Is it Irrational to Assume Rationality in Business?

Abstract

Purpose: Academic research continuously introduces new theories, methodologies, etc. to improve upon prior studies. Researchers commonly base their theories on the assumption that managers and stakeholders have calculated motives and make well-educated decisions. However, they ignore the fact that certain corporate decisions are completely random with no logical explanations. Researchers still are not comfortable with this idea and always try to justify business decisions by advancing new sophisticated theories while in fact, many executives and stakeholders are not that sophisticated. This paper discusses such instances of irrationality.

Methodology: This paper discusses several instances of irrational business decisions in various aspects of finance including capital budgeting, capital structure, stock buybacks, executive compensation, overinvestment, and stock market irregularities. By examining a historical set of corporate events, it is shown that various forms of irrationality, when abundant, may cause empirical studies to refute theories.

Findings: Theories cannot always be justified by empirical work not necessarily because of flaws in these theories but possibly because of irrational behavior of ill-informed executives and stakeholders. That is, if the assumption of rationality commonly imbedded in academic studies does not hold, then it may be the culprit, at least in part, behind the discrepancy between theory and empirical findings.

Unique Contribution to Theory, Practice and Policy: This paper postulates that the discrepancy between theory and empirical findings may, in part, be caused by the common assumption of rationality that may not hold true. By discussing numerous instances of irrational behavior in various aspects of business, this paper attempts to show that irrationality is not uncommon and should be considered in the design of academic research.