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Payoff Externalities, Informational Cascades and Managerial Incentives: a Theoretical Framework for It Adoption Herding

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Payoff Externalities, Informational Cascades and Managerial Incentives: a Theoretical Framework for It Adoption Herding PAYOFF EXTERNALITIES, INFORMATIONAL CASCADES AND MANAGERIAL INCENTIVES: A THEORETICAL FRAMEWORK FOR IT ADOPTION HERDING Robert J. Kauffman Professor and Chair, Information and Decision Sciences Co-Director, MIS Research Center Carlson School of Management University of Minnesota Minneapolis, MN 55455 Email: [email protected] Xiaotong Li Assistant Professor of Management Information Systems Department of Accounting and MIS University of Alabama, Huntsville Huntsville, AL 35899 Email: [email protected] Last revised: May 19, 2003 _____________________________________________________________________________ ABSTRACT We have recently observed herd behavior in many instances of information technology (IT) adoption. This study examines the basis for IT adoption herding generated by corporate decisionmakers’ investment decisions. We propose rational herding theory as a new perspective from which some of the dynamics of IT adoption can be systematically analyzed and understood. We also investigate the roles of payoff externalities, asymmetric information, conversational learning and managerial incentives in IT adoption herding. By constructing a synthesis of the critical drivers influencing managers’ IT investment decisions, this study will help business researchers and practitioners to critically address the issues of information asymmetries and incentive incompatibility in firm- and market-level IT adoption. Keywords: Agency problem, asymmetric information, herd behavior, incentives, informational cascades, IT adoption, network externalities, reputations, signaling games. ______________________________________________________________________________ Acknowledgements: The authors wish to acknowledge Yoris Au, John Conlon, Rajiv Dewan, David Hirshleifer, John Gallaugher, Angsana Techatassanasoontorn and Al Wilhite for helpful discussions on related work. Rob Kauffman thanks the MIS Research Center at the University of Minnesota for support. ______________________________________________________________________________ 1 Published by New Yorker in 1972; reproduced from Bikhchandani, Hirshleifer and Welch (1996). INTRODUCTION In the recent years, there have been many instances of information technology (IT) adoption in which we have observed “herd behavior,” as many investment decisionmakers lost touch with their own cautious value-maximizing approaches to investment decisionmaking, and decided to follow the decision of many “smart cookies.” Bikchandani and Sharma (2001) define herd behavior in terms of three related aspects: (1) the actions and assessments of investors who decide early will be critical to the way the majority decides; (2) investors may herd on the wrong decision; and, (3) if they do make the wrong decision, then experience or new information may cause them to reverse their decisions, and a herd may be created in the opposite direction. Herd behavior has long been studied in other academic fields, including Finance and Economics, where the literature abounds (See Bikhchandani, Hirshleifer and Welch, 1996). In some cases, such as stock market bubbles or the DotCom mania, herding is driven—in the words of Federal Reserve Bank Chairman, Alan Greenspan—by people’s “irrational exuberance.” However, recent theoretical and empirical studies suggest that in many other cases herd behavior is rather counterintuitively caused by the decisions of perfectly rational people. Such rational decisions at the individual level sometimes result in significant information and welfare losses in the marketplace and the economy. 2 In IT adoption, rational herding has the potential to generate several problems. First, valuable information about new technologies is often lost (or at least poorly aggregated) when IT managers blindly follow others’ adoption decisions. Second, payoff externalities-driven herding makes early adopters’ decisions disproportionately important, and it gives other adopters little chance to compare and experience different technologies. Third, managers may intentionally imitate others’ adoption decisions because of their career concerns, and those reputation- motivated decisions usually fail to maximize expected IT investment payoffs. The widespread mimicry in IT adoption and the resultant inefficiencies motivate us to investigate the basis for technology adoption herding generated by corporate managers’ decisions. A common and well-studied justification for IT adoption herding is positive payoff externalities like network externalities. Recent studies have indicated that many technology markets are subject to positive network feedback that makes the leading technology grow more dominant (Brynjolfsson and Kemerer, 1996; Gallaugher and Wang, 2002; Kauffman, McAndrews and Wang, 2000). Because positive network feedback makes a company’s IT adoption return rise as more companies adopt the same technology, it usually gives managers strong incentives to adopt the technology with the larger installed base of users. In addition to the studies of positive payoff externalities, recent research in information economics demonstrates how rational herd behavior may arise because of “informational cascades” (Banerjee, 1992; Bikhchandani, Hirshleifer and Welch, 1992 and 1998) or managers’ career concerns (Scharfstein and Stein, 1990; Zwiebel, 1995). Informational cascades occur when individuals ignore their own private information and instead mimic the actions of previous decisionmakers. Those mimetic strategies are rational when private information is swamped by publicly observable information accumulated over 3 time. This is why informational cascading is sometimes referred to as “statistical herding” (Ottaviani and Sorensen, 2000). Like informational cascade models, career concerns models have information economics and Bayesian games as their theoretical foundations, but they distinguish themselves by examining rational investment herding through the lens of agency theory. The primary implication of those models is that managers concerned about their reputations may imitate others’ investment decisions to positively influence others’ inferences of their professional capabilities. Although reputational herding decisions are rational for individual managers, they are usually not in the best interests of those companies who hire their managers to maximize investment payoffs. Empirical evidence of herd behavior and imitative strategies has been recently documented in stock analysts’ equity recommendations, emerging technology adoption and television programming selection (Hong, Kubik and Solomon, 2000; Kennedy, 2002; Walden and Browne, 2002; Welch, 2000). There is also extensive experimental evidence of rational herding and informational cascades in the economics literature (Anderson and Holt, 1997; Hung and Plott, 2001). Another recent experimental study of behavioral conformity is Tingling and Parent (2002) in which senior IT and business decision-makers instead of college students are used as subjects. Despite the fast-growing rational herding literature and the pervasiveness of imitative behavior in IT adoption, systematic studies of IT adoption herding are still rare in the IS literature. By synthesizing previous rational herding models, this paper proposes an integrated theoretical framework within which the dynamics of IT adoption herding can be better analyzed and understood. The next three sections discuss the underlying theories in greater detail. We investigate the relationship between payoff externalities and IT adoption herding in Section 2. 4 We next demonstrate in Section 3 how information asymmetries and observational learning can lead to informational cascades in IT investment. The problem of managerial incentives in IT investment decisionmaking is the focus of Section 4. We discuss why agency problems predispose the market to reputational herding in IT adoption. Managerial compensation schemes designed to address those incentive issues are also discussed. Section 5 provides a synthesis of critical theoretical drivers of IT adoption herding and brings the ideas together into a single integrative framework. Section 6 concludes the paper with the contributions of this work to ongoing research in IS, and ideas for further research. PAYOFF EXTERNALITIES: DOES ADOPTION HERDING PAY OR HURT? One type of positive payoff externalities that is commonly observed in the IT market is “network externalities” (Economides, 1996; Katz and Shapiro, 1994). Network externalities are sometimes referred to as demand-side economies of scale. (For additional constructs related this area of theory, see Table 1). Table 1. Key Constructs in the Payoff Externalities Theory Relative to IT Adoption CONSTRUCT DEFINITION COMMENTS Rational IT IT adoption herd behavior that can be justified by an Three types of rational justifications adoption herding individual decisionmaker’s rationality. exist for IT adoption herd behavior. Network A type of positive payoff externalities. The value of a They are common in IT markets, and externalities technology increases as the number of users create payoff incentives for decision- increases. Sometimes referred to as network effects. makers to herd in IT adoption. Negative payoff It refers to the situation where a company’s return from They usually punish IT adoption externalities adopting a technology decreases as more companies herding and make informational adopt the same technology. cascades less likely to occur. Technology It refers to the costs incurred for a user to switch from Adopters face significant
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