Information acquisition and optimal project management

This paper provides a rationale for why an organization often generates a bias in favor of a new project even after learning that its profitability will be certainly below more conventional ones. We analyze a principal-agent model with two alternative projects, one of which is to be chosen by the principal. In our model, the profitability of a project is determined by the cost of implementation. All parties are familiar with one of the projects (the known project), and thus the implementation cost of this project is common knowledge. Information on the other project (the new project), however, must be acquired by the agent. We find that the new project may be chosen in the optimal contract even when it turns out to be more costly to implement than the known project, if acquiring information is costly enough and the realized implementation cost of the new project is below a particular level. We also discuss distortion in the new project's output schedule when it is selected. (c) 2007 Elsevier B.V. All rights reserved.