Summary by Mohamed Gomaa
Ph.D. Program in Accounting
University of South Florida, Spring 2002
The main purpose of this article, as stated by Luft, is to address two major questions raised by literature about the alternative-preference model. First, can limited experimental data supporting alternative models be reconciled with the ability of simple self-interest models to predict behavior in empirical research? Second, how do alternative representations of preferences affect current key issues in management accounting? Luft argues that many empirical tests of the simple self-interest model offer little evidence against plausible alternatives. She develops a number of testable research propositions that show how alternative-preference models change the specification of contracting costs which would change the optimal management accounting choices.
Testing the Simple Self-Interest Model
The simple self-interest model is commonly represented as an adequate approximation of reality for predictive purposes. Luft developed the following three arguments related to testing the simple self-interest model:
1. Self-interest behavior may be significantly diminished both statistically and practically by alternative preferences such as fairness or ethical concerns. Typical empirical tests are not designed to detect or measure these effects.
2. Alternative measures can drive some self-interest effects. Many empirical tests and tests based on economic models are not designed to distinguish wealth maximization from alternative preferences as a source of these effects.
3. Agency models of contracting don’t focus on the same set of contracting costs for fairness and ethical behavior.
Countervailing Effects of Preferences Other than Simple Self-Interest
Several studies of the simple self-interest model have shown behavior consistent with its predictions. These studies capture behavior shifts in response to incentives in certain settings, however, they don’t provide tests of the simple self-interest model vs. plausible alternative utility functions. These studies don’t offer evidence against the existence of other significant preferences, however, they do offer evidence for a preference of wealth. The nul hypothesis in these studies is that the observed wealth based incentive has no effect. Therefore, the hypothesis rejected by these tests is either:
1. individuals have no interest in increasing their own wealth, or
2. the ethical considerations that would prevent individuals from shrinking or manipulating accounting numbers completely dominated considerations of wealth.
Luft believes that these are not plausible or interesting alternatives to the simple self interest model, and that rejecting them does not imply rejection of other alternatives. Therefore, on the basis of empirical tests such as these, it is impossible to say whether the effect of additional preferences is significant.
Fairness as an Alternative Explanation for "Self-Interested" Behavior
Several researchers have stated that self-interest and alternative preference models result in opposing, not identical, directional effects, as an assumption implicit to empirical defenses of the simple self-interest model. The alternatives can be seen as:
1. a pursuit of consumption and leisure for oneself.
2. ethical concerns that direct individuals not to pursue wealth and leisure for themselves, at least not beyond a certain point.
However, fairness research in behavioral economics suggests that additional preferences that significantly affect economic behavior are not always ethical in a conventional sense.
Which Contracting Costs are Measured?
Several researchers have suggested that several types of contracting costs exist, however, there is no complete catalogue of these costs or an adequate identification of the factors that determine their magnitude. Luft believes that experimental and empirical tests based on simple self-interest models are designed to detect the specific contracting effects predicted by these models. Several researchers suggest that experimental tests of the basic agency model look for evidence that contracts are structured to reduce these costs. In accounting and economics, fairness research has been primarily occupied with a different set of contracting costs, for example:
1. frictions that delay adjustment to a new equilibrium when market supply and demand change
2. costly delay or failure to agree in bilateral bargaining, or
3. excessive expenditures on monitoring.
Alternative Preference Models, Contracting Costs and the Demand for Management Accounting
Ethics and the Demand for Monitoring
Baiman, 1982, suggests that simple self-interest approaches to contracting assume that individuals will freely misrepresent their actions and characteristics when doing so maximizes their wealth and leisure. Accounting uses values as a monitor because it provides information to support incentive schemes that make misrepresentation costly. Ethics-based research suggested less need for monitoring than simple self-interest models. Noreen, 1988, states "If enough people adhere to the ethical code … resources can be diverted away from monitoring, enforcing, and protecting into more productive uses".
Luft believes that more explicit descriptions of alternative preferences can help sort out these results and their implications. Two views exist. First, all lies are viewed as unacceptable behavior, Second, the difference between big lies and small lies is much more significant, and the difference between truth and relatively trivial falsehoods is less important. Predictions of behavior and inferences that can be drawn from experimental results depend on how dishonesty is represented.
Fairness and Product Costing: Frictions in Markets and Bargaining
Product costs are relevant in determining the supply of an item at a given price, but not in determining market demand, in a world governed by simple self-interest. In this case, transmitting internal accounting information, such as product costs, from the seller to the buyer has no value because it doesn’t affect the prices or quantities of goods traded on the market. Data collected using surveys has suggested that buyers’ willingness to pay a given market price depends on whether they regard the price as fair, and that these fairness judgments are influenced by information about sellers’ costs and profits. For multiproduct firms, the fairness of a products price depends on a product’s profit not on the firm’s total profit. Buyers do not consider it fair to raise the price of one product to cover cost increases in another.
Luft believes that prices for many goods and services are set by bilateral bargaining between a buyer and a seller rather than by the workings of the market. She believes that self-interest models and fairness models generate different predictions about the value of information in reducing bargaining costs. Researchers suggest that simple self-interest models predict that increases in information about the other party’s payoffs lead to greater efficiency in bilateral bargaining, while fairness models distinguish between conditions in which additional information reduces bargaining costs and conditions in which additional information increases bargaining costs. Straub and Murnighan, 1995, suggest that bargaining costs can be lower when subjects have no information about the other party’s payoffs at all than when they have information that clearly indicates unequal payoffs. Other researchers suggest that information also increases bargaining costs when it is ambiguous enough to support more than one definition of a fair outcome because bargainers choose the definition of fairness that is most advantageous to themselves. Luft believes that these results have important implications for the use of management accounting information to reduce transaction costs within firms. Fairness research suggests the following propositions to explain some of the observed variations:
1. intrafirm disclosures should be less likely when market forces or other exogenous factors result in highly unequal divisional payoffs from internal trade or sharp increases in one party’s payoffs.
2. intrafirm disclosures should be less likely when the information increases the number of plausible definitions of fair exchange that can be rationalized.
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