Eisenhardt, K. M. (1989). Agency theory: An assessment and review. Academy of management review, 14(1), 57-74.
Summary
An agency relationship involves a principal (who delegates) and an agent (who performs the work). Agency theory deals with the phenomenon of a principal (e.g., the boss or the customer) and an agent (e.g., the employee or the provider) having conflicting interests. Agency theory deals with two types of problems. The first is called an agency problem and it occurs when the desires of a principal and an agent conflict or when it is difficult to monitor the agent. The second type of problem is called the problem of risk sharing and it occurs when a principal and an agent have different risk preferences. The principal unit of analysis in agency theory is the contract, and that can be either behavior-oriented (e.g., a salary) or outcome-oriented (e.g., commission-based pay). Outcome-based contracts load most of the risk on the agent, while behavior-based contracts load most of the risk on the principal.
“In agency theory, information is regarded as a commodity: It has a cost, and it can be purchased.”
The authors detail ten propositions dealing with agency theory. An outcome based contract is more likely to align the interests of the principal and the manager, resulting in agent behavior that is in the interest of the principal. When principals can verify agent behavior, especially through information systems (e.g., budgeting systems or reporting procedures), agents are more likely to act in the interest of the principal. Increased information will generally result in more behavior-based contracts and less outcome-based contracts.
“The heart of principal-agent theory is the trade-off between (a) the cost of measuring behavior and (b) the cost of measuring outcomes and transferring risk to the agent.”
Outcome uncertainty increases the probability of behavior-based contracts and decreases the probability of outcome-based contracts. Risk averse agents prefer behavior-based contracts. Risk averse principals prefer outcome-based contracts. Decreased goal conflict results in less outcome-based contracts (more trust is extended to the agent). Similarly, longer agency relationships result in more behavior-based contracts. Programmability is “the degree to which appropriate behavior by the agent can be specified in advance.” Highly programmable tasks are more likely to receive behavior-based contracts, because verification of agent behavior is easier. Difficult outcome measurability will result in more outcome-based contracts.
Application
This is a very clear theory that is easily put in practice by managers. Visualizing contracts in terms of “placing risk” allows for informed decision-making. The commoditization of information is also prescient in today’s world of analytics and instant feedback.
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