Has Agency Theory Run its Course?: Making the Theory more Flexible to Inform the Management of Reward Systems

• Date: 01 November 2012
• Published date: 01 November 2012
• Author: Robert M. Wiseman,Gloria Cuevas‐Rodríguez,Luis R. Gomez‐Mejia
• DOI: http://doi.org/10.1111/corg.12004

Has Agency Theory Run its Course?:

Making the Theory more Flexible to

Inform the Management of Reward Systems

Gloria Cuevas-Rodríguez, Luis R. Gomez-Mejia, and

Robert M. Wiseman*

ABSTRACT

Manuscript Type: Conceptual

Research Question/Issue: In this paper we discuss three assumptions of agency theory: (1) conf‌licts of interest between

principal and agent, (2) nature of risk, and (3) the proposed internal mechanisms to reduce agency costs. We review

criticisms of agency theory’s pessimistic assumptions of human behavior and its simplistic view about individual risk

preferences to argue how the context may inf‌luence both the interest and mechanisms for aligning interest of principalsand

agents.

Research Findings/Insights: Wedraw on alternative theoretical perspectives from behavioral and organizational sciences to

describe circumstances under which honesty, loyalty, and trust in agents’ behaviors are possible and also the development

of cooperative rather than contentious relationships.

Theoretical/Academic Implications: This study explores the boundary conditions of traditional agency theory in the hope

of extending agency theory outside its current contextual boundaries. In doing so,we provide a more robust and exhaustive

view of the economic exchange between principals and agents.

Practitioner/Policy Implications: This study offers insights to managers about how intrinsic incentives may provide an

alternative mechanism of control over agents’ behavior to extrinsic incentives prescribed by traditional agency theory.

Indeed, intrinsic incentives of personal satisfaction and identif‌ication with organizational objects, combined with implicit

social obligations and reciprocity may, under certain circumstances, provide stronger restraints on agent opportunism than

the use of traditional extrinsic rewards in the form of incentive alignment.

Keywords: Corporate Governance, Agency Theory, Stewardship, Board Policy Issues, Executive Compensation

INTRODUCTION

Agency theory, as initially conceptualized by Jensen and

Meckling (1976) analyzes the relationship that devel-

ops in an economic exchange when an individual (the prin-

cipal) concedes authority to another (the agent) to act in his

or her name, so that the wealth of the principal is benef‌ited

by the decisions adopted by the agent. According to the

theory,separating ownership from control can result in costs

for the principal, known as agency costs, thus requiring

costly mechanisms for controlling these costs. Agency costs

arise because agents are argued to pursue interests that do

not necessarily coincide with those of the principal. Because

the use of incentives to create alignment of interests between

principal and agency is a primary mechanism proposed by

the theory to reduce agency costs, the theory is without

doubt one of the main (if not the main) theoretical frame-

works in the area of compensation management (particu-

larly at the top management level) (Gomez-Mejia, Berrone,

& Franco-Santos, 2010).

The roots of agency theory are linked to economic utili-

tarianism (Ross, 1973), which suggests that rational indi-

viduals will favor alternatives that enhance their own utility.

The theory has been used widely in areas as diverse as

accounting (Demski & Feltham, 1978), economics (Spence &

Zeckhauser, 1971), f‌inance (Fama, 1980), marketing (Basu,

Lal, Srinivasan, & Staelin, 1985), political science (Mitnick,

*Address for correspondence: Robert M. Wiseman, Eli Broad Graduate School of

Management,Michigan State University, Management,East Lansing, Michigan, USA.

Tel: 517-355-1878; Fax:517-432-1111; E-mail: wiseman@bus.msu.edu

526

Corporate Governance: An International Review, 2012, 20(6): 526–546

© 2012 Blackwell Publishing Ltd

doi:10.1111/corg.12004

1975), organizational behavior (Eisenhardt, 1985), and soci-

ology (White, 1985). Its popularity lies in providing parsi-

monious predictions as to how rational individuals would

behave in bilateral relations between self-interested indi-

viduals, where each individual is faced with information

asymmetry about the other individual’s effort and interests.

In sum, agency theory focuses on identifying the most eff‌i-

cient contract for aligning the interests of an agent with

those of the principal (Fama & Jensen, 1983).

By contrast, critics charge that the theory’s parsimony is

also its Achilles’ heel in that the theory’s simplistic assump-

tions and narrow focus limit its predictive validity (cf. Eisen-

hardt, 1989; Perrow, 1986). For example, as originally

conceptualized, agency theory’s pessimistic assumptions of

human behavior as opportunistic would seem to preclude

trust and cooperation between the principal and agent(Fehr

& Falk, 2002). That is, the theory presupposes that because

economic agents can cover up, cheat, distort, or trick the

contracting party in an economic exchange, opportunism

will prevail in spite of incentives and supervision, resulting

in problems of adverse selection and moral hazard.1This

characterization of agents has been challenged as overly

negative and possibly self-fulf‌illing (Donaldson & Davis,

1991, 1994). Instead, these critics suggest that beginning with

an assumption of trust and viewing agents as “stewards” of

the organization, motivated to act responsibly, may result in

more desirable outcomes for both parties (Davis, Schoor-

man, & Donaldson, 1997). Other critics have noted that

agency theory includes simplistic assumptions about indi-

vidual risk preferences (Wiseman & Gomez-Mejia, 1998),

and does not acknowledge the social context in which the

principal-agent contract resides, and how that context may

inf‌luence both the interests and mechanisms for aligning

interests of principals and agents (Wiseman, Cuevas-

Rodriguez, & Gomez-Mejia, 2012). In sum, critics charge

that economists’ formal vision may be too restrictive, and

that it could prove highly useful to widen the agency

concept by using a behavioral perspective (Tirole, 2002).

In order to overcome the limitations of agency theory, we

propose to incorporate other theoretical perspectives in

order to extend and strengthen agency theory’s predictions.

Specif‌ically, we contrast agency theory’s assumptions about

conf‌lict of interest, nature of risk, and mechanisms for con-

trolling agency costs with alternative views derived from

behavioral and organizational sciences in order to generate a

more robust and exhaustive view of the economic exchange

between principals and agents. As Rabin suggests: “Some

important psychological f‌indings seem tractable and parsi-

monious enough that we should begin the process of inte-

grating them into economics” (1998: 13). Thus, we may be

able to benef‌it from the evidence on human behavior as well

as from organizational theory without necessarily losing the

virtues of economic analysis. In essence we draw on alterna-

tive theoretical perspectives to explore the boundary condi-

tions of traditional agency theory in the hope of extending

agency theory outside its current contextual boundaries.

This paper is structured in the following way. It begins by

summarizing three central features of positive agency

theory, conf‌lict of interest, and mechanisms for controlling

agency costs. We then compare agency assumptions with

new assumptions derived from behavioral and organiza-

tional perspectives to generate contrasting predictions about

agent behavior. In order to do that, we use content analysis

as a research methodology. We searched the major academic

journals in the ABI/INFORM database, searching for those

articles that combine agency theory with other theoretical

frameworks. Then, we checked the abstracts of the reference

lists of articles obtained, and classif‌ied them with regard to

their theoretical or empirical approach (see Table 1). Thus,

our survey of alternative theoretical contributions to agency

theory is meant to be illustrative rather than an exhaustive

exploration of how agency theory may be extended beyond

its present emphasis.

POSITIVE AGENCY THEORY

Positive agency theory is an empirically-oriented examina-

tion of principal-agent relations and has been extensively

used by management scholars as a basis for examining the

eff‌iciency of contractual relationships between owners and

managers of large corporations (Eisenhardt, 1989; Gomez-

Mejia, Tosi, & Hinkin,1987; Tosi & Gomez-Mejia, 1989). This

approach contrasts with the mathematical non-empirical

principal-agent theory proposed by Jensen and Meckling

(1976). Though the two views of agency differ epistemologi-

cally, they each provide important insights into the issues

arising when one party, a principal, hires another party, an

agent, to perform tasksdesired by the principal. We focus on

the positive agency view because of its roots in scientif‌ic

realism, though we acknowledge that the two perspectives

are complementary in that principal-agent theory provides

theoretical guidance to positive agency research.

A positive agency perspective has been extensively used

by management scholars as a basis for examining the eff‌i-

ciency of contractual relationships between owners and

managers of large corporations (Eisenhardt, 1989; Jensen,

1983; Tosi & Gomez-Mejia, 1989). Eff‌iciency is measured by

the costs resulting from the separation of control from own-

ership, which is generally referred to as agency costs. As

such the theory provides a special case of agency within the

nexus of contracts that make up complex organizations.

Agency costs arise because both parties to the relation are

assumed to hold self-serving interests and the contractual

mechanisms used to align those interests are imperfect and

costly (Alchian & Demsetz, 1972). That is, both owners and

agents are rational rent-seekers holding different utility

functions (Jensen & Meckling, 1976). Thus, positive agency

theory assumes a conf‌lict of interest between principals and

agents such that principals desire to maximize personal

wealth subject to risk constraints, while agents seek to maxi-

mize their personal wealth while minimizing personaleffort

and risk. In the context of large organizations, an agent’s

effort toward maximizing the principal’s utility is positively

linked to the pecuniary rewards promisedto the agent in the

contract. Agency costs in the form of moral hazard and

adverse selection arise because contracts are by nature

incomplete and principals face a problem of information

asymmetry with regard to agent effort. More specif‌ically,

agency costs include the pecuniary benef‌its in the form of

contingent compensation tied to agent performance, and

non-pecuniary benef‌its such as “the physical appointments

HAS AGENCY THEORY RUNS ITS COURSE? 527

Volume 20 Number 6 November 2012© 2012 Blackwell Publishing Ltd