Career Concerns and Excessive Risk Taking

• DOI: http://doi.org/10.1111/jems.12085
• Date: 01 March 2015
• Published date: 01 March 2015
• Author: Ying Chen

Career Concerns and Excessive Risk Taking

YING CHEN

Department of Economics

Johns Hopkins University

Baltimore, MD

ying.chen@jhu.edu

In a seminal paper, Holmstr¨

om (1999) shows that an agent who is unsure of her ability and has

a payoff linear in her reputation underinvests in risky projects. I show that if the agent privately

knows her ability, then the opposite must happen, that is, she always overinvests in risky projects,

no matter what the curvature of her payoff in reputation. Moreover,if project quality is verifiable

and the agent is uninformed about her ability, then she reveals project quality and first best is

attained; but if she privately knows her ability, first best is not attainable and she still overinvests.

1. Introduction

Consider the problem of a manager facing the following investment decision: she can

either continue to invest in a well-established market with a known return, or venture

into a new, untested market whose success depends on her managerial talent as well as

the market conditions.1Apart from the financial return on the investment, the manager

also cares about how her ability will be perceived because her future labor market

opportunities depend on her reputation. Similar situations arise in other principal-agent

relationships whenever the agent’s choices differ in their informativeness about her

ability and the agent is (partly) motivated by career concerns. Attorneys, on behalf of

their clients, often have to decide whether to settle (with known reward or punishment)

or to go to trial (whose outcome depends on the merit of the case and the talent of the

attorney). Doctors regularly choose between a safer treatment (e.g., a drug regimen with

known benefits and side effects) and a riskier one (e.g., surgery), whose success depends

on the the doctor’s surgical skill as well as the patient’s medical conditions.

How will the agent’s career concerns affect her decision? Will she act too conser-

vatively because the safe choice prevents unfavorable information being revealed about

her ability? Or will she take too much risk, choosing the risky alternative against the

principal’s best interest, to show confidence in her ability?

That the agent’s career concern may result in conservatism and underinvestment

was first pointed out in an example in Holmstr¨

om’s (1999) seminal paper on managerial

dynamic incentives. Although the intuition for the incentive to underinvest generalizes

beyond the example, it crucially depends on the following assumptions: (1) both the

agent and the principal are uninformed about her ability; (2) the agent’s payoff function

An earlier version of this paper was circulatedunder the title “Career Concerns, Project Choice, and Signaling.”

I am grateful to Hector Chade and Ed Schlee for their extensive comments on earlier drafts of this paper and

to Amanda Friedenberg and an anonymous referee for helpful suggestions. I thank audiences at Arizona

State University,Johns Hopkins University, the 2009 Midwest Economic Theory Meeting, and the 2010 SWET

Conference for their comments and suggestions.

1. Similarly, the manager’s problemmay be the decision of whether to adopt a new, risky technology or

whether to develop a new product. What is important is that the risky alternative will reflect on the manager’s

ability more than the safe one does.

C2015 Wiley Periodicals, Inc.

Journal of Economics & Management Strategy, Volume24, Number 1, Spring 2015, 110–130

Career Concerns and Excessive Risk Taking 111

is weakly concave in her reputation. One main contribution of this paper is to show that

when the agent privately knows her ability, then the opposite must happen, that is, the

agent always overinvests, independent of the curvature of her payoff function.

These results are derived in a simple model of project choice with career concerns.

An agent, hired by a principal, chooses between a safe project and a risky project. How

likely the risky project will succeed is determined by the agent’s ability and the quality

of the project, which is privately observed by the agent and independent of her ability.

Neither the agent’s ability nor the project quality is observable to the market, and the

agent’s reputation is determined by the inference that the market draws based on her

decision and performance.

If the agent does not have better information about her talent than the market

does, choosing the safe project reveals no information about her talent. If she chooses

the risky project, however, then she gains a higher reputation if it turns out to be a

success and suffers from a lower reputation if it fails. In equilibrium the agent chooses

the risky project only when its quality is sufficiently high. Accordingly, when the risky

project is chosen, the market infers that it is likely to succeed (in the manager example,

the mere fact that a new, unestablished market is chosen implies that it is promising).

But without knowing project quality, the market’s expectation of success is higher than

it really is at the threshold, and therefore expected reputation goes down if the agent

selects the risky project. Unless the agent is quite risk loving (in which case she finds

the uncertainty in her reputation attractive), her incentive to choose the risky project

is diminished, resulting in underinvestment. This is the underlying argument for the

example in Holmstr¨

om (1999); in Section 3, I show that it holds under more general

conditions.

The assumption that the agent has no private information about her ability is

perhaps plausible in the internal labor market of certain organizations where employees

are monitored closely and evaluated frequently. But in other kinds of principal-agent

relationships where the agent is kept at arm’s length (Cr´

emer, 1995), for example, self-

employment, it is likely that the agent knows more about her ability than the external

labor market does. Another potential source of asymmetric information is experience:

at an early stage of her career, an agent may not know more about her talent at her job

than the market does, but as she gains experience and accumulates observations of her

performance over time, she obtains private information about her ability.

When the agent privately knows her ability,career concerns have strikingly differ-

ent implications for her incentives because project choice itself may become an informa-

tive signal that influences market perception. Since it is more likely for a talented agent

to succeed with the risky project, the choice of the safe project is a sign of weakness:

the agent’s reputation goes down if she opts for the safe project. On the other hand, the

choice of the risky project shows the agent’s confidence in the project’s success, which in

turn indicates high ability. Although this signaling effect is hardly unexpected, what is

surprising is thatit always leads to overinvestment under a natural condition. Specifically,

when the success rate of the high-ability agent dominates the success rate of the low-

ability agent in the likelihood ratio order, the agent’s reputation is higher if she chooses

the risky project than if she chooses the safe one, even if the risky project fails. So regardless

of her true talent and the curvature of her payoff function, the agent’s career concerns

drive her to take too much risk (Proposition 2, Section 4).

It is useful to note that the benchmark model in which the agent does not know her

ability is one of “signal-jamming” (Fudenberg and Tirole, 1986) because both the agent

and the market are ignorant of her ability but the agent can manipulate the market’s