In the upcoming weeks I am intending on posting a discussion on Sales Force Management and for the paper to make sense the reader needs a basic understanding of Agency Theory. This paper is a targeted review of Agency Theory as an introduction for the uninitiated.
Agency Theory as a whole has been excellently reviewed and summarised by other authors. Two papers that particularly stand out as strong, concise and interestingly written are:
- Kathleen Eisenhardt (1989): Agency Theory: An Assessment and Review.
- Susan Shapiro (2005): Agency Theory.
I highly recommend them for additional reading.
The base concept behind Agency Theory is very simple. It is the study of the relationship between a person (the principal) another person (the agent) who they contract to act on their behalf. If this contract is not created in a fashion that aligns the interests of both parties it is likely that the agent will interpret the contract in ways that maximise their own reward, possibly to the detriment of the principal.
The risk of agents acting in ways that go against their principal’s interests has increased as the use of professional managers (instead of owner-operators) has spread. In particular it is of concern in publicly listed entities where a CEO tends to have high levels of autonomy. The negative outcomes of these actions can be observed in several high-profile company collapses in the past 10 years.
The initial approach to studying Agency Theory (now known as ‘Principal-Agent Theory’) concentrated on developing mathematical models of agency interaction. The studies were based in econometrics and relied heavily on assumptions of self-interest, bounded rationality and agent risk aversion (Eisenhardt 1989). These assumptions allowed issues to be mathematically modelled but, as the influential theorist Jensen (1983, p. 333) states,
“authors are led to assume the problem away or to define sterile ‘toy’ problems that are mathematically tractable”.
When it became evident that this approach too inflexible for the complexity of real-world scenarios a second school was developed incorporating political science, expert agency, the law of agency and sociology (Eisenhardt 1989; Shapiro 2005). The new school is known as ‘Positivist Agency Theory’ and is aimed at finding applicable solutions to agency problems in business and government.
Positivist Agency Theory has become widely accepted since the 1980’s and has been extended from simply looking at the relationship between an owner and their CEO to relationships with multiple principals and/or agents that exist at all levels of the organisation.
Risk Appetite: Agents can have different appetites for risk causing an organisation to take too many or few ‘entrepreneurial decisions’ for the owners.
Goal Conflict: An agent may pursue goals that do not match with the principal’s. For instance if an agent is remunerated on revenue growth they may do so at the expense of profitability and cause an organisation to become bankrupt.
Adverse Selection: The hiring of an agent that lacks skills or attitudes necessary for the role.
Self-Interest: It is assumed that all humans place their own interests ahead of others to some extent.
Moral Hazard: The agent may deliberately not perform to the level they have been contracted for.
Exploiting Perquisites: Roles have benefits that go with them and senior roles can have access to quite extensive benefits. A CEO using company money to outfit his house is exploiting his perquisites.
Bounded Rationality: Within the limits of their experience a person is always assumed to act in a rational fashion.
Information Asymmetry: As the agent works directly within the organisation they will have more detailed information. This asymmetry can be used to slant interpretation of how the organisation is performing or as leverage in negotiations regarding rewards.
Agent Risk Aversion: An agent is generally aware that taking a risk and failing will be damaging to their ongoing employment. This knowledge can cause agents to avoid taking risks out of self-interest even when those risks are in the benefit of the principal.
Eisenhardt, KM 1989, ‘Agency Theory: An Assessment and Review’, Academy of Management Review, vol. 14, no. 1, pp. 57-74.
Jensen, MC 1983, ‘Organization Theory and Methodology’, Accounting Review, vol. 58, no. 2, pp. 319-39.
Shapiro, SP 2005, ‘Agency Theory’, Annual Review of Sociology, vol. 31, no. 1, pp. 263-84.