(This case-let is based on the paper “Agency Theory: An Assessment and Review” by Eisenhardt, K. M. (1989) published in Academy of Management Review, 14(1), 57-74 and uses extracts from the manuscript for academic purpose)

19th December 2024

Introduction

Single-handedly, much cannot be achieved. Notably, in an organization or business, one needs a group of people to accomplish a common goal. Here arises the problem of sharing among individuals. This phenomenon of problem-sharing was explored by economists such as Arrow (1971) and Wilson (1968), to name a few. Specifically, when one party (the principal) delegates work to another (agent) agency, the relationship kicks in, and the so-called agency problem occurs. Agency theory, developed by Michael C. Jensen and William H. Meckling in 1976, describes how conflicts of interest between a company’s owners, managers, and debt providers affect the company’s governance. Agency theory discusses the agency problem and ways of resolving it.

The agency problem manifests first “when (a) the desires or goals of the principal and agent conflict and (b) it is difficult or expensive for the principal to verify what the agent is actually doing” (Eisenhardt, 1989). The second situation is when the principal and agent have different attitudes toward risk. In the first situation, the principal cannot verify how the agent has behaved i.e. appropriately or not and in the second situation, “the principal and the agent may prefer different actions because of the different risk preferences.”

Since the relationship between principal and agent is governed by the contract between them, the contract becomes the unit of analysis to study the agency theory. To minimize the agency problem, it is obvious that the contract should be effective. While framing the contract, the underlying assumptions are about i) people (e.g., self-interest, bounded rationality, risk aversion), ii) organizations (e.g., goal conflict among members), and iii) information (e.g., information is a commodity which can be purchased) holds. In this scenario, we are faced with “the question, Is a behavior-oriented contract (e.g., salaries, hierarchical governance) more efficient than an outcome-oriented contract (e.g., commissions, stock options, transfer of property rights, market governance)? 

According to Eisenhardt (1989), agency theory has developed along two lines: positivist and principal-agent (Jensen, 1983 ). Before delving further, let us understand what is positivist or positivism.

The positivism or a positivist approach to studying society holds that all genuine knowledge is either true by definition or positive – meaning a posterior fact derived by reason and logic from sensory experience. Simply put, positivist knowledge is gained through measurement and scientific evidence, such as experiments and statistics. 

Positivist Agency Theory

According to positivist researchers, an effective governance mechanism can solve the agency problem. Accordingly, two propositions exist—one is outcome-based contracts, and the second is information systems to curb agent opportunism. The logic is that outcome-based contracts coalign the preferences of agents with those of the principal because the rewards for both depend on the same actions, reducing the conflicts of self-interest between principal and agent. In the second proposition, information systems inform the principal about what the agent is actually doing, and this is likely to curb agent opportunism because the agent will realize that he or she cannot deceive the principal.

Principal-Agent Research

Principal-agent researchers are concerned with a general theory of the principal-agent relationship. This theory can be applied to employer-employee, lawyer-client, buyer-supplier, and other agency relationships (Harris, 1978)(Harris & Raviv, 1978). Characteristic of formal theory, the principal-agent paradigm involves careful specification of assumptions. Further, the principal-agent theory is broad-based and of general interest compared to positivism, which focuses on the owner/CEO relationship of the firms.

This research focuses largely on determining the best contract between the principal and the agent. According to this model, the result of the principal-agent conflict is assumed to be measurable. Also, the principal is a risk taker, and the agent is a risk avoider.

Critiques and Limitations

One of the main critiques of agency theory is its assumption of self-interested behaviour by agents. Critics argue that this assumption oversimplifies human behaviour and neglects other motivational factors, such as altruism and intrinsic motivation. Additionally, the theory’s focus on formal contracts and monitoring mechanisms may not fully capture the complexity of real-world principal-agent relationships.

Conclusion

Agency theory provides valuable insights into the dynamics between principals and agents, highlighting the importance of aligning interests and mitigating conflicts. It offers a robust framework for understanding the principal-agent relationship and the mechanisms to mitigate conflicts of interest. While the theory has limitations, it remains a crucial framework for understanding organisational behaviour and governance. It re-establishes the importance of incentives and self-interest in organisational thinking (Perrow, 1986).

There are two main contributions to organisational thinking by the agency theory. The first is about information; the theory implies that organisations can invest in information systems to control agent opportunism.  The second contribution is about risk implications. Accordingly, the outcome uncertainty coupled with differences in willingness to accept risk influences contracts between principal and agent.

As Eisenhardt explains in her seminal work “Agency Theory: An Assessment and Review,”  agency theory contributes to organisation theory, is testable and has empirical support. She also says it is reasonable to urge the adoption of an agency theory perspective when investigating the many problems that have a principal-agent structure.

Case for discussion based on agency theory:

One day, Deng Xiaoping decided to take his grandson to visit Mao. “Call me granduncle,” Mao offered warmly. “Oh, I certainly couldn’t do that, Chairman Mao,” the awe-struck child replied. “Why don’t you give him an apple?” suggested Deng. No sooner had Mao done so than the boy happily chirped, “Oh thank you, Granduncle.” “You see,” said Deng, “what incentives can achieve.” (Capitalism in the making, 1984).

1. The agency perspective can be applied to many problems with a cooperative structure. Can it be applied to husband-and-wife relationships? Why or why not?
2. Agency theory’s relevance in the case of an owner and his manager is discussed. How relevant is it between a manager and his subordinate worker?
3. Tasks that the government delegates to a university – Is it an agency problem?

References

1. Capitalism in the making. (1984). Time.
2. Eisenhardt, K. M. (1989). Agency Theory: An Assessment and Review. Academy of Management Review, 14(1), 57-74.
3. Harris, M. &. (1978). Some results on incentive contracts with application to education and employment, health insurance, and law enforcement. American Economic Review, 68, 20-30.
4. Jensen, M. (1983 ). Organization theory and methodology. Accounting Review, 56, 319 – 338.