Agency Theory

What does it matter to ya
When you gotta job to do
You gotta do it well
You gotta give the other fella hell
--Paul McCartney

Agency theory (Alchian & Demsetz, 1972; Fama, 1980; Jensen & Meckling, 1976) posits that goal incongruence causes problems among cooperating parties. These cooperating parties could be customer and supplier, owner and manager, investor and financial advisor, voter and politician or any relationship where one entity delegates work to another. The delegator is the known as the principal and the delegatee is known as the agent.

The relationship between principal and agent is a contractual one. The principal 'contracts out' to the agent.

Goal incongruence is assumed to stem from axiomatic varied self-interests among individuals, which make it difficult for principals to insure that agents will perform per principal wishes. It is also assumed that information about goodness of agent work and outcomes is a commodity that can be purchased (Eisenhardt, 1989).

Principals therefore contract with agents using two primary approaches. Behavior-oriented contracts (monitoring) employ salaries and hierarchical governance to specify appropriate agent activities and to observe activity execution. Outcome-oriented contracts (incentives) employ commissions, options, and market governance to specify appropriate outcomes and to provide 'carrots' for agents to achieve those outcomes.

Various problems can reduce the effectiveness of these contracts. Regularly monitoring agent behavior may be difficult in many circumstances, thereby making the cost of acquiring information about agent activities prohibitively expenseive. Causal ambiguity about the relationship between agent behavior and outcomes, and poor agreement about goals and means to achieve them can impair the effectiveness of both monitoring and incentive arrangements.

As uncertainty increases, effectiveness of contract is reduced. Agents are more likely to shirk--i.e., fail to fully deliver on their their contractual responsibilites. Principals might also exploit uncertainties to procure better terms from uninformed agents.

High levels of uncertainty suggest alternative mechanisms of integration and coordination (e.g., joint ventures, mergers) in order to manage the relationship (Nilikant & Rao, 1994).

References

Alchian, A.A. & Demsetz, H. 1972. Production, information costs, and economic organization. American Economic Review, 62: 777-795.

Eisenhardt, K.M. 1989. Agency theory: An assessment and review. Academy of Management Journal, 14: 57-74.

Fama, E.F. 1980. Agency problems and the theory of the firm. Journal of Political Economy, 88: 288-307.

Jensen, M.C. & Meckling, W. 1976. Theory of the firm: Managerial behavior, agency costs and ownership structure. Journal of Financial Economics, 3: 304-360.

Nilikant, V. & Rao, H. 1994. Agency theory and uncertainty in organization: An evaluation. Organization Studies, 15: 649-672.