cells A and B versus difference between cells C and D 13.718b • p < 0.05) Adjusted significance levels b p < 0.10) to control for multiple comparisons.

90 Appendix H Experiment 3 - Descriptive statistics of Cost proposed (entire sample)

Descriptive statistics Cost proposed (lira) Mean 654,226 Standard deviation 192,866 Mode 600,000 95% Cl (lower) 617,083 95% Cl (upper) 691,370

N 106

91 Appendix I Experiment 3 - Descriptive statistics of Benefit allocated by cell (entire sample)

Cell I 2 3 4 Total Treatment (lira): Reduction by SBU Y 0 0 100,000 100,000 Reduction by top management 0 100,000 0 100,000 Total reduction 0 100,000 100,000 200,000 Benefit allocated (lira): Mean 71,667 46,708 105,769 45,962 68,075 Standard deviation 100,587 78,773 108,006 73,607 93,820 Mode 0 0 0 0 0 95% Cl (lower) 34,107 13,445 62,145 16,231 50,007 95% Cl (upper) 109,227 79,971 149,394 75,692 86,144

N 30 24 26 26 106

92 Appendix J Experiment 3 - Significance level (adjusted for multiple comparisons) ofTukey HSD test on Benefit allocated by cell (entire sample)

Cell I 2 3 4 I - 2 0.155 - 3 0.513 0.112 - 4 0.725 1.000 0.095 -

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