STRATEGIC INFORMATION TECHNOLOGY ENTRENCHMENT

Transcription

1 Xaotong L* March 006 (To be resubmtted to Journal of MIS for second round revew) * College of Admnstratve Scences, Unversty of Alabama, Huntsvlle, AL 35899, Phone: (56) , Fax: (56) , Emal: lx@uah.edu. I would lke to thank Dave Allen, Edwn Cheng, John Conlon, Dorla Evans, Alok Gupta, Rob Kauffman, Fred Rggns, Rajv Sabherwal, Al Wlhte, Keth Womer and Kevn Zhu for ther helpful comments on early versons of ths paper. Ths paper greatly benefted from the feedback of semnar partcpants at Hong Kong Polytechnc Unversty, Unversty of Alabama, Unversty of Mnnesota and Unversty of Msssspp. I am also very grateful to Gordon Davs for a detaled dscusson on how to better delver the nsghts of ths paper to a broader audence.

2 ABSTRACT Many economc and nformatonal problems assocated wth organzatonal IT spendng can be attrbuted to manageral rent-seekng. Because of the unavodable ncompleteness of labor contracts, managers wth msalgned ncentves and budgetary dscreton often entrench themselves through ther non-value-maxmzng adopton decsons. In order to boost ther barganng power n future contract renegotaton, they nvest excessvely n IT projects they manage more effectvely than ther potental rvals. In addton, they tend to adopt technologes that can create large nformaton asymmetres gvng them sgnfcant knowledge advantage over ther potental rvals ex post. We study the mplcatons and mpacts of ther rent-seekng behavor wthn the context of organzatonal IT adopton and management. The effcaces and the lmtatons of formal ncentve contractng are dscussed to underscore the need for addtonal governance mechansms n combatng entrenchment. Knowledge management s suggested as one of the avalable tools that may mtgate some of the agency problems assocated wth entrenchment. However, we cauton our readers of the manageral self-polcng ssue that mght emerge as companes deploy nformaton systems to facltate effectve knowledge management. We further pont out that the ncentve provson potental of relatonal labor contracts merts systematc exploraton n dynamc settngs wth repeated nvestments and barganng. Keywords: Agency Problems, Barganng, Contract Renegotaton, Entrenchment, Informaton Technology Adopton, Knowledge Management, Organzatonal Decson-Makng, Rent- Seekng.

3 Managers of frms attempt to entrench themselves, ncreasng ther barganng power, e.g. vs-à-vs alternatve management teams, and one of the ways that they do ths s to take actons whch ncrease nformaton asymmetres. Dong so effectvely reduces competton n the market for management. -Joseph E. Stgltz, Informaton and the Change n the Paradgm n Economcs, Lecture to the memory of Alfred Nobel, December 8, 00. I. INTRODUCTION In today s dgtal economy where Informaton Technology (IT) s evdently becomng the backbone, t s not uncommon for managers to emphasze the strategc mportance of IT nvestments. However, they may never tell you that they can secure ther jobs and reap sgnfcant personal benefts by strategcally nfluencng ther organzatons IT spendng. Absent effectve montorng and ncentve algnment, they can entrench themselves and obtan manageral rents by makng opportunstc IT adopton decsons that erode corporate proftablty and shareholder value. Recent emprcal evdence has demonstrated that undscplned IT spendng frequently destroys frms value and sometmes even leads to catastrophes n mplementaton (Carr, 003; McAfee, 003). For example, Carr (003, p.49) wrtes: Some managers may worry that beng stngy wth IT dollars wll damage ther compettve postons. But studes of corporate IT spendng consstently show that greater expendtures rarely translate nto superor fnancal results. In fact, the opposte s usually true. These observatons are actually consstent wth the major fndngs gven by many pror emprcal studes usng frm-level data on IT spendng. For example, Htt and Brynjolfsson (996) fnd lttle evdence of postve effects of IT on frms market valuaton. Ther data analyss even suggests the possblty of an overall negatve mpact of IT on frms proftablty. Usng a resource-based perspectve, Bharadwaj (000) suggests that merely spendng n IT wll not lead to compettvely sgnfcant IT capabltes that enhance frm performance n a sustanable manner. The fact that IT spendng on average does not generate sustanable hgher profts should not surprse those researchers who are famlar wth the The term rent s wdely used by economsts as the fnancal payment that can not be justfed by compettve market mechansms. It has become almost axomatc n the related lterature that rent-seekng, as a market dstortonal behavor, usually leads to sgnfcant welfare losses.

4 compettve market equlbrum or the theores of compettve strategy. It s generally understandable that IT, once commodtzed as a resource, wll no longer confer a compettve advantage or be a source of compettve advantage (Clemons, 99; Varan, 003). Even f a frm s strategc IT nvestments lead to a compettve advantage, ts fnancal performance wll not be sgnfcantly enhanced when, as suggested n Coff (999), nternal stakeholders nstead of shareholders approprate most rents from ths compettve advantage. In a semnal paper, Smon (99a) calls on neoclasscal economsts to take a more serous look at the economc behavor that takes place nsde the skns of frms. Gbbons (999, 004) further ponts out the nevtablty of the convergence between the new organzatonal economcs lterature and the noneconomc lterature on organzatonal decson-makng. Devatng from the tradtonal economcs models where organzatons are smplfed as unfed value-maxmzng nodes n a socal network, our study analyzes the nternal neffcences assocated wth organzatonal IT nvestment decson-makng. More specfcally, n an ncomplete contract settng where contract renegotaton s consdered, our analyss shows why manageral entrenchment wthn organzatons can brng a value-destroyng reputaton to undscplned organzatonal IT spendng. Manageral Empre-Buldng Generatons of researchers have been tryng to better understand the conflct of nterest problem (frequently referred to as the agency problem) behnd corporate vels ever snce Berle and Means (93) publsh ther nfluental book, The Modern Corporaton and Prvate Property. One of the best known manfestatons of corporate agency problems s manageral empre-buldng. Wth dscretonary cash flow n hand, managers tend to nvest excessvely to buld larger companes from whch they can gan more prvate benefts and perqustes (e.g., see Wllamson, 964; Jensen, 986). Although ths emprebuldng theory can be used as one explanaton for the neffcences n corporate IT spendng, t does not

5 necessarly lead to IT overnvestment. Furthermore, the emprcally observed technology overnvestment or undernvestment could be at least partally explaned by many other theores, ncludng rsk preference ncongruty (Holmström, 979; Stgltz, 974; Grossman and Hart, 983), manageral career concerns (Holmström and Costa 986; Holmström, 999), herdng (Kauffman and L, 004; L, 004; Scharfsten and Sten, 990), manageral myopa (Bebchuk and Stole, 993), overconfdence (Rool, 986) and so on. Although these theores allow us to examne IT nvestment decson-makng from multple perspectves, they make t challengng for researchers to select the most approprate theory under dfferent scenaros. As busness researchers, we are more nterested n the busness and technologcal mplcatons of these theores than n theory comparson and evaluaton. We also beleve that t wll be far more productve for researchers to nvestgate how agency problems affect IT managers nvestment strateges than to argue whether frm or market level IT overnvestment s emprcally observed n dfferent ndustres. Therefore, our study does not focus on the controversy surroundng IT overspendng. In order to provde more concrete and specfc busness nsghts, we follow Smon s call to take a closer look at the role played by IT managers n corporate nvestment decson-makng. Beyond Empre-Buldng Untl recently most corporate governance studes (not ncludng the theoretcal lterature on frms nternal herarches) have concentrated on the relatonshp between corporate top executves and outsde shareholders. Some recent studes have suggested that many agency problems can be better understood f the relatonshp between corporate CEO and dvsonal or departmental managers s also consdered (Bernardo, Ca and Luo, 004; Bolton and Scharfsten, 998; Scharfsten and Sten, 000). Most IT managers partcpate n corporate IT nvestment decson-makng processes at the dvsonal or departmental level, and they generally have to get top executves approval for sgnfcant IT spendng (CIOs mght be an excepton, but they usually also need to report to CEOs for fnal nvestment Some theoretcal studes dynamcally model the dscplnary role of corporate debt, and ther results generally suggest that managers empre-buldng preference wll not necessarly result n ex post overnvestment (Hart and Moore, 995; Stulz, 990; Zwebel, 996). 3

6 authorzaton). Because of ther expertse and experence, IT managers are often key advsors who help top executves shape corporate IT spendng strateges. However, they have less dscreton and flexblty n IT spendng than CEOs. For example, they usually have to make nvestment decsons wth nflexble IT budgets or under captal ratonng, whch makes t more dffcult for them to engage n conspcuous IT overnvestment (e.g., empre-buldng). Nevertheless, t would be mstaken to assume that the agency problem of IT spendng s much less severe at the departmental or dvsonal level than t s at the top executve level. One reason s that, unlke top corporate executves whose compensaton packages usually nclude powerful ncentves (e.g., sgnfcant amount of stock optons), most md-level IT managers do not own a lot of stocks or stock optons. Even f they do, there s stll a free-rdng problem because usually ther performance does not meanngfully nfluence ther companes stock performance (Hall and Murphy, 003). More mportantly, IT managers have much more dscreton and flexblty n nfluencng the form of nvestment than they have n nfluencng the level of nvestment, whch n many cases could exacerbate the manageral ncentve problem n nvestment decson-makng. Gven the strategc mportance of technology selecton 3 and IT spendng prortzaton, we beleve that a thorough nvestgaton of IT managers potentally opportunstc behavor s well warranted. If approprately conducted, such a study should not only contrbute to the rch and ever-growng corporate governance lterature that follows Jensen and Mecklng (976), but also yeld new nsghts nto organzatonal IT adopton and management. We study the ncentve for IT managers to entrench themselves by strategcally allocatng the IT budget under ther control. It s well known that IT professonals barganng power vs-à-vs ther employers sgnfcantly affects ther compensaton packages (Ang, Slaughter and Ng; 00). The essental objectve for manageral entrenchment s to make the ncumbent manager more dffcult to be replaced, whch wll offer the ncumbent more leverage and barganng power n future compensaton contract renegotaton. When nformaton and knowledge, as descrbed n our model, are strategcally 3 Usng a real optons model, Kauffman and L (005) analyze the strategc optons embedded n technology selecton under scenaros where ncompatble technologes compete and uncertantes abound. L (005) studes how cheap talk affects emergng technologes dffuson n technology markets subject to network externaltes. 4

7 manpulated ex ante for explotaton ex post, manageral entrenchment becomes an excellent example of the knowledge formaton hazards conceptualzed n Nckerson and Zenger (004). Recent studes have recognzed and emphaszed the strategc role of IT human captal n enhancng organzatonal effectveness (Mata, Fuerst and Barney, 995; Roepke, Agarwal, and Ferratt, 000). We beleve that one major challenge n IT human resource management s what Holmström (999) descrbes as the fundamental ncongruty between IT employees concern for ther human captal returns and companes concern for ther fnancal returns. Our analyss suggests that IT managers, nstead of allocatng more money to the IT projects wth hgher expected fnancal returns, have ncentves to spend excessvely n those projects that they manage more effectvely than ther potental rvals. It further explans why IT managers can entrench themselves and extract sgnfcant rents by creatng ex post knowledge superorty through ther strategc budget allocaton. Potental Remedes of Informaton Technology Entrenchment Although our paper does more to hghlght manageral ncentve problems n IT spendng than to solve them, t does emphasze knowledge management and relatonal contracts as two potental tools n overcomng neffcent entrenchment. Undoubtedly, the optmal ncentve contractng lterature has greatly enhanced our understandng of the successes and lmtatons of contractual ncentve provson n frms (Prendergast, 999). An nterestng queston s: what can knowledge management, as an alternatve to ncentve contractng, help to mtgate managers propensty to entrenchment? So far few economc studes have explctly examned the role of knowledge management n overcomng agency problems. 4 Gven the tremendous success enjoyed by the knowledge management research n both organzaton and nformaton systems lterature (Argote, McEvly and Reagans, 003; Alav and Ledner, 00), t s unfortunate that we have not seen any meanngful convergence and nterplay between the economcs lterature and the non-economc lterature n ths promsng area. 4 Some economsts have long ago suggested the ncentve justfcaton for organzatonal nformaton gatherng and storage (e.g. Holmström and Trole, 989). In the organzatonal lterature on the theores of the frm, we have recently seen some nterestng dscussons of the relatonshp between knowledge and opportunsm (Coff, 003; Conner and Prahalad, 996; Foss, 996; Nckerson and Zenger, 004). 5

8 By exogenously ncorporatng the mpacts of effectve knowledge management nto our analyss, we show that t becomes more dffcult for ncumbent managers to mantan sgnfcant nformaton or knowledge superorty over ther potental rvals. As a result, IT managers ncentves for engagng n neffcent IT nvestment entrenchment wll dmnsh consderably. Of course, the effcacy of knowledge management n overcomng entrenchment depends on how well knowledge management systems are desgned to dscourage knowledge hoardng and to nduce truth-tellng n knowledge valuaton. These mportant ncentve ssues assocated wth organzatonal knowledge management and governance are well elaborated n some recent studes (Ba, Stallaert and Whnston, 00a, b). We beleve that there s another fundamental ncentve ssue that could sgnfcantly lower the effcacy of knowledge management n dscplnng manageral opportunsm and rent-seekng. If those managers, who are the prmary benefcares of exstng nformaton asymmetres and knowledge superorty, are delegated the decson-makng authorty n knowledge management, how can they behave benevolently and weaken ther lucratve entrenchment voluntarly? Ths manageral self-polcng ssue and other dffcultes wth knowledge management underscore the need for other ncentve provson mechansms. Based upon the recent development n the relatonal contract lterature, we argue that selfenforcng relatonal contracts can play an nterestng role n supplementng both formal contracts and knowledge management to combat entrenchment. The remander of ths paper s organzed as follows: Secton II nvestgates the mpacts of two manageral entrenchment strateges on corporate IT nvestment effcency. In Secton III, we examne, n the context of IT adopton and management, the potental of knowledge management n overcomng manageral entrenchment and n mprovng shareholder value. The last secton provdes further dscusson and concludes the paper. II. STRATEGIC ENTRENCHMENT AND CONTRACT RENEGOTIATION Strategc IT nvestment, to whch manageral expertse and nformaton avalablty are essental, s more susceptble to manageral entrenchment, and that s why we beleve that examnng IT nvestment 6

9 decson-makng may yeld mportant new nsghts. In fact, the mportance of manageral ncentve algnment n strategc nvestment has been repeatedly emphaszed n pror economcs lterature. For example, (Holmström and Costa 986, p. 857) remnds us: The need to harmonze preferences between superors should be strongest n areas where ablty plays a sgnfcant role. Strategc nvestment decsons, whch are lkely to nvolve szeable human captal rsks and opportuntes for the manager, need ncentve algnment and control. In addton to manageral ablty, nformaton plays a sgnfcant role n strategc IT adopton. Modern lterature n decson-makng under uncertanty has provded us wth a good understandng of the relatonshp between nformaton avalablty and decson qualty. However, the nformaton structure n our model affects manageral decson-makng through another avenue. We show that nformaton asymmetres, n many cases of strategc IT nvestments, are ntentonally created and mantaned by managers whose objectve s to maxmze ther own human captal returns. We argue that ths manageral ncentve problem s especally serous n IT adopton decson-makng. The reason s because that the causally ambguous nature of strategc IT nvestments often makes t hard to confrm or dsconfrm, at least n the short run, any lnk between adopton decson qualty and organzatonal performance. The Model We present a three-stage model wth four dates (t = 0,,, 3). At tme 0, an IT manager s gven a budget C for a frm s long-term strategc IT nvestment. The manager s supervsed by the top executves actng n the nterest of the frm s shareholders. The top executves know that the manager has an emprebuldng preference (he always nvests all the money under hs control), and thus mpose a bndng IT spendng budget. At tme, the manager splts C between two types of IT projects. He spends C on the frst type of projects, those he manages better than hs potental rval does, and he spends C = C C on the second type of projects, those hs potental rval manages as well as he does. 5 After tme, the 5 A more general assumpton s that the potental rval manages the second type of projects at least as well as the ncumbent does. Such a scenaro would not change the nsghts of our paper. It actually strengthens our core argument, because such a manager would have stronger ncentves to prortze type- projects over type- ones. The presence of a symbolc management rval n the labor market (or an emblematc corporate rader n the captal market) has been extensvely dscussed n the corporate governance lterature as a manageral dscplnary mechansm (Shlefer and Vshny, 989; Walsh and Kosnk, 993; Walsh and Seward, 990; Edln and Stgltz, 7

10 manager starts to manage the nvested IT projects that are assumed prohbtvely expensve to be reversed. He has an opportunty to renegotate hs compensaton contract wth the top executves at tme. The expectatons that contracts wll be renegotated n the future, an essental feature of most ncomplete contract models (e.g., Hart and Moore, 999; 004; Wernerfelt, 004), are the drvng force behnd strategc entrenchment n our model. After the contract renegotaton, the manager contnues to manage the nvested IT projects untl tme 3 when the termnal long-term nvestment payoffs are calculated. The sequence of events descrbed above s depcted n Fgure. The manager s gven an IT nvestment budget C The manager allocates C between two types of IT projects The manager renegotates hs compensaton contract The long-term nvestment payoffs are calculated t = 0 3 IT Project Selecton Stage Short-term IT Management Stage Long-term IT Management Stage Fgure. Sequence of Events n the Three-stage Model The frm s long-term IT nvestment payoffs under the ncumbent manager and the potental rval are gven as R = q E, I ) B ( C ) qb ( ) and R = q E, I ) B ( C ) qb ( ), where B ( ) and B C ) are ( + C r ( r r + C C ( the two types of IT projects nvestment payoff per unt of manageral effectveness, and q( E, I) s manageral effectveness as a functon of a manager s expertse E and nformaton qualty I. We assume that B ( C ) 0, B ( C 0 and ) B ( C ) 0, B ( C ) 0, whch smply mples that, holdng manageral > > < < effectveness constant, the nvestment payoffs ncrease as more money s nvested, but they ncrease at a decreasng rate. It s also reasonable to assume that manageral effectveness ncreases n both E and I. As descrbed above, for the second type of IT projects there s no dfference between the ncumbent and the rval n terms of ther manageral effectveness. So we use a constant q to express both managers effectveness n managng ths type of projects. 995; Chemmanur and Yan 004). The potental rval descrbed n our model s some ndvdual who mght step nto the ncumbent manager s job ether through nternal promoton or external hrng. The dfferent mplcatons of the two types of replacements wll be dscussed later. 8

11 The ncumbent s ntal salary s normalzed to 0. He renegotates hs salary wth the top executves at tme, and hs new salary at that tme depends on how well he can manage the nvested IT projects vs-à-vs the potental rval n the long run. We assume that hs new salary s S = λ R R ), ( r where R measures the extra nvestment payoff the frm can get under the ncumbent, and R r λ (0,) s the ncumbent s share of the extra payoff (t obvously depends on hs barganng power at tme ). The ncumbent s objectve n the budget allocaton s to maxmze hs long-term human captal return, gven as λ R R ) + θ ( R C λ( R R )), where 0 θ << s the ncumbent s very small share of frm ( r r ownershp. So the frst part of hs return comes from hs manageral rents and the second part comes from hs stock ownershp. The sequence of events descrbed n our model s smlar to that n Shlefer and Vshny (989). They analyze the nvestment strategy of a top executve (e.g., a CEO) who has much more dscreton over the magntude of captal nvestment than the IT manager has n our model. Consequently, ther paper s major nsght s that managers entrenchment ncentves tend to result n corporate overnvestment and excessve busness expanson, and that corporate and dvson-level captal ratonng can help to counter manageral entrenchment. Our analyss, however, shows that IT managers wth captal allocaton dscreton can engage n neffcent entrenchment even f they have a bndng nvestment budget. Our paper s concentraton on the form of nvestment rather than the level of nvestment s partcularly pertnent n the context of corporate IT adopton and management. Instead of jonng the argument about whether consstent evdence of corporate-level IT overnvestment exsts, our paper attempts to help practtoners and researchers to take a more serous look at the followng questons: Are we observng overnvestment n some types of IT and undernvestment n some other types of IT? If yes, where does ths nvestment dstorton come from, and how can we deal wth t? Make Your Expertse Pay: Buy More Manager-Specfc IT We frst consder the mpact of the ncumbent manager s expertse on hs IT nvestment strategy. The manager has the dscreton to allocate C between two types of IT projects. The frst type of projects 9

12 s manager-specfc, whch means that the ncumbent has more project-specfc expertse n managng them than the potental rval has. We assume that the ncumbent and hs rval have access to the same nformaton and ther expertse does not change over tme (ths assumpton wll be relaxed later). So we can wrte ther effectveness n managng the frst type of IT projects as two constants wth q > q r. To demonstrate the ncumbent s preference for manager-specfc projects and the resultant nvestment neffcences, we frst derve the frm s optmal IT budget allocaton ( C *, C * ) that maxmzes the frm s long-term nvestment returns. To make thngs nterestng, we assume that ( C *, C * ) s an nteror soluton, whch smply mples that * C (0, C). We then compare ths effcent captal allocaton to the ncumbent s personal optmal budget allocaton ( C, C ) that maxmzes hs long-term human captal returns. PROPOSITION (IT INVESTMENT ENTRENCHMENT: MANAGER-SPECIFIC RENTS). The ncumbent IT manager lkes to nvest excessvely n those IT projects that better utlze hs specfc manageral expertse. Consequently, hs IT budget allocaton n those projects s always greater than the effcent allocaton that maxmzes the frm s long-term nvestment returns (All Proofs are n Appendx A). Proposton suggests that the manager has the ncentve to overspend money n those IT projects that he manages better than others, and consequently he spends less n other projects that do not gve hm an edge over hs potental compettors. As a result of hs dscrmnatory budget allocaton, he fals to maxmze the frm s long-term nvestment returns. Ths result may seem counter-ntutve. How could t be less effcent for the manager to nvest more money n projects that better utlze hs personal expertse? The answer to ths queston s that the effcency loss actually comes from the manager s opportunstc overnvestment beyond the frm s optmal budget allocaton that has already taken manageral expertse nto consderaton. The logc behnd ths type of IT nvestment dstorton s very clear: the ncumbent manager can effectvely entrench hmself and bargan for more compensaton than justfed by the management labor market (hs rents) n future contract renegotaton. 0

13 It s well known n the transacton cost and the asset ownershp lterature that, because of opportunsm and contract ncompleteness, there s usually undernvestment n relatonshp-specfc assets. 6 The reason our analyss suggests overnvestment rather than undernvestment n managerspecfc IT projects s smply that the manager s not spendng hs own money (Shlefer and Vshny, 989). In one extreme case where the IT manager s ownershp of the frm s zero ( θ = 0), he wll nvest all the money under hs control n manager-specfc IT projects ( C = C, C = 0). In another extreme case where the manager s also the frm s sole owner ( θ = ), he has no ncentve to devate from the frm s optmal budget allocaton ( C *, C ). As dscussed before, compared to top executves lke a CEO, most dvson or department-level IT managers have neglgble frm ownershps, whch unfortunately mples that they may be more prone to entrench themselves. * Excessvely nvestng n manager-specfc IT projects s only one strategy used by managers to fortfy ther trenches and to extract rents. Many IT managers who have successfully entrenched themselves do not have any dstnctve expertse that can gve them an edge over ther potental rvals. Ther alternatve entrenchment strategy, whch wll be demonstrated n a more general verson of our model, s arguably more harmful to frm-level IT adopton and management. Make Your Knowledge Pay: Create Informatonal Superorty We now drop the assumpton that the manager and hs rval have access to the same nformaton and ther expertse does not change over tme. Recall that the manager s future salary depends on R R r, the extra IT nvestment payoff he can brng to the frm. So the ncumbent, who wants to maxmze hs human captal return, wll strategcally allocate hs IT nvestment budget to ncrease R. Because manageral effectveness s a functon of a manager s expertse E and nformaton qualty I, R can be expressed as q( E, I ) q( E, I )) B ( C ). Ths expresson mples that there are two R r ( r r reasons why the ncumbent manages the frst type of IT projects better than hs potental rval does. Frst, R r 6 Early nfluental studes n ths area nclude Wllamson (979) and Klen, Crawford and Alchan (978). Grossman and Hart (986) present a more formal treatment of contract ncompleteness and asset ownershp. For a recent lterature survey, see Trole (999).

14 hs personal expertse s more approprate for ths type of projects ( E > Er ). Second, the qualty of hs project-related nformaton s better than that of hs rval s I > I ). It s easy to see that Proposton s results are stll applcable to ths settng. ( r PROPOSITION (IT INVESTMENT ENTRENCHMENT: INFORMATIONAL RENTS). The ncumbent IT manager wll nvest excessvely n those IT projects that offer hm nformatonal advantages over hs potental rval. Consequently, hs IT budget allocaton n those projects s always greater than the effcent allocaton that maxmzes the frm s long-term nvestment returns. Ths proposton mmedately leads to several mportant mplcatons to IT nvestment decsonmakng. Ceters parbus, the ncumbent manager favors IT nvestment projects wth uncertanty that can be more quckly resolved for hm than for hs potental rvals. These projects offer the ncumbent sgnfcant nformatonal advantages that materalze n future contract renegotaton. Interestngly, most long-term strategc IT projects create substantal uncertanty and nose that can sustan the ncumbent s nformatonal superorty over a sgnfcant tme perod. Moreover, the payoffs of most strategc IT nvestments are notorously dffcult to quantfy n the short run, whch provdes managers wth more flexblty n justfyng ther nvestment decsons ex ante. Therefore, t s understandable that IT managers wth msalgned ncentves prefer to spend excessvely n long-term strategc IT projects even f they know that many of those projects are of lower qualty than other avalable IT projects. It s worth notng that our model does not explctly descrbe how the qualty of project-related nformaton affects manageral effectveness. In an nsghtful paper, Edln and Stgltz (995) analyze several mechansms through whch the ncumbent manager can extract sgnfcant nformatonal rents. In ther model, rsk-averse rvals, because of ther nformatonal dsadvantage, make fewer efforts than the ncumbent does n managng nvested projects. Consequently, ther manageral effectveness s reduced. In addton, they tend to ask for hgher salares to compensate for ther perceved rsks. Sometmes the problem of the wnner s curse under nformaton asymmetry further makes potental rvals more reluctant to compete for the ncumbent manager s job.

15 There are two reasons why we do not drectly model these mechansms. Frst, dervng the ncumbent manager s optmal budget allocaton requres some strngent assumptons about these mechansms, whch unnecessarly lmts the generalzng ablty of our analytcal results. Second, explctly modelng these mechansms excludes other nterestng scenaros where the ncumbent IT manager can create or worsen nformatonal problems to extract rents. The analyss n Edln and Stgltz (995) focuses on the ncumbent and hs rvals asymmetrc nformaton about the nvested projects prospects. Ths type of nformaton asymmetry s not the only source from whch the ncumbent manager can extract rents n nvestment decson-makng. As dscussed n Stgltz (000), nformaton asymmetres are a subset of the broader problem of knowledge mperfectons. Nckerson and Zenger (004) explctly pont out that agents, wth the ntenton to enhance ther barganng power n the future, possess ncentves to strategcally nfluence organzatonal knowledge development and accumulaton. In the context of IT adopton decson-makng, we show that there are ncentves for managers to nvest excessvely n any IT projects that make them more knowledgeable than ther potental rvals n the future. Clearly, knowledge plays a crtcal role here n our study of the strategc entrenchment n IT adopton. So t s mportant for us to connect our analyss to knowledge management whose prmary functon s to deal wth organzatonal knowledge-related problems. III. CAN KNOWLEDGE MANAGEMENT OVERCOME ENTRENCHMENT? There are at least two reasons why we argue that researchers should pay more attenton to the nterplay between the lterature on corporate governance and the lterature on organzatonal knowledge management. Frst, the problems of manageral entrenchment and rent-seekng, as Stgltz (999) ponts out, may be partcularly acute n knowledge-based enterprses and the knowledge-drven economy n general. Ths judgment s also consstent wth the major emprcal nsght gven by Coff (003). Second, there are nterestng nteractve dynamcs between corporate governance and knowledge management. For example, as our analyss suggests, many manageral ncentve problems arse because of knowledgerelated ssues whch are frequently addressed n knowledge management studes. At the same tme, there 3

16 are varous knds of ncentve algnment ssues n acqurng and n managng organzatonal knowledge and knowledge management systems (Ba, Stallaert and Whnston, 00a, b). Before we examne the nteractve dynamcs between knowledge management and corporate governance, we dscuss the role of some tradtonal methods n combatng managers IT nvestment entrenchment. Actve Montorng and Contractual Remedes One major condton under whch the IT manager n our model can engage n neffcent entrenchment s that the frm s top management cannot dfferentate hs normal nvestment behavor from rent-seekng entrenchment. There are many reasons why ths condton exsts for long-term strategc IT nvestment. For example, the long-term payoffs of strategc IT nvestments are extremely dffcult to quantfy n the short run. In addton, many IT projects that can strongly entrench the ncumbent manager are also proftable, at least n terms of the pre-compensaton nvestment returns (Edln and Stgltz, 995; Shlefer and Vshny, 989). Undoubtedly, the frm s top management can be more proactve n montorng the IT manager s nvestment behavor, whch may help to stop some blatant cases of entrenchment. Top management may further reduce the manager s budgetary dscreton to avod the extreme stuaton where certan types of IT nvestment are not funded at all because of manageral bases (Ross and Beath, 00). However, actve montorng and supervson are usually costly and n some cases may result n effcency loss because of budgetary nflexblty. They reman, at best, a partal soluton to manageral entrenchment as long as the fundamental knowledge-related problems exst n an organzaton. The tradtonal wsdom from the optmal ncentve contractng lterature suggests that, f a frontal attack on the nherent organzatonal nformatonal problems s nfeasble or too costly, provdng managers wth ncentves not to behave opportunstcally mght be a reasonably good soluton. In the context of manageral entrenchment, Edln and Stgltz (995) argue that contractual restrcton of salary barganng or ncentve provson through stock ownershp could mtgate managers propensty to entrenchment. We formalze ther argument n the next two propostons. 4

17 PROPOSITION 3 (INCENTIVE PROVISION THROUGH STOCK OWNERSHIP). Provdng the IT manager wth ntal hgher stock ownershp moves hs personal optmal IT budget allocaton closer to the frm s effcent budget allocaton. PROPOSITION 4 (CONTRACTUAL RESTRICTION OF SALARY BARGAINING). Contractual restrcton of the manager s salary barganng power reduces hs rents assocated wth IT nvestment entrenchment, whch moves hs personal optmal IT budget allocaton closer to the frm s effcent budget allocaton. Although the two approaches seem to have potental n combatng manageral entrenchment, ther effcacy n the real busness organzaton s consderably attenuated by several factors. Frst of all, as we have dscussed before, t s very uncommon and often mpractcal for a md-level IT manager to own a sgnfcant share of the frm n whch he works. Even f the decson-maker s a top executve, the effcency loss resultng from grantng hm sgnfcant stock ownershp may sgnfcantly outwegh the benefts of curbng manageral entrenchment (Bebchuk and Fred, 003; Hall and Murphy, 003). Furthermore, contractual restrcton of salary barganng, lke the preventon of contract renegotaton or rent-sharng, has serous problems n ts mplementaton. 7 In a dynamc settng, the frm s commtment not to engage n future contract renegotaton or rent-sharng wll not mpact managers entrenchment ncentves unless t s deemed credble (n the terms of game theory, any credble strategy n a dynamc game must be subgame perfect). Even f the frm fnds some mechansms to make a bndng commtment at a reasonable cost, restrctng contract renegotaton n a compettve management labor market often has some undesrable consequences on effcency. For example, wthout contract renegotaton and rentsharng, a frm may contnue to lose the ablest managers to the job market because of ts compensaton rgdty. 7 For example, some companes specfy detaled executve compensaton schemes n ther corporate bylaws to leave very lmted room for contract renegotaton. Some organzatons have a no counteroffer polcy to dscourage salary barganng. See secton 3 of Hart and Moore (999) for an n-depth dscusson of the dffcultes assocated wth commttng not to renegotate a contract. 5

18 All the methods dscussed so far attempt to remedy the problem of manageral entrenchment wthout drectly attackng ts nherent cause. By amng to tackle organzatonal nformaton and knowledge related problems, knowledge management could open a new front n the fght aganst manageral rent-seekng behavor such as IT nvestment entrenchment. Knowledge Management vs. Manageral Entrenchment To search for fresh nsghts nto how to overcome entrenchment, we need to go beyond the tradtonal economcs lterature that often vews a frm as a nexus of contracts. By vewng a frm as an nsttute of knowledge ntegraton, the knowledge management lterature, n our opnon, could shed new lght on IT nvestment entrenchment caused by varous knowledge-related problems. Our prevous dscusson argues that targetng nformaton asymmetres and knowledge mperfectons could have drect mpacts on manageral ncentves for entrenchment. We formalze ths argument n the next two propostons. PROPOSITION 5 (THE EFFECT OF EXPERTISE DISPARITY ON ENTRENCHMENT). Other thngs beng equal, the smaller the ncumbent IT manager s expertse advantage over hs potental rval at the tme of contract renegotaton, the closer the ncumbent s personal optmal IT budget allocaton s to the frm s effcent budget allocaton. PROPOSITION 6 (THE EFFECT OF INFORMATION DISPARITY ON ENTRENCHMENT). Other thngs beng equal, the smaller the ncumbent IT manager s nformatonal advantage over hs potental rval at the tme of contract renegotaton, the closer the ncumbent s personal optmal IT budget allocaton s to the frm s effcent budget allocaton. It s obvous that companes should not reduce the ncumbent manager s expertse or lower the qualty of hs project-related nformaton. They nstead should concentrate on makng the rval more knowledgeable after he s hred to replace the ncumbent. Why do we consder the dsparty n manageral expertse as a knowledge related problem? In the knowledge management lterature, there are clear dstnctons between tact knowledge (knowng how) and explct knowledge (knowng about). Intutvely, a manager s personal expertse sgnfcantly depends on hs specfc tact knowledge that can 6

19 only be gradually revealed through ts applcaton (Smon, 98, 99b; Grant, 996; Kogut and Zander, 99). As a result, observed dsparty n manageral expertse usually reflects the dfference n tact knowledge whch s much more dffcult to observe. Compared to expertse dsparty, the nformaton qualty dsparty (nformaton asymmetry) n our model measures the ncumbent manager s advantage of havng more explct knowledge of the nvested IT projects. It s worth notng that, as emphaszed n Nonaka (994), tact knowledge and explct knowledge are often mutually convertble. For example, an IT manager who can access explct knowledge of a project n the short run may be able to develop manager-specfc tact knowledge (e.g., through learnng by dong) over tme. To effectvely combat manageral entrenchment n IT spendng, Propostons 5 and 6 suggest that the frm should try to reduce the knowledge gap between the ncumbent manager and hs potental replacement. The key to mplementaton les n the frm s learnng of ts employees lke the ncumbent manager, whch, as argued by Smon (99b), s one of the two ways n whch organzaton learnng can be acheved. In the real busness world, there are many examples where frms retan ts key employees knowledge through dfferent methods of learnng. For example, frms sometmes assgn assstants to work wth key employees who are expected to leave n the near future. By dong that, they try to retan knowledge and mnmze the dsrupton that mght be caused by key employees departure. 8 By facltatng organzatonal learnng and knowledge retenton, knowledge management understandably has some potental n overcomng entrenchment. Ths asserton also apples to knowledge management systems whch are, n most cases, IT-based systems. Frms need to focus on dfferent aspects of knowledge management when they deal wth the two types of knowledge dsparty descrbed n our analyss. To reduce the nformaton asymmetry between the ncumbent and hs potental rvals, frms need to spend more resources on nformaton retenton and knowledge storage. Organzatonal amnesa may negatvely affect decson-makng qualty n many ways (e.g., see Hrshlefer and Welch 00). In our model, poor retenton of explct knowledge about IT 8 We thank Gordon Davs for offerng us ths example based on hs own experence. Gordon worked as a consultant before he joned academa, and an assstant was assgned to work wth hm shortly after hs frm learned hs ntenton to leave. 7

20 projects creates nose and reduces the manageral effectveness of potental rval managers, whch offers the ncumbent ncentves to engage n neffcent entrenchment. Reducng tact knowledge dsparty s more challengng. Ths s because tact knowledge generally can not be easly codfed or revealed. Therefore, frms should make more efforts to encourage meanngful knowledge sharng, to reduce nternal knowledge transferrng costs, and to facltate the ntegraton of manageral tact knowledge nto organzatonal knowledge bases. By dong that, even f a new manager who replaces the ncumbent lacks certan expertse to manage some type of IT projects, he can quckly develop the requred expertse wth the help of the relevant knowledge retaned by the frm. Consequently, t becomes more dffcult for the ncumbent to engage n entrenchment facltated by organzatonal knowledge mperfectons. Manageral Self-Polcng and Relatonal Governance When we emphasze the potental of knowledge management n overcomng manageral entrenchment n IT nvestment, we mplctly assume that effectve knowledge management systems can be mplemented by the frm to delver the desrable mpacts on ts organzatonal memory. In fact, one motve for capturng employee expertse n automated systems, as ponted out by Smon (99b, p.9), s that t makes organzatonal memory less vulnerable to personnel turnover. Some recent studes nvestgate how knowledge management systems can be mplemented to enhance an organzaton s memory capacty and retenton capablty of ts employee s knowledge and nformaton (Sten and Zwass, 995; Alav and Ledner 00). Nevertheless, t s our belef that, even n today s economy where advanced knowledge management systems abound, ths assumpton should be subject to scrutny and debate. The key ssue here s not whether a frm has the resources to acqure varous knowledge management systems, but whether t can, through sound decson-makng processes, mplement those systems to acheve the desrable objectves. Ths ssue s absolutely not trval gven the fact that most companes n today s knowledge-drven economy stll exhbt some features of the organzed anarchy descrbed n Cohen, March and Olsen s (97) garbage can model. If many companes, as argued n Feldman and March (98), nvest heavly n nformaton gatherng and knowledge acquston prmarly 8

21 for sgnalng or other symbolc purposes, we should not expect to see any sgnfcant mprovement n ther capabltes of fghtng manageral entrenchment. For example, Glmour (003) ponts out that there s no sold evdence of the payoffs of bllons of dollars spent n knowledge management technologes, and he attrbutes t to corporate culture problems: People guard ther nformaton and selectvely release t. Ths tendency to hoard knowledge s a core problem of corporate culture. It s easy to see that ths corporate culture problem usually arses because of ncentve msalgnment n knowledge management. Pnpontng potentally acute ncentve problems n knowledge acquston and sharng, Ba, Stallaert and Whnston (00a) advocate the vew that ncentve algnment should be ncluded as a thrd dmenson n knowledge management system desgn. In the context of our model, we agree wth them that, to realze the full potental of knowledge management systems n overcomng entrenchment, system desgners must approprately address ncentve ssues lke free-rdng or knowledge hoardng. We further argue that, even f system desgners can take care of those ssues, there s stll one fundamental ncentve problem assocated wth knowledge management system adopton and mplementaton. It s mperatve to pont out that t s corporate managers (n many cases IT managers) who make decsons on what knowledge management systems to adopt and on how to mplement the adopted systems. Unfortunately, those managers happen to be the major benefcares of manageral entrenchment created and sustaned by varous knowledge-related problems that knowledge management ntends to solve. Because of ths nherent ncentve conflct, managers are very lkely to take advantage of ther authortes by mnmzng the mpacts of knowledge management systems on ther personal lucratve entrenchment. Consequently, t s a myth that, wthout successful ncentve algnment, corporate managers wll behave benevolently and play a self-polcng role n knowledge management decson-makng. In addton to ths self-polcng ssue, there are other strategc ssues that may sgnfcantly lmt the potental of knowledge management n weakenng manageral ncentves for entrenchment. For example, many frms may not want to codfy ther managers knowledge and expertse nto systems, because they 9

22 fear that ther knowledge resource may become more mtable and transferable so rval frms can apply t (Mata, Fuerst and Barney, 995; Coff, Coff and Eastvold, 006). Therefore, we beleve that knowledge management, lke formal contractng and montorng, has ts nherent lmtatons n overcomng entrenchment. Effectvely mtgatng entrenchment problems n today s knowledge-drven economy, n our opnon, entals the employment of other channels of ncentve provson, and relatonal ncentve provson s certanly among these channels. Recent development n the organzatonal economcs lterature demonstrates the potental of relatonal contracts n overcomng opportunsm both between and wthn frms (e.g., Gbbons, 005; Levne, 003). The essental tradeoff emphaszed n ths lterature s between the short term gans from opportunstc behavor and the long term losses from damaged relatonshps. In our model, the ncumbent manager s ncentve for entrenchment wll be sgnfcantly weakened f hs decson qualty s somewhat lnked to hs long term humane captal returns. Because of the causally ambguous nature of IT nvestments, frms often assess the qualty of managers IT adopton decsons subjectvely, whch underscores the mportance of relatonal governance. Baker, Gbbons, and Murphy (994) demonstrate why effcency can be mproved by smultaneously usng formal contracts based on objectve performance and relatonal contracts based on subjectve assessments. Poppo and Zenger (00) provde emprcal evdence substantatng the argument that there are valuable complementartes between formal contractng and relatonal ncentve provson. So t would be nterestng to nvestgate the nteractve dynamcs between the two mechansms n the context of organzatonal IT adopton, and to study how organzatons can take advantage of these complementartes to fght neffcent entrenchment more effectvely. IV. DISCUSSIONS AND CONCLUSION Could manageral opportunsm weaken strategc IT nvestment s contrbuton to corporate proftablty? How can an IT manager wth a bndng IT budget, by strategcally overspendng n certan types of IT projects, establsh nformaton and knowledge advantages over hs potental rvals n the future? What s the role of compensaton contract renegotaton n facltatng manageral rent-seekng? 0

23 What are the mpacts of manageral entrenchment on corporate IT adopton and management? Our study attempts to provde researchers wth a theoretcal perspectve from whch these questons can be formally studed. By lookng through the corporate vel behnd whch most IT nvestment decsons are made, our analyss sheds fresh lght on the neffcency of organzatonal strategc IT spendng. Specfcally, t shows that forward-lookng IT managers, n order to gan leverage n future contract renegotatons, have ncentves to entrench themselves n nvestment decson-makng. Wth manageral dscretons n IT budget allocaton, they tend to nvest excessvely n those projects that they can more effectvely manage n the long run vs-à-vs ther potental rvals. Unlke most agency-theoretc models that assume exogenous nformaton asymmetres, our model recognzes the ncumbent IT manager s ablty to create nformatonal problems that he can explot ex post. Ths recognton s partcularly mportant n the context of strategc IT nvestment where opportuntes for nformatonal rent-seekng abound. Its sgnfcance s even more notceable when we analyze the IT manager s ncentve for creatng knowledge superorty over hs potental rvals. Our study concentrates on the entrenchment problem assocated wth nvestments n managerspecfc projects. Followng the semnal work n Becker (964), there s a great deal of theory around frm-specfc human captal. Before we dscuss the IT nvestment scenaros nvolvng frm specfcty, we lke to emphasze the dfference between project-specfc human captal and frm-specfc human captal. Shlefer and Vshny (989) use manager-specfc nvestment to stress the fact that a manager may possess specfc human captal that can be better utlzed n some nvested projects. Gbbons and Waldman (004) propose the term task-specfc human captal to conceptualze the smlar dea that some of the human captal s specfc to the tasks beng performed, as opposed to beng specfc to the frm. They demonstrate how the concept of task-specfcty can be appled to better explan the well documented cohort effects studed n Baker, Gbbs and Holmström (994). In addton, they argue that ths new human captal concept can be used n some busness strategy studes where the ssue of frm specfcty has been well understood.

24 Despte the dfference between frm-specfcty and manager-specfcty, most results of our study can be extended to address the potental entrenchment problem caused by frm-specfcty. It s commonly observed that frms often nvest n customzaton when there are more cost-effectve off-theshelf products that better serve ther needs. Here the customzed products may not be manager-specfc, but they are generally frm-specfc, whch, because of learnng by dong, offers ncumbents an edge over ther external rvals n the long run. Of course, n terms of entrenchment, frm-specfc nvestments may not be as effectve as manager-specfc nvestments. The reason s that frm-specfc nvestments do not protect ncumbent managers from the competton of nternal rvals. Moreover, managers frm-specfc human captal tends to deprecate upon ther leavng the frm, whch not only lmts ther labor moblty, but also reduces ther barganng powers n contract renegotaton. On the other hand, human captal specfc to tasks or projects, as argued n Gbbons and Waldman (004), s more lkely to be reasonably valued n the labor market. Although managers may have stronger ncentves to accumulate human captal specfc to ther expertse than that specfc to ther companes, they often face a lower hurdle n justfyng frm-specfc nvestments than manager-specfc nvestments. Because most nsders can somewhat beneft from frmspecfc nvestments, the lnk between entrenchment and frm-specfcty s presumably stronger n stuatons where a group of nsders make nvestment decsons. It s often argued from the resourcebased perspectve that manageral expertse s the only attrbute of IT that can generate sustanable compettve advantage (Mata, Fuerst and Barney, 995). By relatng our study to both project-specfc and frm-specfc human captal, organzatonal strategy researchers could further nvestgate the core rgdty assocated wth IT human captal (Leonard-Barton, 99). In our opnon, ncorporatng frmspecfcty n the study of entrenchment n organzatonal IT adopton could also shed fresh lght on the relatonshp between IT and frm boundares. It s well understood that IT, f properly deployed, can mprove ncentve structure and consequently facltate more effcent organzatonal desgn (Nault, 997; Zenger and Hesterly, 997). However, there s stll an ongong debate between researchers about the jont mpacts of technologcal advance and asset specfcty on frm boundary choces (e.g., Poppo and Zenger