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 The Effect of Superiors’ Exogenous Constraints on Budget Negotiations

Markus Arnolda

April 2014

preprint
Editor’s note: Accepted by Donald V. Moser.
Submitted December 2011
Accepted June 2014

accepted
Acknowledgements: manuscript
I greatly appreciate the helpful comments and suggestions from Don Moser (Editor) and two
anonymous reviewers, as well as from Martin Artz, Robert Gillenkirch, Robert Grasser, Lynn
Hannan, Kelvin Liu, Dominik Schreiber, Ivo Tafkov, Kristy Towry, workshop participants at the
University of Mannheim, and participants of the 2011 AAA annual meeting and the 2011 EAA
annual meeting. I also thank Elke Lay for programming assistance and the University of
Hamburg Research Laboratory for its support.

Author’s note:
a
University of Bern, phone: +41 31 631 37 35; fax: +41 31 631 37 80; email:
markus.arnold@iuc.unibe.ch
 The Effect of Superiors’ Exogenous Constraints on Budget Negotiations

Abstract

In a world characterized by increasing pressure from financial and product markets, the ques-

tion of how exogenous constraints affect internal coordination and control processes has become

increasingly important. This experiment investigates how two exogenous constraints that superiors

can face in budget negotiation settings, increased opportunity costs and financial pressure to meet

unit targets, affect budget negotiations and subordinate effort. The results show that both constraints

induce more cooperation, but in different ways. Financial pressure on the superior leads to more co-

operative negotiation behavior by superiors and subordinates than increased opportunity costs. Spe-

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cifically, subordinates do not take advantage of the superior’s increased financial pressure to enforce

lower budgets. After negotiation, both constraints strongly mitigate the negative effects of superior
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budget imposition on subordinate effort because exogenous constraints eliminate the effect of pro-
manuscript
cedural fairness considerations on subordinate effort.

Keywords: Budget negotiations, performance evaluation, negotiation costs, financial pressure,

performance.
 I. INTRODUCTION

Large and medium-sized companies commonly use budgets for the performance evaluation and mo-

tivation of subordinates (Horngren, Datar, and Rajan 2012; Umapathy 1987). However, despite po-

tentially increasing subordinate motivation, this practice can also induce severe conflicts of interest

between the superior and the subordinate (Hansen, Otley, and Van der Stede 2003; Jensen 2003).

Usually, firms employ negotiations to solve this conflict and determine the budget target (Fisher,

Frederickson, and Peffer 2000).

Prior studies on budget negotiations have mainly focused on internal issues like the organiza-

tion of the budget-setting process itself (Fisher et al. 2000, Fisher, Frederickson, and Peffer 2006;

Wolfe and Murthy 2006), the degree of information asymmetry (Chalos and Haka 1989; Fisher,

Frederickson, and Peffer 2002a), and the interaction of different budgeting functions (Fisher,

Maines, Peffer, and Sprinkle 2002b). However, even though evidence from the field has called into
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question whether findings derived under normal conditions can be generalized to constrained set-

tings, prior experimental research has not fully addressed how exogenous constraints affect budget
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negotiations. For example, recent evidence indicates that adverse financial conditions lead to unreal-

istically high budget targets as well as the constriction of control and less participative decision-

making (D’Aunno and Sutton 1992; Indjejikian, Matějka, Merchant, and Van der Stede 2014). Thus,

in constrained situations, firms seem to adopt particularly efficient internal coordination processes.

This study investigates how two specific exogenous constraints that superiors can face in budget

negotiation settings, financial pressure to meet unit targets and high opportunity costs, influence

budget negotiations and subsequent subordinate effort, thereby focusing on behavioral effects that

go beyond monetary incentives.

Firms may face a variety of exogenous constraints due to capital or labor market conditions,

legal or contractual requirements, or increased pressure owing to public awareness (Beck,

1
Demirgüç-Kunt, and Maskimovic 2005; Porter and Kramer 2006). These constraints can affect

firms’ business decisions and internal processes. Investment decisions and capital budgeting pro-

cesses, for example, can be influenced by financial constraints (Hubbart 1998; Stein 1996), and de-

cisions to hire or dismiss employees can be limited by legal requirements or by a shortage of skilled

labor (Espenshade 2001; Jensen and Meckling 1979). Even if the firm itself is not exogenously con-

strained, lower hierarchy levels may still be restricted by firm policies. For example, superiors may

not be able to fund all projects in their business units owing to rationing of resources (Antle and

Eppen 1985). In budget negotiations, superiors themselves may feel pressure to reach goals imposed

by top management or may face time constraints because of other pressing tasks.

Financial pressure to meet unit targets and the opportunity costs of negotiation have received

considerable attention in recent years. Traditional budgeting systems and negotiations have been

criticized by practitioners and academics for generating high financial pressure to meet targets and
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for being too time-consuming (Hansen et al. 2003; Hope and Fraser 2003; Jensen 2003). In fact,

these constraints may even interact, such that high opportunity costs of negotiations may be particu-
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larly harmful when the financial pressure to meet unit targets is high. Still, the two constraints do

differ in one important aspect. Superiors can unilaterally avoid an increase in opportunity costs by

imposing budgets. However, financial pressure to meet unit targets is reduced only if the whole unit

performs well, and this typically requires subordinate cooperation.

The influence of exogenous constraints on budgeting may be substantial because prior re-

search indicates that fairness concerns may differ according to the circumstances of the interaction

(De Dreu, Giebels, and Van de Viert. 1998; Hannan 2005). In this study, I develop theory to predict

that both financial pressure and opportunity costs lead to more cooperation in budgeting processes,

but in different ways. First, I predict that during negotiation financial pressure increases superior and

subordinate cooperation more than increased opportunity costs because the superior can unilaterally

2
avoid increased opportunity costs but needs subordinate cooperation under financial pressure. Thus,

financial pressure increases the subordinate’s accountability more than increased opportunity costs.

Second, I predict that under both exogenous constraints a subordinate is more likely to attribute a

superior’s budget imposition to situational constraints than to the superior’s predispositions. Conse-

quently, imposing versus negotiating a budget has a less negative effect on subordinate effort in the

presence of exogenous constraints. Finally, by drawing on fairness heuristic theory (Tyler and Lind

1992; Van den Bos, Wilke, and Lind 1998), the causal model linking budget negotiations to subor-

dinate effort predicts that procedural fairness loses importance under exogenous constraints since

external reference points emerge for judging behavior.

In my experiment, participants assume the role of either a superior or a subordinate, and both

parties perform with real effort. Before performing the effort task, the superior and subordinate ei-

ther negotiate a budget or the budget is imposed by the superior. To increase experimental control
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over the subordinate’s behavioral motives, I use a setting in which the subordinate’s payoff function

is not affected by any of my manipulations. High and low opportunity costs of negotiation are opera-
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tionalized by making the superior’s time to perform the effort task contingent on the negotiation

length. Financial pressure on the superior to meet unit targets is operationalized by making the supe-

rior’s payoff contingent on total output exceeding a performance hurdle.

The experimental results support my predictions. First, financial pressure increases cooperative

negotiation behavior by superiors and subordinates more than increased opportunity costs. Thus,

subordinates do not take advantage of superiors’ financial pressure by enforcing lower budgets. Se-

cond, after controlling for monetary incentives, both exogenous constraints mitigate the negative

effects of imposing budgets on subordinate effort. Finally, both exogenous constraints moderate the

effect of procedural fairness on budget commitment: Procedural fairness has a strong effect on

budget commitment in the absence of exogenous constraints but does not in their presence.

3
 My study makes three primary contributions to the literature. First, to my knowledge, this is the

first study of the effects of exogenous superior constraints on budgeting processes under controlled

conditions that differentiates between specific types of constraints. The results provide evidence that

budget negotiations and the parties’ reactions to outcomes are not only affected by internal charac-

teristics of the budgeting process, but also by the exogenous conditions in which the budget negotia-

tion takes place.

Second, similar to Kuang and Moser’s (2011) analysis of wage negotiations, this study also

suggests that exogenous constraints on the superior may not necessarily harm her negotiation out-

come. While Kuang and Moser (2011) find that the positive and negative effects of employee partic-

ipation play out more positively if the superior is restricted to a fixed wage contract, the findings of

the current study show that exogenous constraints may serve as a justification for budget imposi-

tions and lead to less negative subordinate reactions. Thus, in constrained situations, the trade-off
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between efficiency in decision-making and the motivational benefits of participation might change,

indicating an interactive effect of participative decision-making and exogenous constraints on per-

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formance (Locke and Schweiger 1979; Wagner 1994).1

Finally, my study extends theory about the importance of procedural fairness (e.g., Fisher et

al. 2002a; Lindquist 1995) by providing evidence that exogenous constraints can moderate the effect

of procedural considerations on budget commitment.

Section II next discusses the background literature. Section III derives hypotheses, and Section

IV describes the experimental method. Section V reports the results, and Section VI summarizes and

discusses the results.

1
This line of inquiry also relates to the more general question of the effects of the firm’s environment on management
control processes (Shields and Shields 1998).

4
 II. BACKGROUND

Firms commonly allow superiors and subordinates to negotiate budgets (Fisher et al. 2000),

with the superior having the final say if negotiations fail (Rankin, Schwartz, and Young 2003). From

a purely economic perspective, negotiations are irrelevant if the contract is slack-inducing and the

superior has the ability to set the budget (Brown, Evans, and Moser 2009), because the subordinate

has no incentive to communicate any valuable information and the superior should set the budget to

the level that optimally trades off the subordinate’s effort levels and his information rents (Laffont

and Martimort 2002). However, prior research shows that participation can affect employee behav-

ior even if it should be irrelevant under the assumption of full rationality of all actors (Covaleski,

Evans, Luft, and Shields 2003). Participation may increase employee satisfaction and motivation

(Kren 1992), but employees may also react negatively when their aspiration level is not satisfied

during a negotiation (Kuang and Moser 2011) or when they perceive the negotiation to be pseudo-
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participative (Krishnan, Marinich, and Shields 2012). Overall, evidence on the effects of participa-

tion on performance is mixed (Locke and Schweiger 1979; Wagner 1994), implying that participa-
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tive decision-making may play out differently under different circumstances.

A series of experiments by Fisher et al. (2000, 2002a, 2006) on budget negotiations and their

consequences are closely related to this study. In a setting similar to the one studied here, failed ne-

gotiations resulting in budgets imposed by the superior can lead to reduced subordinate effort (Fish-

er et al. 2000). In unconstrained settings, this reduced effort appears to be driven by procedural fair-

ness concerns (Fisher et al. 2002a). Further, the negative effect of imposed budgets on employee

effort is not significantly influenced by the degree of information asymmetry between the negotiat-

ing parties (Fisher et al. 2002a), although it can be mitigated by the expectation of future interaction

(Fisher et al. 2006). Overall, these findings reflect a potentially negative consequence of budget ne-

5
gotiations and imply that, in contrast to economic reasoning, the superior may not be indifferent

between obtaining a budget via negotiation agreement or the same budget via imposition.

The effects of exogenous constraints on behavior in budget negotiations have not been studied

by experimental researchers. Some prior evidence, however, suggests that exogenous constraints on

the superior may affect subordinates’ negotiation behavior and subsequent effort. Kuang and Moser

(2011) study the effects of wage negotiations under alternative wage contracts (fixed wage vs. out-

come-based) on subsequent effort. They find that wage negotiations are characterized by reciprocal

interactions and that this reciprocity plays out more positively if the superior is restricted to a fixed

wage contract. Even though they vary the type of contract, their study is related to mine because they

provide evidence that suggests that exogenous constraints may not necessarily lead to a bad negotia-

tion outcome for the superior because the exogenous constraints can affect the behavioral forces in

play.
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Hannan (2005) investigates a gift-exchange setting in which the firm is affected by a positive

or negative exogenous shock and finds that a given wage change is associated with greater effort
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following a negative shock. Thus, even though her study does not examine negotiation in a budget-

ing setting, the findings indicate that, after controlling for monetary incentives, subordinates’ effort

can be influenced by an exogenous factor that affects the firm.

Other empirical studies also provide evidence regarding the effects of exogenous constraints

on internal organization (Indjejikian et al. 2014; Senbet and Seward 1995; Wruck 1990). However,

these studies either do not examine employee reactions or performance or cannot separate nonmone-

tary motives from purely monetary incentives.

III. HYPOTHESES DEVELOPMENT

6
Incentives and Setting

My experimental setting is a modification of the budget negotiation setting developed by Fish-

er et al. (2000). In superior-subordinate dyads, both the superior and the subordinate provide real ef-

fort and receive the following payoffs in the baseline setting without exogenous constraints:

⎧F if XSub ≤ B
Π Sub = ⎨ (1)
⎩F + A ⋅ (XSub − B) if XSub > B

⎧C ⋅ XSuper + D ⋅ XSub − F if XSub ≤ B

Π Super = ⎨ (2)
⎩C ⋅ XSuper + D ⋅ XSub − [F + A ⋅ (XSub − B)] if XSub > B

where F is the subordinate’s fixed wage, and A is the bonus coefficient per unit of output exceeding

the budget. XSub and XSuper represent the subordinate’s and the superior’s actual performance, re-

spectively, and B is the budget used in the subordinate’s bonus function. C and D are the contribu-

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tion margins per unit of superior and subordinate output. Thus, C · XSuper + D · XSub is the firm’s

profit assigned to the superior. Since budget negotiations are most helpful in an environment with

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high information asymmetry (Fisher et al. 2002a), both parties receive no information about their

counterpart’s performance capability. manuscript

The payoff functions create a conflict of interest between the superior and the subordinate.

The subordinate’s payoff is maximized if the budget is set to zero, but the superior’s incentives are

more ambiguous. As the superior is the residual claimant, she profits from increasing the budget for

a given subordinate effort, as this increase reduces the subordinate’s bonus. However, the superior

risks undermining the subordinate’s monetary incentives if she increases the budget too much. Con-

sequently, the superior’s goal is to make the budget as challenging as possible without demotivating

subordinate effort.

To potentially mitigate these conflicts of interest in setting the budget, the superior and subor-

dinate have the opportunity to negotiate. Specifically, the subordinate can submit budget proposals

7
and the superior can make counteroffers. Each party can accept the counterpart’s proposal or coun-

teroffer at any time. However, as in practice, the superior can abandon the negotiation early and im-

pose a budget on the subordinate. Similarly, if the negotiation ends without agreement, the superior

has the authority to set the final budget.

I examine the effects of the financial pressure to meet unit targets and high opportunity costs

on budget negotiations and subsequent subordinate effort in a setting where the constraints affect the

superior but not the subordinate as discussed in more detail in the method section. This design al-

lows me to isolate the effects of subordinate’s behavioral motives from the effects of monetary in-

centives.

Hypotheses

Negotiation Process preprint

As explained above, in my experimental setting, financial pressure to meet unit targets affects
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manuscript
the superior but not the subordinate. Consequently, the superior has a financial incentive to elicit

cooperation from the subordinate since the subordinate’s effort is necessary to meet the target. Ow-

ing to this increased financial pressure, the superior is expected to react more cooperatively to a giv-

en level of the subordinate’s budget proposal during negotiation. Because less extreme initial nego-

tiation positions are usually regarded as a signal for cooperation (Benton, Kelley, and Liebling 1972;

Fisher et al. 2006), financial pressure can be expected to lower the superior’s initial counteroffers.

Similarly, under high opportunity costs, the superior may try to resolve the constraint by

quickly negotiating a cooperative agreement. However, an increase in opportunity costs is likely to

affect the superior’s behavior less than financial pressure for two reasons. First, in contrast to finan-

cial pressure, the superior has the option to avoid higher negotiation costs without the subordinate’s

8
agreement by abandoning negotiations early and simply imposing a budget. Second, after negotia-

tion, the subordinate’s cooperation is likely to have less impact on the superior’s welfare under high

opportunity costs than under financial pressure. While under financial pressure, the superior’s wel-

fare highly depends on whether the subordinate cooperates to meet unit targets, under increased op-

portunity costs, subordinate cooperation may affect the superior’s overall bonus to some degree, but

a large share of her bonus will depend on how much time she spends in negotiations. For both rea-

sons, the superior may feel less dependent on the subordinate’s cooperation under increased oppor-

tunity costs than under financial pressure, a result that is likely to reduce the superior’s willingness

to cooperate. Consequently, the effects of financial pressure on the superiors’ initial counteroffers

should be stronger than the effects of increased opportunity costs.

H1a: Financial pressure on the superior decreases the superior’s initial counteroffers in budget

negotiations more strongly than the superior’s increased opportunity costs of negotiation.
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The reasoning for H1a suggests that, under exogenous constraints, the subordinate’s bargain-

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ing power increases. If the subordinate correctly anticipated the superior’s negotiation behavior, he

manuscript
could exploit the superior’s increased exogenous pressure and lower his own initial budget proposal

to obtain a lower budget. However, such a decrease would contradict the behavioral forces that are

likely to be triggered in my setting.2 Prior evidence shows that, in budget negotiations, fairness con-

cerns affect subordinate behavior and may dominate monetary incentives (Chalos and Haka 1989;

Fisher et al. 2002a). As fairness concerns may depend on the situation in which the interaction takes

place (De Dreu et al. 1998; Hannan 2005), exogenous constraints may increase the subordinate’s

concern for the superior.

2
Additionally, experimental evidence shows that people’s ability to anticipate others’ negotiation behavior is limited
(Binmore, McCarthy, Ponti, Samuelson, and Shaked 2002; Johnson, Camerer, Sen, and Rayon 2002).

9
 Research in social psychology emphasizes the importance of accountability for another per-

son’s outcome as a variable that affects negotiation behavior (Tetlock 1985). Accountability exists

when an actor is responsible for another person’s outcome and his actions have to be justified to an

external audience or to himself (Carnevale and Pruitt 1992; Lerner and Tetlock 1999; Schlenker,

Britt, Pennington, Murphy, and Doherty 1994). However, the way accountability affects subordinate

negotiation behavior depends on the social context (Kramer, Pommerenke, and Newton 1993).

While prior studies have mainly focused on constituent accountability as leading to more competi-

tive negotiation behavior (Ben-Yoav and Pruitt 1984; Carnevale, Pruitt, and Britton 1979), exoge-

nous constraints increasing the importance of subordinate cooperation for the superior’s welfare are

likely to raise the subordinate’s interpersonal accountability owing to his increased responsibility for

the superior’s outcome. In these cases, interpersonal accountability acts as a self-regulating device

for the subordinate, who may even see cooperation as a moral obligation (Schlenker and Weigold
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1992). Thus, exogenous constraints on the superior should induce more cooperation (Kramer et al.

1993), which should raise the subordinate’s initial budget proposals as a signal for his increased
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cooperation (Carnevale and Pruitt 1992).

Nevertheless, as in the case of the superior, two factors contribute to less interpersonal ac-

countability for the subordinate under increased opportunity costs than under financial pressure.

First, since the superior can abandon the negotiation at an early stage, she depends less on the sub-

ordinate’s cooperation to remove the constraint. Second, after negotiation, the subordinate’s cooper-

ation is likely to have a much weaker impact on the superior’s welfare under increased opportunity

costs because the superior’s welfare depends less on whether unit targets are met. These arguments

imply that, even though opportunity costs may generally increase the subordinate’s cooperation, the

effect of increased opportunity costs on the subordinate’s initial budget proposals is likely to be

smaller than the effect of financial pressure. I therefore predict:

10
H1b: Financial pressure on the superior increases the subordinate’s initial budget proposals in

budget negotiations more than the superior’s increased opportunity costs of negotiation.

The reasoning for H1a and H1b implies that financial pressure reduces the distance between

initial negotiation positions. This distance is an important determinant of negotiation agreement

(Druckman 1994). Since the negotiation does not last indefinitely, a smaller initial distance raises

both the probability that a zone of agreement exists between the two parties and the likelihood of

agreement (Fisher et al. 2000). Financial pressure should lessen this difference and increase the like-

lihood of agreement regardless of the opportunity costs conditions. Therefore, I predict the follow-

ing main effect:

H2: Financial pressure on the superior increases the likelihood of negotiation agreement.

In contrast, the prediction is less clear for an increase in opportunity costs. H1a and H1b imply

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that increased opportunity costs may decrease the distance in initial negotiation positions, which

could increase the likelihood of agreement. But, if the opportunity costs increase, the superior will

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be less willing to spend time in the negotiation and may impose the budget to save time, which de-

creases the likelihood of agreement. Because itmanuscript

is unclear which effect will dominate, I test the fol-

lowing research question:

RQ1: When opportunity costs for the superior increase, does the likelihood of agreement increase

or decrease?

Subordinate Effort following Negotiation

In contrast to negotiations in which the parties can exhaustively specify the terms of trade, a

characteristic of budget negotiations is that, owing to unobservability, the two parties cannot con-

tractually determine the subordinate’s subsequent effort. This implies that an important issue in the

11
context of budget negotiations is the effect of the procedures and results of the negotiation on the

subordinate’s motivation to expend effort after the negotiation. Whereas the subordinate’s effort

following the negotiation is likely to be influenced by his monetary incentives, exogenous con-

straints may also affect his effort beyond his monetary incentives. Specifically, exogenous con-

straints may mitigate the negative effects of superior budget imposition on subordinate effort if the

subordinate attributes the imposition to the superior’s exogenous constraints rather than to the supe-

rior herself. That is, theory suggests that any exogenous constraint perceived by the subordinate as a

justification for the superior to impose a budget mitigates the subordinate’s decrease in effort as a

response to the budget imposition. This implies that the effects of multiple exogenous constraints on

subordinate effort may not be additive. Thus, the following theoretical development does not differ-

entiate between the two different constraints but only between the presence and absence of exoge-

nous constraints.
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If the two parties reach an agreement, the effect of the presence of exogenous constraints on

effort should be small since the subordinate’s aspiration level is likely fulfilled (Kuang and Moser
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2011). Consistent with this argument, prior evidence shows that, when agreement is reached, subor-

dinates’ performances are close to their capabilities under high effort in the treatment conditions that

have been manipulated so far (Fisher et al. 2000, 2002a, 2006).

In contrast, prior research provides ample evidence that, in unconstrained settings, negotiation

disagreement and superior imposed budgets hurt subordinate effort (e.g., Fisher et al. 2000, 2002a)

because subordinates feel mistreated and respond with low effort (Blau 1964; Kuang and Moser

2011). Attribution theory suggests that a determinant of an individual’s reaction is whether he/she

attributes another person’s action to external/situational factors or internal/dispositional factors

12
(Dobbins and Russell 1986; Ross 1977).3 Therefore, a subordinate’s reaction to an imposed budget is

likely to be affected by the subordinate’s interpretation of the superior’s motives. In unconstrained

settings, the subordinate is likely to attribute the budget imposition to dispositional factors. In con-

trast, the subordinate may not be able to make unambiguous inferences about the superior’s predis-

positions in the presence of exogenous constraints and he may interpret the superior’s behavior in

terms of the situation rather than dispositional factors (Gilbert and Malone 1995). Thus, I expect

subordinate effort to decrease less following budget impositions when superiors face exogenous

constraints than when they do not.

In line with these arguments, prior evidence shows that, when subordinates can attribute budg-

et impositions only to situational constraints because superiors are restricted from negotiating at all,

their effort is higher than after an imposition in an unconstrained negotiation setting (Fisher et al.

2000). Thus, I test the following hypothesis:

H3:
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Controlling for subordinate’s monetary incentives, the negative effect of budget impositions

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on subordinate effort is smaller when superiors face exogenous constraints than when they

do not.
manuscript
Finally, I investigate a causal model that links negotiation agreement and budget imposition to

subordinate effort. Figure 1 displays the framework based on Fisher et al. (2002a). They predict and

find that, in unconstrained settings, subordinates’ favorable perception of the budgeting process posi-

tively affects their budget commitment. This is consistent with procedural fairness theory in which a

fair process increases the legitimacy of its outcome (Lind, Kander, and Early 1990; Thibaut and

Walker 1975) and research on goal setting theory showing that budget commitment is larger when

the budget comes from a legitimate source (Locke, Latham, and Erez 1988). Because budget com-

3
Likewise, prior evidence shows that the attribution of intentionality is a strong driver of subordinate reactions to the
installation of control systems (Falk and Kosfeld 2006; Kuang and Moser 2009).

13
mitment is a central determinant of effort (Locke and Latham 1990), favorable procedural percep-

tions can ultimately increase subordinate effort.

-- Insert Figure 1 about here. --

However, according to fairness heuristic theory (Tyler and Lind 1992; Lind, Kulik, Ambrose,

and de Vera Park 1993), the way individuals make their fairness judgments depends on the infor-

mation they possess. Fairness heuristic theory argues that people refer to procedural aspects as heu-

ristic substitutes to judge the fairness of their outcomes only if they lack direct information that is

useful for judging the fairness of an action (Lind, Kray, and Thomson 2001; Van den Bos, Vermunt,

and Wilke 1997). That is, in the absence of any reference point—as in the unconstrained baseline

setting—procedural fairness may serve as a heuristic substitute for evaluating the superior’s negotia-

tion behavior and may therefore affect budget commitment. However, in situations with exogenous

constraints, subordinates may directly refer to the exogenous constraints to judge the legitimacy of
preprint
the superior’s negotiation behavior and, particularly, her budget impositions and may refer less to

the fairness of the process (Van den Bos et al. 1998). Thus, in a constrained environment, the posi-
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manuscript
tive effect of favorable process perception on budget commitment should decrease relative to uncon-

strained settings. Therefore, I predict that the presence of exogenous constraints moderates the effect

of procedural fairness on budget commitment:

H4: The positive effect of favorable budgeting process perceptions on budget commitment is

smaller when exogenous constraints are present than when they are absent.

IV. METHOD

Design

Figure 2 displays the design of the experiment.

14
 -- Insert Figure 2 about here. --

The experiment employed a 2 (superior’s financial pressure to meet unit targets no/yes) x 2

(superior’s opportunity costs of negotiation low/high) between-subjects design. The first variable

(superior’s financial pressure to meet unit targets) was manipulated by making the superior’s payoff

shown in equation (2) contingent on whether total superior and subordinate performance beat a per-

formance threshold, HURDLE. Thus, the superior’s total compensation function was as follows:

total ⎧0 if XSuper + XSub < HURDLE

Π Super =⎨ (3)
⎩Π Super if XSuper + XSub ≥ HURDLE

where ΠSuper is defined according to equation (2). When financial pressure was absent, HURDLE

was set to zero. Thus, whether the superior’s payoff, ΠSuper, was paid out did not depend on actual

superior and subordinate performance. When financial pressure was present, HURDLE was set such

that the superior could only beat the hurdle in cooperation with the subordinate. The superior re-

preprint
ceived no compensation unless total performance beat the performance threshold.4

The second variable (superior’s opportunity costs of negotiation) was manipulated by making
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the superior’s working time dependent on the length of the negotiation or not dependent on the length

of the negotiation. When the opportunity costs were high, the superior’s working time was reduced

based on the length of the negotiation. When the opportunity costs were low, the superior’s working

time was unaffected by the negotiation length. As a result, payoff functions (1) and (2) were unaf-

fected by the opportunity costs of negotiation, but a decrease in working time would reduce the su-

perior’s performance, XSuper, and therefore decrease the first part of her payoff function, C · XSuper.

4
HURDLE was set in advance of the experiment based on the experience with performance capabilities from prior ex-
periments using the same task. My objectives in setting HURDLE were to make it unbeatable by a superior or a subor-
dinate on his/her own but, simultaneously, to maximize the likelihood that superior and subordinate could beat HURDLE
together. Based on the results of simulations, HURDLE was set to 60. In the experiment, the objectives associated with
HURDLE were reached. No participant had the capability of reaching HURDLE on his/her own, but in all but one dyad
(98.9 percent), the joint capabilities were large enough to beat HURDLE together. In the one dyad with insufficient
capabilities, the fact that HURDLE could not be reached was not apparent due to the information asymmetry about the
counterpart’s performance capability, and the observed behavior in this dyad is in line with other dyads’ behavior.

15
 In contrast, the subordinate’s payoff function was never affected by any manipulation. As a

consequence, the subordinate’s monetary incentives for negotiating a lower budget were identical

across conditions.5 This design choice increases internal validity as it allows the isolation of behav-

ioral factors on subordinates’ behavior beyond monetary incentives, without imposing a parameter-

specific trade-off between monetary and behavioral incentives (Hannan, McPhee, Newman, and

Tafkov 2013). Moreover, the choice reflects the fact that superiors are more strongly affected by

exogenous constraints than subordinates in many actual company settings. For example, a superior

at a department or business unit may be required to meet the performance hurdle or be laid off or

suffer diminished career opportunities. While the superior would have to bear costs such as losses in

future compensation or reduced managerial power (Gilson 1989), subordinates are unlikely to be

monetarily affected, even if a new department or business unit head is installed. Similarly, a superior

may face greater opportunity costs than a subordinate because the superior may perform tasks that
preprint
are more value-creating than the subordinate’s tasks. Thus, the time lost in the negotiation is more

costly for the superior. For example, Ross’s (1986) evidence suggests that larger investment deci-
accepted
manuscript
sions are made at higher levels of the firm hierarchy, and findings from Graham, Harvey, and Puri

(2010) show that the decisions that are most relevant for firm strategy and its financial structure are

dominated by the CEO. Finally, because a subordinate’s increased monetary incentives from finan-

cial pressure as well as increased opportunity costs should further raise his cooperation during and

after the budgeting process, the design choice to leave the subordinate’s monetary position unaffect-

ed by the superior’s exogenous constraints does not threaten the validity of the study since it is like-

ly to work against finding the predicted results.

In contrast to prior studies on budget negotiations, in my experiment, the superior performs the

same task as the subordinate. This design choice was made for two main reasons. First, it allows for

5
Since the subordinate’s monetary incentives after the negotiation depend on the amount of the negotiated budget, they
cannot be controlled by experimental design but are controlled during the statistical analysis.

16
the opportunity cost manipulation and the reduction of the superior’s working time based on the

negotiation length. Second, it reflects the realistic feature that superiors also contribute to their unit’s

output.6 However, one may object that superior knowledge of her performance capability could re-

duce her perceived information asymmetry and therefore affect the participants’ behavior. I address

this concern in the results section.

Participants and Procedure

A total of 170 students from a large European university participated in the experiment. Fig-

ure 2 shows the number of participants in each experiment cell. 52 percent of the participants were

women, and 58 percent majored in business or economics. Three sessions were conducted for each

treatment condition, and no subject participated in more than one session. Sessions lasted between 60

and 75 minutes. Participants received a show-up fee of €5 and additional variable compensation in
preprint
the form of points that were converted into cash at the end of the session. Average compensation

was €13.48 (approximately $16.53 at that time), and compensation varied between €6.25 ($7.70)
accepted
manuscript
and €20.30 ($25.04).

The entire experiment, including the negotiation, was computerized and was conducted in a

laboratory using SoPHIE software (Hendriks 2012). Instructions appeared on the computer screens

and were simultaneously read aloud. The instructions used context-free language to increase exper-

imental control and reduce the risk of undesired contextually induced incentives (Friedman and

Sunder 1994; Moser 1998). For example, the context of exogenous constraints may have led subor-

dinates to think about layoffs and other consequences of not cooperating with the superior that go

beyond the monetary consequences implemented in the experiment. That said, neutral language is
6
While the implementation of a superior’s task different from that of the subordinate would have also allowed for the
opportunity cost manipulation, such a distinct task has the major disadvantage that a comparison of the effects of superi-
or and subordinate effort would have been very difficult. In this case, it would have been necessary to provide a conver-
sion rate for how the different tasks map into firm profit, and the fact that the performance hurdle could not be unilater-
ally reached by the superior would not have been salient to the participants, creating problems of experimental control.

17
likely to work against the predicted results because perceived accountability should increase in a

context-rich setting (Haynes and Kachelmeier 1998).

The experimental procedures were similar to those of prior budget negotiation studies and

consisted of the following steps:

1) Upon arrival, participants were randomly assigned to computer terminals and were separated

from each other by blinders. Superior and subordinate were paired anonymously and randomly.

2) The production task was explained at the outset. It consisted of decoding two-digit numbers

into letters, a task that has been regularly used in experimental budgeting research (e.g., Chow

1983; Fisher et al. 2000). The decoding task was performed at the computer using decoding

keys distributed by the experimenter. Participants’ performance was measured as the number of

correct blocks decoded, where a block consisted of two numbers.

3) Participants then completed a practice round for two minutes to become familiar with the task.

4) preprint
Next, all participants completed three four-minute training rounds. For each round, the experi-

menter distributed new and modified decoding keys. Participants were told that, at the end of
accepted
manuscript
the experiment, one of the training rounds would be randomly selected and they would earn 5

cents for every block correctly decoded in this training round. Experience from the pretest sug-

gests that the incentive payment is sufficient to motivate participants to expend high effort in

the training rounds. Participants received feedback on the number of correctly and incorrectly

decoded blocks after each training round.

5) After the last training round, participants submitted a best estimate of the number of blocks

they could correctly decode in another four-minute round. They were informed that no other

participant would learn their estimate and that their estimate would not affect their remunera-

tion. As the training rounds were sufficiently incentivized, the performance estimate represents

a measure for the participants’ performance capability under high effort. The variable was col-

18
 lected to calculate the budgetary slack as well as the potential bonus the participants could have

obtained in the experimental work round under high effort (Fisher et al. 2000, 2002a, 2006).

The participants’ potential bonus represents a proxy for their financial incentives and is used as

a covariate in the statistical analysis. Consistent with the instructions, this measure had no ef-

fect on the participants’ payoffs.

6) Next, participants were informed about the setting as well as the subordinate’s and the superi-

or’s compensation schemes. The parameter values for the payoff functions in equations (1) and

(2) were set to F = 150, A = 4, C = 3, and D = 8.7 To prevent low superior concern for the sub-

ordinate and to avoid the possibility that the superior could substitute her own effort for the

subordinate’s effort on a 1:1 basis, the revenue coefficient of the superior, C = 3, was lower

than the subordinate’s coefficient, D = 8. These coefficients signal that, even if the superior’s

effort generates revenue for her, subordinate effort leads to higher revenue per decoded item—
preprint
even net of subordinate bonus costs once the budget is exceeded. Further, if the drop in subor-

dinate effort following a budget imposition was the same in the high opportunity costs condi-
accepted
manuscript
tion as in prior studies without exogenous constraints, the superior would suffer a financial dis-

advantage by abandoning the negotiation in round 1 to increase her working time. The perfor-

mance threshold HURDLE in the case of financial pressure was set to 60.

7) Subsequently, participants were informed about the budget setting process and its consequences

for the superior’s working time (if applicable). At the outset, the superior could choose between

entering a budget negotiation with the subordinate or imposing a budget without negotiation. If

the superior chose to negotiate, the negotiation had at maximum three rounds. In each round,

the subordinate made a budget proposal, and the superior could accept the proposal or make a

counteroffer. If the subordinate did not accept the counteroffer, the superior could decide whether

7
The minimum compensation for the subordinates was F. Superiors were endowed with 150 points so that they did not
have to pay the fixed wage from their own resources.

19
 to continue the negotiation or impose a budget. These steps constituted one round. If no agree-

ment resulted at the end of the third round, the superior imposed the final budget. The conse-

quences for the superior under high opportunity costs were the following. If the superior did not

enter the negotiation or the negotiation ended in round 1, the superior’s working time was four

minutes. If the negotiation ended in round 2 (3), the working time was reduced to three (two)

minutes. This process reflects the structure of budget negotiations in practice (Umapathy 1987).

8) Participants then answered a quiz about the procedures and the payoffs. To remind the partici-

pants that they had no information about their counterpart’s performance capability, one ques-

tion asked them whether they knew their counterpart’s performance capability; 157 of 170 par-

ticipants (92 percent) answered the question correctly, indicating that they did not know their

counterpart’s performance capability. The others—like any participant giving a wrong answer

to any other question—were returned to the relevant parts of the explanatory computer screens.
preprint
They were instructed to read the relevant instructions again, but did not answer the question

again. The quiz ensures that all participants understood the instructions and their payoff func-
accepted
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tions and helps establish the information asymmetry in the experimental setting.

9) Before the budget-setting process started, all participants were informed of the range of per-

formance capabilities that emerged in a pre-test of the experiment. They were told that 80 per-

cent of the pre-test participants had correctly decoded between 30 and 48 blocks of numbers in

four minutes, indicating a broad range of capabilities. Again, it was pointed out that no one

would receive any information about the capability of his or her counterpart. The information

about the pretest range served three purposes. First, it addresses the lack of information about

others as a reason for individuals to project their own abilities on others (Hoch 1987; Van

Boven and Loewenstein 2003). Second, the wide range of potential capabilities highlights the

degree of information asymmetry between the parties and helps prevent participants from be-

20
 lieving that knowledge of their own capability is informative about their counterpart’s capabil-

ity. Finally, in the financial pressure condition, this information helps participants understand

that the likelihood of reaching the performance hurdle is high if superiors and subordinates ex-

pend high effort but low if one of them doesn’t expend much effort.

10) Next, the budget-setting process started. First, the superiors had to decide whether to enter the

negotiation. If the superior chose to enter, the negotiation between superior and subordinate oc-

curred via the computer network. The two parties could only exchange budget proposals and

counteroffers and could accept the other party’s offer but could not exchange any other mes-

sage. Exchange was not necessary as the negotiation did not involve any coordination. The

procedure ensured anonymity of the participants and removed any interpersonal influences.

11) After negotiation ended, participants completed the experimental work round for four minutes.

At the end of the round, participants were informed of their performance and their payoffs. Fi-
preprint
nally, they completed a post-experiment questionnaire and received their payoffs and partici-

pants fee in cash. Participants interacted for only one working round. This design choice avoids
accepted
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ambiguities due to relationship dynamics, in particular reputation building and other aspects of

the social interaction.

Measures

Table 1 summarizes the measures used in the analysis.

-- Enter Table 1 about here. --

PERFSub is the subordinate’s performance in the experimental work round, and ESTPERFSub is

the subordinate’s estimate of his performance capability at the end of the training rounds. Due to the

fact that the training rounds were incentivized, ESTPERFSub represents the estimated performance

capability under high effort. As a real effort experiment may run the risk of losing control over the

21
subordinate’s effort because the measured performance usually includes both effort and capability

(Falk and Fehr 2003; Church, Libby, and Zhang 2008), NORMPERFSub is used to normalize subor-

dinate performance. NORMPERFSub is computed by dividing PERFSub by ESTPERFSub. Because

ESTPERFSub represents the estimated subordinate performance capability under high effort, normal-

ized subordinate performance (NORMPERFSub) measures subordinate effort as the percentage of

performance in the experimental work round relative to performance under high effort. Disentan-

gling effort from capability is important because subordinates with low capabilities depend more on

the superior’s willingness to concede during the negotiation and thus may react more negatively to

budget impositions. Finally, MAXPERFSub/Super measures the participants’ maximum performance

during the training rounds.8

B represents the budget. To capture a subordinate’s monetary incentives for a given budget,

BONUSPOT measures the potential bonus a subordinate could obtain based upon his estimated per-

formance capability, ESTPERFSub. preprint

In the negotiation, PROPOSAL measures the subordinate’s initial budget proposal, and
accepted
manuscript
COUNTER measures the superior’s initial counteroffer. DELTA = COUNTER − PROPOSAL

measures the distance in initial negotiation positions. FREQNEG is the frequency with which the

superiors chose to negotiate, and FREQAGREE represents the frequency of agreements if the superi-

or opted for the negotiation. LENGTH measures the number of negotiation rounds. If the superior did

not enter the negotiation, LENGTH was set to 0.

On the post-experiment questionnaire, subordinates indicated their agreement with several

statements using a scale ranging from 0 (“fully disagree”) to 100 (“fully agree”). These items were

used to examine the process underlying the subordinate’s effort in more detail and particularly, the

8
The use of a normalized performance measure as a proxy for effort is consistent with prior experiments using real ef-
fort (e.g., Brüggen and Strobel 2007; Church et al. 2008; Van Dijk, Sonnemans, and Van Winden 2001). None of the
results are affected if subordinate performance is normalized by MAXPERFSub instead of ESTPERFSub.

22
moderating role of exogenous constraints on the effect of procedural considerations on budget

commitment predicted in H4. In line with Fisher et al. (2002a), the following items were measured:

CONTROL: I had a great deal of power in determining my performance target for the work session.

PROCESS SATISF: I was very satisfied with the way my performance target was determined.

BUDGET SATISF: I was very satisfied with my performance target.

COMMITMENT: I was very committed to attaining the performance target.

V. RESULTS

Descriptive Statistics

Table 2 displays the descriptive statistics and shows that the performance capabilities of the

superiors and subordinates in the four treatments were very similar. One-way ANOVAs do not show
preprint
any significant difference across treatments with respect to MAXPERFSub, MAXPERFSuper,

ESTPERFSub (p > .10 in every case).9 Table 2 further reveals that financial pressure seems to increase
accepted
manuscript
the subordinates’ budget proposals, PROPOSAL, more and seems to decrease the superiors’ coun-

teroffers, COUNTER, more than increased opportunity costs. As H1a and H1b predict that subordi-

nates’ initial budget proposals increase and superiors’ initial counteroffers decrease more under fi-

nancial pressure than under high opportunity costs, this result provides initial evidence in favor of

both hypotheses. However, in contrast to H2, financial pressure decreases FREQAGREE under low

opportunity costs (56 percent vs. 68 percent) and increases FREQAGREE only under high oppor-

tunity costs (77 percent vs. 17 percent). Finally, Table 2 shows that the negotiation length is consid-

erably shorter in the treatments with high opportunity costs. In these cases, the mean LENGTH is

9
Additionally, for every treatment, t-tests indicate that superior and subordinate performance capabilities are not signifi-
cantly different from each other (p > .10 in every case). Further, one-way ANOVAs indicate that, in every treatment,
participant behavior does not vary significantly across sessions. For every treatment, no significant differences were
found for any dependent variable across sessions (p > .10 in all cases).

23
below 1, reflecting that the negotiations took less than one round on average. Only two of 43 dyads

negotiated more than one round in the high opportunity costs condition, one in each treatment. The

fact that nearly all superiors had the same amount of working time available implies that differences

in subordinates’ effort across treatments cannot be driven by differences in fairness considerations

due to reduced superior working time.

-- Enter Table 2 about here. --

The results in the treatment without exogenous constraints, T1, can be compared with those in

Fisher et al. (2002a), who studied budget negotiations under information symmetry and asymmetry

between superior and subordinate in a setting in which the superior did not perform the same task as

the subordinate. The comparison reveals that the findings in T1 resemble their information asym-

metry condition. For example, mean PROPOSAL equals 54 percent of the subordinates’ perfor-

mance capability in T1, while in Fisher et al. (2002a), initial subordinate proposals equal 53 percent
preprint
of their capability under information asymmetry and 79 percent under information symmetry. Fur-

thermore, whereas the distance in slack between negotiations ending and not ending in agreement is
accepted
manuscript
small in Fisher et al.’s information symmetry condition (3 percent of the subordinates’ capability), it

is much larger in their information asymmetry condition (36 percent) and in T1 (30 percent). These

results suggest that the participants perceived my experimental setting to be one of rather high in-

formation asymmetry.10

10
Additional tests provide further evidence against confounding effects of the superior’s task on the results. First, Pear-
son correlations show that neither COUNTER nor the final budget, B, are significantly positively correlated with the
superiors’ performance capability (p > .10 in both cases). This suggests that the superiors’ knowledge of their own per-
formance capabilities affected neither their negotiation behavior nor the final budget. Second, 58 of 85 budgets (68 per-
cent) were below the superior’s performance capability, and results do not differ significantly across treatments
(Kruskal-Wallis, p > .10). Finally, the agreement frequency in T1 is close to the agreement frequency in comparable
conditions without superior task (Fisher et al. 2002a). The two latter findings provide evidence against reduced superior
concern for the subordinate and the budget negotiation.

24
 Hypotheses Tests11

H1a and H1b refer to the negotiation process and state that financial pressure makes subordi-

nates raise their initial budget proposals and superiors lower their initial counteroffers more than an

increase in opportunity costs. Table 3 displays the results of the ANOVAs conducted. Panels 1 and 2

show that both PROPOSAL and COUNTER are significantly affected by financial pressure but not

by opportunity costs. This result supports H1a and H1b. Likewise, Panel 3 shows that financial pres-

sure, but not opportunity costs, reduces the distance between initial negotiation positions, DELTA.

Additionally, OLS regressions (untabulated) were run with PROPOSAL, COUNTER, and DELTA

as dependent variables, respectively, and the treatment variables as independent variables. Subse-

quent Wald tests show that the effect of financial pressure is significantly larger than the effect of

increased opportunity costs on COUNTER (F = 3.93, p = .03, one-tailed) and DELTA (F = 5.32, p =

.01, one-tailed) but not on PROPOSAL (F = .23, p > .10, one-tailed). Together, these results support

H1a and partially support H1b. preprint

accepted
-- Enter Table 3 about here. --

manuscript
H2 predicts an increase in the likelihood of agreement under financial pressure, regardless of

the opportunity cost condition. However, the logit regression in Table 4 does not show a positive

effect of financial pressure on the frequency of agreement, although a significant interaction effect is

present. Thus, H2 is rejected. Supplemental analysis described later explores this surprising result in

more detail. RQ1 addresses whether an increase in opportunity costs increases or decreases the likeli-

hood of agreement. Table 4 reports a significantly negative effect of the opportunity costs but simulta-

neously a positive interaction. While the effect of a rise in opportunity costs is negative when financial

pressure is absent, the total effect is positive but insignificant (χ2 = 1.46, p > .10, two-tailed) when fi-

11
All tests used in this section are two-tailed unless stated otherwise.

25
nancial pressure is present. Thus, the superior’s greater incentive to abandon negotiations early seems

to dominate only in the case without financial pressure.

-- Enter Table 4 about here. --

H3 predicts an interaction between budget impositions and the presence of exogenous con-

straints with respect to subordinate effort because the negative effect arising from imposing the

budget versus reaching negotiation agreement is smaller under exogenous constraints. Figure 3 dis-

plays the normalized subordinate performance (NORMPERFSub) as a measure of subordinate effort

in the four treatments. Consistent with the suggested interaction, the figure shows that

NORMPERFSub decreases less strongly when the superior faces financial pressure or increased op-

portunity costs. Table 5 provides the means of NORMPERFSub contingent on whether budgets are

imposed and displays the results of the ANCOVA run to examine H3. BONUSPOT is used as a co-

variate to ensure that the results are not driven by the subordinates’ monetary incentives. As report-
preprint
ed in Table 5, the ANCOVA reveals a significant interaction effect. This result supports H3. Simple

effects tests show that the decrease in NORMPERFSub after budget impositions is significant when
accepted
manuscript
superiors do not face exogenous constraints (F = 15.82, p < .01) and when they do (F = 3.80, p =

.05). All statistical inferences remain the same if PERFSub is used as the dependent variable in the

ANCOVA and the estimated performance capability, ESTPERFSub, is included as an additional co-

variate. The results are also unchanged if PERFSub is used as the dependent variable without control-

ling for ESTPERFSub.

-- Enter Figure 3 and Table 5 about here. --

Finally, H4 predicts a moderating effect of exogenous constraints on the association between

procedural considerations and budget commitment. Figure 4 reports the results of the path analysis

conducted to test H4. The path analysis is conducted using SmartPLS (Ringle, Wende, and Will

26
2005).12 Without exogenous constraints, the results are broadly consistent with those in Fisher et al.

(2002a).13 In particular, the effect of process perception on budget commitment is highly positive.

However, the interaction term between process perception and exogenous constraints is negative and

highly significant. Thus, consistent with H4, the existence of exogenous constraints negatively mod-

erates the effect of procedural fairness considerations on budget commitment. To determine the

marginal effect of the procedural considerations on budget commitment when exogenous constraints

are present, I combine the two corresponding path coefficients. The effect remains positive (.056)

but becomes small and insignificant (p > .10). Together, these results support the view that, in set-

tings with exogenous constraints, procedural fairness loses importance because situational aspects

provide direct information that is useful for judging the legitimacy of the superior’s negotiation be-

havior. The results of the path model are not affected if, as an alternative measure of effort, PERFSub

is used as the final dependent variable and performance capability is controlled by including
preprint
ESTPERFSub as a control variable in the model or is not controlled.14

accepted
-- Enter Figure 4 about here. --

manuscript
Supplemental Analysis

Contrary to H2, the tests reported earlier revealed that financial pressure decreases the likeli-

hood of negotiation agreement under low opportunity costs. Further analysis shows that this result is

due to the superior’s behavior in the treatment with financial pressure and low opportunity costs

(T3). Many superiors abandoned negotiations early and imposed a budget even though the negotia-

tion was costless to them: five of ten superiors who had not reached an agreement at the end of

12
Standard errors are obtained with a standard bootstrapping procedure using 5,000 samples. Case-wise replacement is
used for missing observations. Results remain inferentially and statistically unaffected if mean replacement is used.
13
The only exception is the path from budget perception to budget commitment, which is not significant in the data
presented here. However, this relationship is also the weakest in Fisher et al. (2002a).
14
In both cases, the coefficient of the final path from budget commitment to subordinate effort is very similar and highly
significant (path coefficient > .530 and p < .001 in both cases).

27
round 1, and one of three superiors who had not reached an agreement at the end of round 2, aban-

doned the negotiation. This result contrasts sharply with the baseline treatment (T1), in which only

one of 15 superiors abandoned the negotiation after round 1 and zero of 12 superiors in round 2.

Including the decision not to enter the negotiation at all, 43 percent of the superiors in T3 versus 14

percent in T1 did not pursue the negotiation to its end, even though negotiations were costless in

both treatments. This difference is highly significant (χ2 = 7.00, p < .01), which implies that superi-

ors acting under financial pressure seem to feel more justified in imposing budgets.

VI. CONCLUSION AND DISCUSSION

My study investigates how two exogenous constraints that superiors can face in budget negoti-

ation settings, financial pressure to meet unit targets and high opportunity costs, influence budget

negotiation and subordinates’ subsequent effort, with the main focus on the effects of behavioral
preprint
factors beyond the effects of monetary incentives. The experimental results show that both con-

straints induce more cooperation, but in different ways. Financial pressure leads to more cooperative
accepted
manuscript
negotiation behavior by both superiors and subordinates than increased opportunity costs. Both

types of constraints increase subsequent subordinate effort when superiors impose budgets. Moreo-

ver, procedural considerations lose importance for subordinates in the presence of exogenous con-

straints on superiors.

These findings have implications for the design of management control systems. My results

imply that in the presence of exogenous constraints, centralized decisions about budgets may occur

more often and be more acceptable to subordinates. Moreover, designing fair budgeting processes

might not be equally important under all circumstances. My findings offer a possible behavioral

rationale for the previous observation that firms tend to use participative decision-making less in

financially constrained situations (D’Aunno and Sutton 1992; Pfeffer and Leblebici 1973), because

28
in such situations, the trade-off between efficiency in decision-making and the motivational benefits

of participation might change. Taken together, the prior and current findings suggest the possibility

of a separating equilibrium in which budgeting tends to be more participative in settings without

constraints and more centralized in settings with constraints. Likewise, because subordinates more

readily accept more centralized budgeting processes when superiors’ opportunity costs are high,

corresponding changes in the decision-making process may be useful if these processes become ex-

cessively time-consuming.

An important question is whether my findings generalize to settings in which the exogenous

constraints also affect the subordinate. In practice, financial pressure and high opportunity costs

could have a direct monetary effect on both superiors and subordinates. In this case, the subordinate

would have increased financial incentives to cooperate with the superior during and after budgeting.

As discussed previously, the design choice to make the subordinate’s position unaffected by the ex-
preprint
ogenous constraints is likely to work against the increased cooperativeness documented in this

study. Interestingly, the results of my study imply that monetary incentives might not be necessary
accepted
manuscript
to elicit cooperation when superiors face exogenous constraints because in such cases, behavioral

mechanisms already foster a tendency toward cooperation.

My results may also have implications for how exogenous constraints other than those investi-

gated here affect budgeting. For example, firms are likely to be constrained in competitive or fast-

growing markets and high growth environments to focus on firm survival in these markets (Agarwal

and Audretsch 2001). The current findings suggest that challenging budget targets may be more ac-

ceptable and more common in such environments. This would be consistent with existing evidence

that market growth and the degree of market competition are important determinants of managerial

compensation (Balkin and Gomez-Mejia 1990; Karuna 2007). Similarly, the use of budgets for pur-

poses other than performance evaluation may also represent an exogenous constraint in budgeting

29
processes. Because budgeting purposes such as for planning, coordination, and strategy formulation

often conflict with performance evaluation (Hansen and Van der Stede 2004; Sprinkle 2003), subor-

dinates may more readily accept centralized budgeting or more challenging targets when the superi-

or can justify her choices through the need to accomplish other goals.

Like all experiments, this study is subject to limitations. First, imposed budgets might be less

acceptable to subordinates when opportunity costs for the superior increase less strongly than in the

experiment. However, while the magnitude of the subordinate’s increase in cooperativeness may be

different under different opportunity costs, the directional effect is likely to be unaffected.

Second, the experiment was conducted in a one-shot setting, whereas budgeting interactions in

the real world are likely to be repeated. I made this design choice to avoid ambiguities due to rela-

tionship dynamics, in particular reputation building and social interaction, such as the development

of trust or mistrust. Fisher et al. (2006) provide evidence that increased social interaction in a multi-
preprint
period relationship generally decreases negotiation conflict. However, in a multi-period setting, fi-

nancial pressure may also emerge endogenously owing to one or the other party’s prior decisions or
accepted
manuscript
performance. Whether endogenous constraints affect subordinate cooperation more or less than ex-

ogenous constraints may depend on whether the subordinate attributes the responsibility for the

emergence of endogenous constraints exclusively to the superior as opposed to assuming some re-

sponsibility for the constraint. The issue of endogenously arising constraints in a multi-period set-

ting is beyond the scope of this paper, but would be an interesting question for future research.

30
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 FIIGURE 1
Path Model
M Explaaining Suboordinate Efffort

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36
 FIGURE 2
Experimental Design and Number of Participants

Superior’s Opportunity Costs of Negotiation

Low High
Treatment 1 Treatment 2
No
Superior’s financial n = 42 n = 46
pressure to meet unit
targets Treatment 3 Treatment 4
Yes
n = 42 n = 40

Note: n is the number of participants in every treatment.

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37
 FIGURE 3
Effect of Budget Imposition on
o Subordin
nate Effort

ORMPERFSuuba
NO

Notte: NORMPER RFSub is used as a measure of subordinate

s efffort and is com
mputed by dividding subordinatte per-
form
mance in the ex xperimental woork round (PER RFSubb) by the estimated
e suboordinate capabiility under highh effort
(ESTPERFSubc). Thus, NORMPE
periimental work ro
preprint
ERFSub measurres subordinatee effort as the percentage
ound relative to estimated peerformance undder high effort.
p of performance
p in the ex-

Loww opportunity costs:

c The supeerior’s workingg time is indepeendent of the negotiation
n lenggth. High oppoortunity

accepted
costts: The superioor’s working tim
me is reduced the
t more roundds a negotiationn lasted. No finnancial pressurre: The
i independent of subordinatee’s and superioor’s total perforrmance. Financial pressure: The su-
supeerior’s payoff is
periior’s payoff is only
o paid out if the subordinaate’s and the suuperior’s total performance
p iss larger than orr equal
to 60.
a
NO
ORMPERFSub = PERFSub / ES STPERFSub is the
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t subordinatee’s normalized performance.
b
PE
ERFSub is the su t experimenttal work round.
ubordinate’s peerformance in the
c
ES
STPERFSub is th he subordinate’s estimated peerformance cappability.

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 FIIGURE 4
Empiriccal Results of
o the Path Model Explaining Sub
bordinate Efffort

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manuscript
Note: The annalysis is conduucted using a partial
p least squuare (PLS) pathh model. The path
p coefficientt and two-tailedd signif-
icance level are
a shown next to each path. The standard errors
e are calcuulated using a standard
s bootsttrapping proceedure
with 5,000 saamples. Case-wwise replacemeent is used for missing
m observvations. ***, *** and * denotee significance at
a the 1
percent, 5 peercent and 10 percent
p levels, respectively
r (tw
wo-tailed tests)).
Construct Proxy Measure off proxy
Negotiationn Agreement 1 if dyad reeached an agreeement, 0 otherw wise
Degree of Process
P Contro
ol CONTR
ROL “I had a greeat deal of powwer in determinning my perform mance
target for thhe work sessionn.”
Perception of Budgeting PROCE
ESS SATISF “I was veryy satisfied with the way my peerformance tarrget
Process was determ mined.”
Perception of Budget BUDGE
ET SATISF “I was veryy satisfied with my performannce target.”
Exogenouss Constraints 1 if there were
w high superior opportunityy costs and/or supe- s
rior’s financcial pressure too meet unit targgets, 0 otherwiise.
Budget Commitment COMM
MITMENT “I was veryy committed to attaining the performance
p tarrget.”
Subordinatte Effort NORMP
PERFSub Subordinatee’s normalizedd performance in i the experimeental
work roundd

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 TABLE 1
Summary of Measures

Measure Description

PERFSub Subordinate performance in the experimental work

round
ESTPERFSub Subordinate’s estimated performance capability
NORMPERFSub= PERFSub / ESTPERFSub Subordinate’s normalized performance
MAXPERFSub/Super Subordinate’s / superior’s maximum performance
in the training rounds
B Budget
BONUSPOT Subordinate’s potential bonus based on his estimat-
ed performance, ESTPERFSub, and his budget, B
PROPOSAL Subordinate’s initial budget proposal
COUNTER Superior’s initial counteroffer
DELTA = COUNTER – PROPOSAL Distance in initial negotiation positions

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FREQNEG Frequency of negotiation
FREQAGREE Agreement frequency given that the superior opted
for the negotiation
LENGTH accepted
Number of negotiation rounds

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 TABLE 2
Mean (Standard Deviation) for Key Measures
and Number of Observations by Condition

No financial pressure Financial pressure

Low opp. High opp. Low opp. High opp.
costs (T1) costs (T2) costs (T3) costs (T4)
MAXPERFSuba 39.76 37.26 37.43 38.55
(5.69) (4.05) (7.31) (6.96)
MAXPERFSuperb 37.14 39.35 39.71 37.60
(6.97) (5.89) (4.60) (5.26)
c
ESTPERFSub 40.86 38.61 39.38 40.00
(5.85) (4.54) (8.70) (6.70)
d
B 36.10 37.13 32.52 35.75
(9.83) (6.23) (7.42) (13.14)
BONUSPOTe 8.05 2.95 7.62 8.00
(8.16) (5.88) (10.13) (7.99)
PERFSubf 33.38 31.70 36.14 35.05
(19.25) (15.85) (12.45) (13.88)
NORMPERFSubg .8001
(.4496)
preprint
.8131
(.3978)
.9224
(.2442)
.8871
(.3289)
PROPOSALh 22.11 24.00 26.00 32.62
(10.56) accepted
(9.16) (10.85) (20.04)

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i
COUNTER 41.21 40.16 34.06 36.92
(8.04) (5.94) (8.04) (14.81)
DELTAj 19.11 16.17 8.06 4.31
(12.73) (10.09) (9.28) (9.64)
FREQNEGk .9047 .7826 .8571 .6500
(.3008) (.4217) (.3586) (.4894)
FREQAGREEl .6842 .1667 .5556 .7692
(.4775) (.3835) (.5113) (.4385)
LENGTHm 2.14 .87 1.19 .70
(1.11) (.548) (.814) (.571)
Number of observ. 21 23 21 20
Note: Low opportunity costs: The superior’s working time is independent of the negotiation length. High opportunity
costs: The superior’s working time is reduced the more rounds a negotiation lasted. No financial pressure: The superi-
or’s payoff is independent of subordinate’s and superior’s total performance. Financial pressure: The superior’s payoff
is only paid out if the subordinate’s and the superior’s total performance is larger than or equal to 60.
a
MAXPERFSub is the subordinate’s maximum performance in the training rounds.
b
MAXPERFSuper is the superior’s maximum performance in the training rounds.

41
c
ESTPERFSub is the subordinate’s estimated performance capability.
d
B is the final budget used for performance evaluation.
e
BONUSPOT is the bonus the subordinate would have received based on his estimated performance capability,
ESTPERFSub, and the budget, B.
f
PERFSub is the subordinate’s performance in the experimental work round.
g
NORMPERFSub= PERFSub/ESTPERFSub is the subordinate’s normalized performance.
h
PROPOSAL is the subordinate’s initial budget proposal in the negotiation.
i
COUNTER is the superior’s initial counteroffer in the negotiation.
j
DELTA= COUNTER – PROPOSAL is the distance in initial negotiation positions.
k
FREQNEG is the frequency with which superiors chose to enter the budget negotiation.
l
FREQAGREE is the agreement frequency given that the superiors opted for the negotiation.
m
LENGTH is the number of negotiation rounds. If the superior did not enter the negotiation, LENGTH is set to 0.

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42
 TABLE 3
Analysis of the Negotiation Process

Panel 1: PROPOSALa df MS F p

Financial pressure (Y/N) 1 650.29 4.06 .05**

Opp. costs (High/Low) 1 300.92 1.88 .18
Fin. pressure x Opp. costs 1 92.60 .58 .45
Error 64 160.20

Panel 2: COUNTERb df MS F p

Financial pressure (Y/N) 1 449.30 5.23 .03**

Opp. costs (High/Low) 1 13.82 .16 .69
Fin. pressure x Opp. costs 1 63.57 .74 .39
Error 64 85.87

Panel 3: DELTAc df MS F p

Financial pressure (Y/N) 1

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2180.65 19.31 <.001***
Opp. costs (High/Low) 1 185.77 1.64 .20

accepted
Fin. pressure x Opp. costs 1 2.72 .02 .88
Error 64 112.94
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Note: The dependent variables of the ANOVAs are: the subordinates’ initial budget proposals (Panel 1:
PROPOSAL), the superiors’ initial counteroffers (Panel 2: COUNTER) and the distance in initial negotiation posi-
tions (Panel 3: DELTA). The independent variables are whether superior’s financial pressure to meet unit targets ex-
isted or not (Y/N) and whether the superior’s opportunity costs of negotiations were high or low.
Low opportunity costs: The superior’s working time is independent of the negotiation length. High opportunity costs:
The superior’s working time is reduced the more rounds a negotiation lasted. No financial pressure: The superior’s
payoff is independent of subordinate’s and superior’s total performance. Financial pressure: The superior’s payoff is
only paid out if the subordinate’s and the superior’s total performance is larger than or equal to 60.
The observations include all dyads that entered a negotiation. For every dyad, there is one observation. Thus, every
ANOVA contains 68 observations.
***, ** and * denote significance at the 1 percent, 5 percent and 10 percent levels, respectively (two-tailed tests).
a
PROPOSAL is the subordinate’s initial budget proposal in the negotiation.
b
COUNTER is the superior’s initial counteroffer in the negotiation.
c
DELTA= COUNTER – PROPOSAL is the distance in initial negotiation positions.

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 TABLE 4
Negotiation Agreement in the Experiment

Dependent variable Negotiation

agreement (0/1)

Independent variables Coefficient

(Standard error)

Constant .77
(.49)
a
Opportunity costs (0/1) -2.38
(.80***)
b
Financial pressure (0/1) -.55
(.68)
Opportunity costs x Financial pressure 3.36
(1.14***)

N 68
Pseudo R2 .16
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Note: The table reports results of a binary logistic regression. The dependent variable is an in-
dicator variable capturing whether negotiation agreement was reached (1) or not (0). The inde-
pendent variables are an opportunity costs indicator variable (equal 1 for high superior oppor-

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tunity costs and 0 for low superior opportunity costs), a financial pressure indicator variable
(equal 1 for superior financial pressure and equal 0 for no superior financial pressure), and the

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interaction of both indicator variables.
The observations include all dyads that entered a negotiation. For every dyad, there is one ob-
servation. Thus, the regression contains 68 observations.
***, ** and * denote significance at the 1 percent, 5 percent and 10 percent levels, respectively
(two-tailed tests).
a
Opportunity costs is an indicator variable that takes on the value 1 if the superior’s opportuni-
ty costs are high and 0 if they are low.
b
Financial pressure is an indicator variable that takes on the value 1 if superior’s financial
pressure to meet unit targets exists and 0 if there is no financial pressure on the superior.

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 TABLE 5
Subordinate Effort following the Budget Setting Process

Panel 1: Summary of means

Exogenous constraints
NORMPERFSuba
No Yes Total
No. of dyads

1.03 .99 1.01

No
Budget 13 23 36

imposition .42 .81 .74

Yes
8 41 49

.80 .87 .85

Total
21 64 85

Panel 2: ANCOVA: NORMPERFSub df MS F p

BONUSPOTb preprint
1 .07 .70 .40
Budget imposition (Y/N) 1 2.00 18.91 <.001***
Exogenous constraints (Y/N)
accepted
1 .44 4.21 .04**

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Budget imposition x Exog. Constraints 1 .66 6.19 .01***
Error 80 .11
Note: The table presents means and marginal means of the subordinates’ normalized performance (NORMPERFSub)
according to whether exogenous constraints exist or not and whether budgets were imposed or not (Panel 1).
NORMPERFSub is used as a measure of subordinate effort and is computed by dividing subordinate performance in the
experimental work round (PERFSubc) by the estimated subordinate capability under high effort (ESTPERFSubd). Thus,
NORMPERFSub measures subordinate effort as the percentage of performance in the experimental work round relative to
estimated performance under high effort. The dependent variable of the ANCOVA (Panel 2) is NORMPERFSub. The
independent variables are whether exogenous constraints exist for the superior or not (1/0) and whether budgets are
imposed or not (1/0). Exogenous constraints exist when the superior’s opportunity costs of negotiation are high, finan-
cial pressure for the superior to meet unit targets exists, or both. Moreover, the interaction of these two indicator varia-
bles is used. The subordinates’ potential bonus, BONUSPOT, is used as a covariate to control for financial incentives.
Every dyad in every treatment represents an observation. Thus, the ANCOVA contains 85 observations.
***, ** and * denote significance at the 1 percent, 5 percent and 10 percent levels, respectively (two-tailed tests).
a
NORMPERFSub= PERFSub/ESTPERFSub is the subordinate’s normalized performance.
b
BONUSPOT is equal to the bonus the subordinate would have received based upon his performance estimate,
ESTPERFSub, and the budget, B.
c
PERFSub is the subordinate’s performance in the experimental work round.
d
ESTPERFSub is the subordinate’s estimated performance capability.

45