AGENCY THEORY

Agency theory pertains to the relationship between two parties; the first is the principal (or principals) and the second, the agent (or agents), who are engaged as employees or independent contractors. Considered a subunit of the theory of contracts, agency theory deals with the determination of the general structure of such contractual relationships and factors that influence behavior of the parties involved.

While the principal/agent relationship was recognized in the writing of early economists, including Adam Smith, the identification of this special aspect of contracts dates to the 1970s. A significant paper published in 1976 by Michael Jensen and William Meckling identified elements from the theory of agency in their consideration of the theory of the firm. They commented:

The firm is a "black box" operated so as to meet the relevant marginal conditions with respect to inputs and outputs, thereby maximizing profits.… Except for a few recent and tentative steps, however, we have no theory which explains how the conflicting objectives of the individual participants are brought into equilibrium so as to yield this results.

The theory has continued to evolve since the Jensen-Meckling paper was written. In noting the basic analyses still to be undertaken, J. Gregory Dees stated in 1992, "principal-agent analysis is a diverse and rapidly developing field.… While commonly referred to as 'agency theory,' … I … believe the label is misleading. It is more accurate to describe it as a modeling approach within which there are some common structure and assumptions with wide variations" (p. 27). Yet, in 2002 Eric Brousseau hinted at the incompleteness of the theory in considering the future economic analysis of this type of contract and in stating that this would require the "collaboration with professionals and scholars in other disciplines" (p. 27).

SOME PROBLEMS IDENTIFIED

Some problem areas that have been highlighted in studies are: agency costs, adverse selection, and moral hazard. Each of these aspects is briefly defined and explained below.

Agency Costs

Expenditures for monitoring, perceived to be necessary, are critical costs in a principal/agency relationship. Since the principal is delegating authority and responsibility, prudent management undertakes some type of monitoring to have assurance that decisions are optimal from the point of view of the principal. Reports, observational visits, and supervision are common types of monitoring, none of which is cost-free.

Adverse Selection

The incompleteness of information that is generally available to the principal and to the agent is the core concept of adverse selection. Agents present their credentials in résumés; they discuss their qualifications in interviews. Based on such information, the principals conclude whether such agents are qualified or not for positions to be filled. In some instances, such résumés are later found to contain inaccurate information, or representations made in interviews are later recognized as not the same as what is learned about actual performance.

Principals, too, may misrepresent information or provide incomplete information. Principals in interviewing prospective accountants, for example, may state that high ethical standards are to be maintained in processing and reporting financial information to shareholders. Agents accept such representations as in line with their beliefs. After accepting positions as accounting managers, though, agents are informed that the company figures must reflect a specified level of profit for the end of the fiscal year, regardless of what the actual accounting records reflect. The words of the principal during the initial interview are not supported by the demand to manipulate the figures.

Moral Hazard

The possibility that agents will not choose to optimize the wishes of principals is the essence of this problem. For example, a company executive hires a manager for a manufacturing plant for which standards of output have been established. The manager agrees to a fixed income with no bonus. The manager soon learns that the standards of output are not demanding; it would be possible to readily achieve higher levels of output—which seems a good idea because the demand for the product is greater than current production. The manager, however, perceives no incentive to increase the level of activity, since just meeting the standards is the critical basis for evaluation and determination of the next year's salary for the manager. The manager has decided to keep "the job easy," rather than inform a supervisor that a higher level of productivity is reasonable and would aid in meeting the unmet demand for the product.

THE REALITY OF CONTEMPORARY PRINCIPAL/AGENT EFFECTIVENESS

Financial accounting scandals in U.S. companies reflect the ineffectiveness of principal/agent relationships and the insufficiency of current agency theoretical efforts. As a result of the cascade of scandals in the decade prior to 2002, the U.S. Congress enacted the Sarbanes-Oxley Act of 2002, which imposed new regulations on public companies and their auditors. Such rules are assumed to be effective in ensuring that executives fulfill their obligations. Such rules affect a hierarchy of principal/agent relationships: Shareholders are principals of public companies and their immediate agents are boards of directors. Boards of directors are principals; their agents are the executives selected to carry out policies and the independent auditors they engage to audit the financial statements of the company. The principal/agent relationships continue to lower levels of organizations.

Many opportunities exist within publicly owned companies for less than optimum effectiveness in principal/agent relationships. Such opportunities are predicted to decline with successful implementation of the new rules and regulations. Even with new rules and regulations, however, there is an awareness that the knowledge of how equilibrium (where both the principal and agent are optimally behaving for both the interests of the entity and of the personal executive or employee) can be predicted continues to be insufficient.

SUMMARY

The need for increasing understanding of the principal/agent relationship continues. While attention to agency theory began in the field of economics—including the practical fields of finance and accounting—interest in the subject has developed among some political scientists, historians, sociologists, psychologists, and ethicists. Considerable empirical investigations, as well as refinements at the theoretical level, are needed. Studying and thinking are continuing.

see also Contracts

bibliography

Bowie, Norman E., and Freeman, R. Edward (Eds.) (1992). Ethics and agency theory: An introduction. New York: Oxford University Press.

Brousseau, Eric, and Glachant, Jean-Michel (Eds.) (2002). The economics of contracts: Theories and applications. New York: Cambridge University Press.

Dees, J. Gregory (1992). Principals, agents, and ethics. In Norman E. Bowie and R. Edward Freeman (Eds.), Ethics and agency theory: An introduction (p. 25). New York: Oxford University Press.

Gutner, Tamar L. (2005, May). Explaining the gaps between mandate and performance: agency theory and world bank environmental reform. Cambridge: The Center for Strategic and International Studies and the Massachusetts Institute of Technology. Retrieved July 25, 2005 from LexisNexis.

Jensen, M., and Meckling, W. (1976, October). Theory of the firm: managerial behavior, agency costs and ownership structure. Journal of Financial Economics. (3) 4, pp. 305–360.

Karake-Shalhoub, Zeinab (2002). Trust and loyalty in electronic commerce: An agency theory perspective. Westport, CT: Quorum Books.

Mary Ellen Oliverio