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Agency Theory

Agency theory is a framework for analyzing the process and outcomes that occur when one actor, the agent, performs services for another actor, the principal. Over the past two decades, agency theory has become increasingly influential for analyzing the owner-manager relationship in corporate governance, and is thought to represent a theory of the firm.

Conceptual Overview

Emanating from law and economics, agency theory assumes that humans are motivated by self-interest and offers a contractual approach to analysis. Two factors are stressed: the agent's contractual obligation to the principal, and the agent's self-interest, which diverges from that of the principal. Information asymmetries or gaps might exist and allow the agent to engage in self-serving behavior; they include adverse selection or incomplete precontract information, and moral hazard or postcontract hidden action or hidden information.

As the agent has the self-interest motive and might have the means to deviate from the contract due to adverse selection or moral hazard, agency costs can emerge in contract execution. Agency costs reduce the principal's outcome or benefit from the contract. However, principals can minimize agency costs by assuming they will tend to occur and attempt to preempt them by controlling the agent. The principal should monitor the agent's performance, and should create an incentive system that aligns the agent's interests with those of the principal. While the controls of monitoring performance and creating aligning incentives are themselves costly to principals, it is thought that a contract can be structured so that the cost of effective preemptive controls is low.

Agency theory has been touted as a theory of the firm, with the firm viewed as a nexus of contracts. Here, agency theory's dyadic contractual approach, assumption of self-interest, and recommended use of control mechanisms is viewed as appropriate framework for the employment relationship and the owner-manager relationship. Agency theory has become a dominant theory of corporate governance, and has had great influence on business practice, most notably through the use of executive stock options as a mechanism for aligning shareholder and executive interests.

Critical Commentary and Future Directions

Agency theory is a parsimonious framework for analyzing transactions between parties, viewing transactions as implicit contracts. It offers the benefit of concise explanatory power while ignoring the potential effects of a more realistic range of human motivations and conditions. The theory is unabashedly economic in perspective, making assumptions about human behavior that reflect worst-case thinking. It ignores any attempt at incorporating psychological and sociological perspectives that could well indicate that its dire assumptions and proposed solutions might not be well-grounded. Yet, this overly simplistic framework does cause us to focus on the most basic aspects of transacting, which can well be lost in more inclusive theories, and has generated a groundswell of reaction and new theorizing that might not have otherwise occurred.

Agency theory challenges most organization theorists to refute it. Organization theorists have long taken issue with the assumption of self-interest and the resulting tendency toward opportunism, and have developed theories that better reflect motivation as a complex construct. In a particular critique of agency theory, managers are presented to not be mere atomistic or solo actors, but instead are social beings that might have a sense of stewardship for their organizations.

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