Far East University

Angelo Carlo M. Rosario -

Graduate School of International Development Major in Business Administration

The Principal-Agent Theory Angelo Carlo Rosario

Business Ethics Spring Semester 2012 Dr. Orapin Sopchokchai June 06, 2012

Table of Contents
Chapter 1 Executive Summary.....1 Introduction..2 What is Agency Relationship? 3 Agency Theory.4 Critisms of Agency Theory..4 Importance of Agency Theory.6 Overview......7 Chapter 2 The Principal-Agent Theory8 Origins of Principal-Agent Theory....10 Development of the Principal-Agent Theory.16 Agency Relationships18 Types of Agency Relationships.19 Levels of Agency Relationships20 Assumptions about Agency Relationship..22 Roles f Agency Theory..24 Corporate Considerations...32 Chapter 3 Principal-Agent Problem...33 Agency Problems...33 Problem of Adverse Selection.......34 Agency Cost and Variables38 Government Inefficiency...41 Maximizing Utility41 Distorted Bonus Bonanza..42 Corporate Governance Failure...42 Chapter 4 What ethical Issues can arise with Agency Theory? 44 Agency and Ethics.44 Conflict of Interest.45 Moral Hazard.45 Tacit Information...46 Trust...47 Logical Inconsistency48

Chapter 5 Summary, Theoretical Implications and Future Research Directions...50 Conclusion.52 References....54 List of Tables and Figures Table 1.140

Executive Summary This paper attempts to provide an overview of the major literatures, which has developed in the area of the principal-agent theory. This research is divided into four sections. First, the introduction and overview of the topic with arguments pertaining to this theory, arguments and the importance of the said concept. Second is the discussion about Principal agency theory, its origins and development focusing in different aspects of this theory. Third, are the discussions about the problems of principals and agents. Fourth, the issue about principals and the agents, which is Ethics, is addressed. Last, a summary and lessons learned about the basic tenets of this paper and theoretical implications are considered and future research directions are recommended.

1.1 Introduction The principal-agent-theory is a theoretical approach within the social sciences and delivers a model to explain the behavior of actors within a hierarchical order as well as general assumptions on explicit as well as implicit treaty formulations. this theory acts on the assumption that rationally thinking economic actors are constrained within their decision making. One possible reason could be an asymmetric distribution of information. In the model, the principal entrusts his agent with a task. Both of them act according to their own interest, which could lead to conflict situation since they could pursue different aims. But the agent is generally considered to be more risk-averse than the principal. Principal Agent Theory refers to the arrangement that exists when one person or entity (called the agent) acts on behalf of another (called the principal). For example, shareholders of a company (principals) elect management (agents) to act on their behalf, and investors (principals) choose fund managers (agents) to manage their assets. This arrangement works well when the agent is an expert at making the necessary decisions, but doesn't work well when the interests of the principal and agent differ substantially. In general, a contract is used to specify the terms of a principal-agent relationship. (Stevens 2002), The principal expects his agent to completely engage himself in fulfilling his task by pursuing the principal's aims and not his own. But the principal is limited in recognizing the engagement as well as the qualities of his agent and is only able to see the final result. Therefore, the agent possesses an advantage considering information, since he is more capable of judging the success of his efforts. The agent is now able to utilize this informational asymmetry in order to follow his own purposes by acting to the disadvantage of the principal. This theory also underlies most studies of organizational control in accounting and economics is principal-agent theory (See reviews by Baiman 1982, Pratt and Zeckhauser 1985, Eisenhardt 1989, Baiman 1990, and Mitnick 1992). Traditional principal-agent models, however, assumes that individuals are self-interested, opportunistic, and motivated solely by wealth andleisure (Luft 1997). In particular, individuals are indifferent to the utility of others or abstract values such as honesty or duty (Koford and Penno 1992). Based on this behavioral assumption, principal-agent models prescribe complex incentive schemes and costly monitoring to control opportunistic behavior within the organization. Employment contracts found in practice, however, are simple and incomplete and the level of monitoring is far less than that required by the theory (Stiglitz 1991). This has led economists to search for ways to enhance the external validity of the theory (Akerlof 1984; Simon 1991; Besley and Ghatak 2003) Researchers have long asserted that incorporating ethics could enhance both the internal and external validity of agency theory. Noreen (1988) argued that ethical behavior makes the formation of organizations possible. Koford and Penno (1992) asserted that most people have attitudes toward telling the truth and providing fair amounts of effort, 2

and agency models neglect a significant element of reality by failing to incorporate such attitudes. Luft(1997) argued that integrating ethics within agency theory could yield new insights regarding transaction costs within the organization and the effects of accounting information. Results from recent experimental studies also suggest that concerns for ethics are a major motivator. For example, researchers have documented that human subjects sacrifice earnings to honestly report their production potential (Evans et al. 2001), reduce budgetary slack (Stevens 2002), reduce shirking (Schatzberg and Stevens 2005), and reciprocate for acts of kindness (Hannan 2005). Of particular relevance to agency theory, Stevens (2002) demonstrates that concerns for ethics can affect behavior independent of concerns for reputation. Despite the growing evidence that integrating ethics with economic theory would improve internal and external validity, we are not aware of any published study that integrates ethics with traditional principal-agent theory. To address this void in the literature, we study the feasibility and desirability of this integrative approach. Specifically, we introduce a principal-agent model with ethics and investigate the properties of an ethics-based solution to the moral hazard problem In the traditional principal-agent framework, the principal offers the agent a wage for performing a productive effort, and the agent accepts the offer as long it adequately compensates him for his effort. After accepting the offer, however, the agent prefers to shirk his moral obligation to the principal because he is opportunistic and cares only about wealth and leisure. When effort is unobservable, the agents potential moral failure gives rise to a moral hazard problem for the principal. Traditional solutions to this moral hazard problem involve financial incentives or external monitoring. We examine a third solution that involves internal or self-monitoring. In particular, we examine a solution that relies on the likelihood that the agent will suffer at least some disutility for shirking his moral obligation to the principal. This disutility arises because shirking violates the ethical norm that valid-agreements-should-be-kept.(Mitnick 1992). It differs by agent and may still be zero as in the traditional case 1.2 What is an agency relationship? An agency relationship arises when one or more principals (e.g. an owner) engage another person as their agent (or steward) to perform a service on their behalf. Performance of this service results in the delegation of some decision-making authority to the agent. This delegation of responsibility by the principal and the resulting division of labor are helpful in promoting an efficient and productive economy. However, such delegation also means that the principal needs to place trust in an agent to act in the principals best interests. What happens when concerns arise over the motives of agents and cause principals to question the trust they place in them?

1.3 Agency Theory Agency Theory refers to analyses associate with the Principal-Agent Relationship which occurs whenever one person acts in the interests of another. Many situations create a principal-agent relationship between two people. Explicit relationships include those situations where one person acts in the interests of another through contractual agreements. For example, when owners of a corporation hire a manager to run the company using his/her expertise and experience, a formal contract is created where the managers act in the interests of the owners in exchange for compensation such as a salary, stocks, and even perquisites (Mitnick 1992). A simple agency model suggests that, as a result of information asymmetries and self interest, principals lack reasons to trust their agents and will seek to resolve these concerns by putting in place mechanisms to align the interests of agents with principals and to reduce the scope for information asymmetries and opportunistic behavior. Motives of agents and information asymmetries Agents are likely to have different motives to principals. They may be influenced by factors such as financial rewards, labor market opportunities, and relationships with other parties that are not directly relevant to principals. This can, for example, result in a tendency for agents to be more optimistic about the economic performance of an entity or their performance under a contract than the reality would suggest. Agents may also be more risk averse than principals. As a result of these differing interests, agents may have an incentive to bias information flows. Principals may also express concerns about in formation asymmetries where agents are in possession of information to which principals do not have access. Some principal-agent relationships do not operate formally but exist as though there is agency. For example, employees and managers in a corporation do not have a formal agency relationship. This is because the managers do not themselves compensate the employees for working on behalf of the managers. However, at some point in their relationship, the managers must rely on the employees without monitoring them all the time. This relationship can still be defined and governed by theories of agency. (Evans et al. 2001) 1.4 Criticisms of Agency Theory Agency theory remains somewhat controversial, particularly in the literature on financial ethics. For example, Horrigan claims that agency theory "raises the ethical danger of creating a very contentious, litigious view of financial relationships, pitting agents against principals and principals against principals as perpetual adversaries."That the business world is a litigious place very few would deny. It has been so for some time for longer, even, than Jensen and Meckling's article has been in print. Horrigan's view that the business world is an adversarial place is valid also, but this also hardly originated with agency theory. The world of business has competition at its very core. Competition exists not only among firms, but within firms, as employees compete for recognition,

promotions, and salary increases. Agency theory acknowledges this world, but did not create it Dobson claims to be quoting Jensen and Meckling when he says that agency theory is based on the view that management's thirst for perquisites at the expense of firm value is as inviolable as 'a world in which iron ore is a scarce commodity.' In fact, Dobson quotes this passage out of context. The passage merely refers to the pointlessness of comparing outcomes in a world with agency costs to outcomes where the presence of agency costs are denied, and saying that the latter is preferable. The full passage is below: In conclusion, finding that agency costs are non-zero and concluding therefore that the agency relationship is non-optimal, wasteful, or inefficient is equivalent in every sense to comparing a world in which iron ore is a scarce commodity (and therefore costly) to a world in which it is freely available at zero resource cost, and concluding that the first world is 'non-optimal'" Brennan objects to the "cynicism" and "harshness" of agency theory. He says that "the prerequisite consumption model of Jensen and Mecklingrests on the assumption that a manager (agent) will steal what he does not own, so that it is probably more efficient to give it to him at the outset rather than put him to the trouble of stealing it." Brennan goes on to state that such agents should probably be replaced rather than tolerated within the organization. Brennan's recommendation about replacement is probably sound. It is (perhaps) made in tongue-in-cheek fashion, exaggerated (in Brennan's mind) for effect. However, it may be a denial of reality. For example, retailers traditionally have suffered more shoplifting losses from their employees than from the public. Those who steal are fired when caught, but it doesn't seem to slow the tide of losses. It seems that many of the criticisms of agency theory rest on an implicit assumption of the perfectibility of man. The critics imply that if honesty and virtue were only given greater emphasis in our moral discussion, then people will behave in a more honest, virtuous manner. For example, Horrigan says that "Positive ideas inevitably become normative ideas when they are promulgated in decision oriented subjects, such as financial management." Dobson agrees, saying that "By assuming unbridled self-interest, financial economics promotes unbridled self-interest." However, evidence of the innate sinfulness of mankind is all around us. The Scriptures admonish Christians not to become too comfortable with their moral righteousness. The Apostle Paul, in the Book of Romans, compiles quotations from several Old Testament passages when he writes: As it is written: There is no one righteous, not even one; there is no one who understands, no one who seeks God. All have turned away, they have together become worthless; there is no one who does good, not even one. Their throats are open graves; their tongues practice deceit. The poison of vipers is on their lips. Their mouths are full of cursing and bitterness. Their feet are swift to shed blood.; ruin and misery mark their ways, and the way of peace they do not know. There is no fear of God before their eyes. Paul sums it up by saying "For all have sinned and fall short of the glory of God.

If any theory or set of ideas is going to help develop the moral sensibilities of managers, it must start with a view of the (business) world in which is accurate in every respect. We cannot build a moral and virtuous world by assuming that immorality does not exist, nor by assuming that mankind is perfectible or is naturally evolving into such a state. The purposes of reform are best accomplished by starting with a realistic view of the world and of the nature of mankind. Agency theory does this, but receives criticism for it. Agency theory is grounded in the view that mankind is not perfect, nor naturally evolving in that direction in assuming self-interest as the primary motive of mankind, agency theory makes no claim that self-interest is morally preferable. In this sense, it recognizes our fallen state. 1.5 The importance of the Agency Theory (Principal- Agent) The concepts of agency theory has become a lot more important now than ever before, especially with the corporate collapses of major multinational companies such as Enron in 2001, WorldCom in 2001, Lehman brothers 2008, and the nationalization of many financial institutions in recent months as a result of the global financial crisis. Lots of companies have been nationalized in recent times than ever before across all developed economies, such companies include Washington mutual, Bradford and Bingley, Northern rock and the like. Agency theory or agency relationship is the theory which looks at the relationship between the owners of the company in the form of shareholders (equity investors) and those have been given responsibility to take charge of the management of the company in the form of directors. Agency theory is one of the key concepts underlying the importance of corporate governance, which has taken prominent role in business activities in the last few decades. (Armah, 2002) It has its roots in almost every aspect of business activities and plays a very significant role in decision-making by directors (both executive and non-executive directors. And we must know and understand how Principal and Agents act upon these. Agency theory has been considered especially valuable in re-establishing the importance of incentives, interests and information in organizational thinking. It assumes that whether we like it or not, much of organizational life is partly based on peoples self interest, opportunism and goal conflicts. In addition, the theory has drawn attention to the issues related to information, and especially the asymmetries of information. An important contribution of agency theory is its risk implications. Organizations are assumed to have uncertain futures. Agency theory extends the ramifications of outcome uncertainty to their implications for creating risk. Uncertainty is viewed as risk / reward trade-offs with the implication that outcome uncertainty coupled with differences in willingness to accept risk should influence contracts between the principal and the agents. (Eisenhardt, 1989, pp. 64-65.) Agency theory draws attention, above all, to the theoretical and practical issues related to control. The theory asserts that there are two.

The criticisms of Donaldson are also orientated towards Organizational Economics in general. Donaldson discusses agency theory mainly in the context of corporation management. However, the criticism is so general that it can also be applied to other agency relationships. Problems for intra- and inter-organizational settings: the problems of adverse selection and moral hazard. The theory also points to perspectives and mechanisms for overcoming these problems. Recognizing the problem of adverse selection offers more understanding, for example, as to why the recruitment of an agent might sometimes fail, and why there is a need to reduce information asymmetries between the principal and the prospective agent. The problem of moral hazard, on the other hand, has increased the understanding of why organizations or individuals invest in monitoring mechanisms, and why piece-rate salaries are sometimes used. Additionally, agency variables have been able to clarify the benefits and shortcomings of different control procedures in a certain context. In general, it seems that agency theory has made its greatest contributions in understanding the nature of the goal conflicts that can arise between principals and agents, informational asymmetries and the potential problems that result from the different forms of agent opportunism, and the governance structures that evolved to contain them (cf. Davis et al., 1997, p. 45). The scholarly interest in agency theory has seemingly not decreased in the last two decades. On contrary, new fields of applications are being introduced continuously. Also, the numerous attempts to develop the theory further can also be interpreted as confirmation of the general perspective and problems that agency theory attempts to address. Although the descriptive, explanatory and predictive qualities of agency theory still seem to have remained context-bound and debated, the theory has offered alternative views for understanding the dynamics of different types of agency relationships. As a framework it has provided interesting new ways of thinking (Koelble, 1996, p. 261), it has had considerable value in helping to sort out and clarify relationships of power (Laffin, 1997, p. 56), and contributed understanding of existing governance structures (Ferris & Graddy, 1998, p. 228) 1.6 Overview In this paper we would discuss some arguments and problems about the agency theory, the impact of this theory to each sector maybe in business, economy, ethical standards and the like, the term Principal and Agent which is indeed used in widespread in artificial intelligence specially in complex systems, and regarded as one of the most important foundations of this discipline. This paper will help us understand the role and the problems in a easier sense, magnifying some arguments and of past researchers and particularly discussing some of the actors role in different settings,

Chapter 2 2.1 The Principal-Agent Theory The Principal agent theory is a theory explaining the relationship between principals, such as a shareholders, and agents, such as a company's executives. In this relationship the principal delegates or hires an agent to perform work. The theory attempts to deal with two specific problems: first, that the goals of the principal and agent are not in conflict (agency problem), and second, that the principal and agent reconcile different tolerances for risk. Agency theory is a concept that explains why behavior or decisions vary when exhibited by members of a group. Specifically, it describes the relationship between one party, called the principal that delegates work to another, called the agent. It explains their differences in behavior or decisions by noting that the two parties often have different goals and, independent of their respective goals, may have different attitudes toward risk. Principal-Agent theory emerges with the division of labor and exchange. The division of labor induces the need for delegation and the first historical contracts appear probably in agri-culture when a landlord (principal) contracts with his tenant (agent). It is then no wonder that Adam Smith encountered incentive problems in his discussion of this theory The concept of this theory originated from the work of Adolf Augustus Berle and Gardiner Coit Means, who were discussing the issues of the agent and the principal as early as 1932. Berle and Means explored the concepts of agency and their applications toward the development of large corporations. They saw how the interests of the directors and managers of a given firm differ from those of the owner of the firm, and used the concepts of agency and principal to explain the origins of those conflicts. Michael C. Jensen and William Meckling shaped the work of Berle and Means in the context of the risk-sharing research popular in the 1960s and '70s to develop agency theory as a formal concept. Jensen and Meckling formed a school of thought arguing that corporations are structured to minimize the costs of getting agents to follow the direction and interests of the principals Principal-agent theory arises in a business management context associated with behavioral studies of employer-contractor or employer-employee interactions but it can be applied to public and non-profit settings as well. Early work centered on dilemmas of dealing with incomplete information in insurance industry contracts (Spence and Zeckhauser, 1971; Ross, 1973). The theory was soon generalized to dilemmas associated with contracts in other contexts (Jenson and Meckling, 1976; Harris and Raviv, 1978). Because some research in this area utilizes experiments in small group interaction, there is a close relation to game theory, as some principal-agent writers make explicit criticism about this theory

When you hire a solicitor, however, it is almost impossible for you to monitor her effort and diligence on your behalf. You have not studied law, and much of what the solicitor does will be a mystery to you. This latter situation is close to the relationship that exists between shareholders and managers. The managers have information and expertise that the shareholders do not have-indeed, that is why they are the managers. The shareholders can observe profits, but they cannot directly observe the managers' efforts. To complicate matters further, even when the managers' behavior can be observed, the shareholders do not generally have the expertise to evaluate it. Everyone can see the firm's revenues, but it takes very detailed knowledge to estimate how large those revenues could have been if the managers had acted differently. Boards of directors, who represent the firm's shareholders, can acquire some of the relevant expertise and monitor managerial behavior, but again this is costly. Agency theory essentially acknowledges that different parties involved in a given situation with the same given goal will have different motivations, and that these different motivations can manifest in divergent ways. It states that there will always be partial goal conflict among parties, efficiency is inseparable from effectiveness, and information will always be somewhat asymmetric between principal and agent. Agency theory has been successfully applied to a lot of disciplines including accounting, economics, politics, finance, marketing, and sociology. Research on principal-agent theory has had several findings. Most notably, an agent is more likely to adopt the goals of the principal, and thus behave in the interest of the principal, when the contract is outcome-based. Also, when the agent is aware of a mechanism in place that allows the principal to verify the behavior of the agent, he is more likely to comply with the goals of the principal. Furthermore, outcome uncertainty has a positive relationship to behavior-based contracts, while there is a negative relationship to outcome-based contracts. Goal conflict has a negative relationship to behavior-based contracts with a positive relationship toward outcome-based contracts. Outcome measurability is negatively related to behavior-based contracts; there is a positive relationship with respect to outcome-based contracts. Opponents to agency theory criticize it as being too general and claim that it is pseudoscientific. They also claim that its interpretation is subjective and the validity of agency theory is not testable. The ability to be empirically tested is a necessary component of any hypothesis.

2.2 Origins Principal agent Theory The agency theory paradigm, first formulated in the academic economics literature in the early 1970s (Ross 1973, Jensen & Meckling 1976) had diffused into the business schools, The first scholars to propose, explicitly, that a theory of agency be created, and to actually begin its creation, were Stephen Ross and Barry Mitnick, independently and roughly concurrently. Ross is responsible for the origin of the economic theory of agency, and Mitnick for the institutional theory of agency, though the basic concepts underlying these approaches are similar. Indeed, the approaches can be seen as complementary in their uses of similar concepts under different assumptions. In short, Ross introduced the study of agency in terms of problems of compensation contracting; agency was seen, in essence, as an incentives problem. Mitnick introduced the now common insight that institutions form around agency, and evolve to deal with agency, in response to the essential imperfection of agency relationships: Behavior never occurs as it is preferred by the principal because it does not pay to make it perfect. But society creates institutions that attend to these imperfections, managing or buffering them, adapting to them, or becoming chronically distorted by them. Thus, to fully understand agency, we need both streams -- to see the incentives as well as the institutional structures. In economic perspective, the problem is one of selecting a compensation system that will produce behavior by the agent consistent with the principals preferences. Thus the focus is on the nature of the incentive system and the contracting system that guides the distribution of those incentives, as well as the conditions of risk and information that condition the choices of the actors. With his typical elegance, Ross lays out the problem with great clarity as well as brevity in a paper he delivered at the December 1972 economics meeting and which was published in the AER Proceedings issue in May 1973. He clearly identifies the agency problem as generic in society, not merely as a problem in the theory of the firm. This sets his work apart from the existing stream on the theory of the firm (e.g., Baumol 1959, Marris 1964, Williamson 1964, Alchian and Demsetz 1972) as well as the more general formal approaches on decision making under risk or uncertainty, and under different information states (e.g., Arrow 1963, Spence and Zeckhauser 1971, Marshak and Radner 1972), though it drew much from this work. Ross had recast the problem in terms of agency relationships, and clearly identified the key problem and the key variables. After Rosss paper, scholars would see agency problems and incentive mechanism design issues within agency relationships; the frame of inquiry was refocused. For Ross, however, the problems are still within the realm of decisions and sequences of decisions regarding incentives; the contexts that actually constitute the agency relationship are removed from the analysis and are reduced to their contributions of incentives or contractual constraints or risk/uncertainty conditions to decisions. Working independently of Ross, Mitnick followed parallel, if overlapping lines of literature that

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were more institutional in character. Barnard (1938) had observed that in the employment relation supervisors and workers observed a zone of discretion or indifference within which the worker made key choices. Simon had written about employment as a relation and with March (1958) had developed an inducements-contributions model that worried explicitly about managerial issues in the relationship, such as decisions to join and stay in the relationship. Simons work straddled both economics and public administration, and it was not surprising therefore that, in political science, Clark and Wilson (1961) developed an incentives model of organizations. Thus both relational and incentives-based arguments had developed within, or migrated to, the parallel literature. On the economics side, Williamsons managerial discretion model (1964) recalled, at least superficially, some features of Barnards old argument about the discretionary zone of managers behaviors, but it introduced an elegant utility tradeoff in which managers could survive while making allocation decisions that benefitted themselves as well as giving receivers of profit consequently less than maximal returns. Recalling the classic work of Coase (1937), Williamson (1975) then introduced a new approach to why hierarchies could be superior to market contracting. This transaction cost approach suggested that institutions could form because they were a better means of dealing with such costs, given other conditions such as the nature of the assets, technology, opportunism, and so on. But although Williamson with others applied this approach to the employment relation, his transaction costs model (1975) was based on a new view of exchange that is, it existed as a contrast to traditional models of market exchange and was not offered as a model of control. His firms, though nominally hierarchical and subject to issues of corporate control by the owners, were understood functionally more in terms of exchanges transactions rather than of true hierarchical behavior in which some actors are modeled as acting for others. The existence of costs of control, however, suggested to Mitnick that a theory of control centered on agency not just a theory of exchanges might generate new insights into common social institutions. In a 1965 review of theories of the firm, Alchian remarked in analyzing Williamson (1964) that unfortunately for the owners, there are costs of detecting and policing [the managers] actions. Once these costs are recognized, it is obviously better to avoid some of these costs if the profits saved are less than the costs (Alchian 1965: 35). Mitnick realized that Alchians observation was a perfectly general one that it was true across the host of agency relationships, not merely as a characteristic of corporate governance. In essence, it would be productive to create a vertical theory of control as well as a horizontal one of exchange. We are then led to focus on the mechanisms, and costs, of specifying what the agent is to do, as well as the costs of observing and policing him or her. The approach becomes vertically relational, as institutions are created to instruct and manage agents, and to deal with the inevitable (and sometimes rationally tolerated) imperfections of control.

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Like Ross, Mitnick first presented his work in a conference paper, which was given at a regular panel of the American Political Science Association Meeting in 1973. The APSA does not publish selected papers in a journal issue, as does the AEA, but it did put panel papers into microfilmed proceedings that were generally available (as dissertations have been), from what was Xerox University Microfilms and its corporate heirs. Both Ross and Mitnick were at the University of Pennsylvania (as was Williamson); Ross was a young faculty member in economics; Mitnick was a doctoral student in political science interested in public choice, bureaucracy, and political economy. Mitnick developed his work on agency in the Fall of 1972, writing the long paper that became the central analytic part of his dissertation and his 1973 APSA paper over a period of months up to the 1973 meeting. After his comprehensive examination in early 1973, Prof. Stephen Elkin asked him what the topic of his dissertation would be. Mitnick described his agency thesis, and Elkin said that he should talk to Ross, who had recently presented a paper on what he called the theory of agency. Mitnick said that he had also come to that name, having studied the law of agency for his paper and because of simple common usage of the term agency. Mitnick did not see Rosss paper until it was published in the May 1973 AER Proceedings, however. At that point (perhaps June 1973), he did go to speak with Ross, and had a brief exchange about the difficulty of creating a formal model of acting for. Ross had a wonderful term for it that stuck in Mitnicks mind the ice cream cone problem the agent's problem of selecting what the principal wants without knowing the principals preferences. Ross saw the problem as essentially insoluble as a pure choice problem without greater information on those preferences. Mitnick believed that institutions and social mechanisms exist to guide such behaviors. People make decisions based on things like norms, information with social origins, and what more recent literature terms cognitive heuristics or biases. In essence, information can be gathered indirectly or created to solve or remove the ice cream cone problem. Mitnick put a brief summary and critique of Rosss paper in his own 1973 paper since Rosss paper appeared before the APSA meeting, but the two works were created quite independently. Rosss 1973 paper was tightly focused on the formal analysis of the principals problem of selecting optimal compensation for the agent, and has only the briefest mention of the societal contexts and relevance of a theory of agency. He published a second conference paper in a proceeding in 1974 that focused on the formal principle of similarity. In contrast, Mitnicks 1973 paper and 1974 dissertation (1974a) presented an extensive study of many aspects of the theory of agency. It made the case for developing a general theory, presenting a detailed set of agency concepts and sorting them in typologies, identifying types of agency relationships as well as a language for describing agency and for developing theoretical explanations for behavior in agency.

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For example, Mitnicks work identified the fiduciary norm as a common social norm and noted how such norms economized on agency costs.4 It also developed a theoretical logic about agency in general that permitted the generation of theory in a wide variety of social contexts. In other words, it actually began developing an institutional theory of agency. Mitnick presented applications to such social relationships as advisers and clients, lawyers negotiating with one another, diplomats negotiating with foreign governments and one another, the behavioral patterns of legislative representatives, the advocacy of interest groups, regulators as agents subject to policing by public observers, regulatory incentive systems (with a specific application to regulation of power plant siting), and so on. He took the Clark and Wilson (1961) incentive system model and modified it to make it systematic and applicable to agency relationships. It was not unusual in the formal work on economic agency to see a focus on normative theory: For example, researchers asked such questions as, is there an optimal fee schedule that would align the agent and principal under certain conditions? Approaches of this type often seek to derive general principles from assumptions about initial conditions, abstract relationships among variables, and so on, via formal proofs. Having derived the principle, some researchers may then search for empirical evidence consistent with the abstract result. In contrast, from the beginning Mitnicks institutional approach focused on developing the core theory logics of agency that made it possible to generate statements about behavior in the real world, i.e., descriptive theory: How can we explain a series of diverse but commonly observed contexts of agent-principal relationships using the logics of agency theory? For example, under what conditions are lawyers, acting as advocates in conflict, more or less likely to reach settlement? Why do critics of the performance of public agencies focus on preventing self-enriching behavior by public employees rather than on the problem itself, relatively poor outcomes for the public interest? This emphasis on descriptive theory continued over the years. For example, Mitnicks more recent theory of testaments (Mitnick 1996/1998, 1999, 2000), a component of his institutional agency approach, addresses such questions as, why do selective colleges limit the number of recommendation letters from applicants? Why do organizations hire imperfectly trained employees? Why do incumbents have advantages that challengers do not, and what factors generate greater advantage than others? All of these apparently diverse circumstances can be understood by applying the logics of institutional agency theory. The first regular, non-proceedings journal article on agency as a general theoretical approach was published by Mitnick (1975b) in Public Choice in the Winter 1975 issue (end of 1975). The widely-cited work by Jensen and Meckling (1976) that proposed an agency theory of the firm was not published until almost a year later. In 1976 Mitnick published another article (1976a) that made use of his agency approach, this time applied to agency in the public sector, specifically in the context of the public interest and the use of public interest rhetoric in advocacy. Mitnick also presented several papers on agency during this period. He was invited by Oliver Williamson to present parts of his dissertation at Williamson's Organizations Workshop in October 1974 (Mitnick 1974b). He also presented papers on agency at the American Sociological Association meetings

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in 1975 and 1976 (Mitnick 1975a, 1976b). The distinguished political scientist Edward C. Banfield served on Mitnick's dissertation committee. Banfield passed away a couple of years ago, but two active members of the committee, the dissertation chair, Russell Hardin, now at New York University, and Stephen Elkin, now at the University of Maryland, are aware of Mitnick's dissertation work. Hardin is generally considered one of the leading political philosophers in the world today, known for his work in public choice, collective action, and trust; Mitnick was his first doctoral student. Elkin is a distinguished scholar in urban and political economy who was one of the founders of a prominent organization of political economists in the U.S., and remains one of its central figures. Thus, by the time the classic paper by Jensen and Meckling appeared in print in late 1976, Ross's economic theory of agency was widely known in economics, and Mitnick's institutional theory of agency had been published in two articles, used in a third by another scholar, and been presented at major meetings in three of the social sciences: economics, political science, and sociology. Although the Jensen and Meckling paper has had enormous influence in the literature, its occasional citation as the primary originating paper in agency theory is incorrect. Indeed, it actually originated a variant of an agency theory of the firm, not agency theory in general. Of course, the theory of agency did not appear, whole cloth, in the works of Ross and Mitnick in 1973. As noted above, key concepts were developed by scholars in economics, political science, and elsewhere in a variety of streams on the firm, on organizations, and on incentives and information, and were later incorporated into the agency approach. In addition, agent-principal language was employed in a number of works across the social sciences well before an explicit theory of agency was proposed. Thus it is important to both acknowledge the earlier work and recognize that it waited for the primary work by Ross and by Mitnick for the frame of reference to center on agency theory. For example, in the accounting and control literature, Cooper (1949, 1951) discussed agents inside the firm; in economics Downs (1957) referred to agents in his economic theory of democracy and Arrow (1963) referred to agents and to delegation to agents in his discussion of characteristic problems in medical care and the response of institutions to those problems; in political science, Pitkin (1967) and Tussman (1960) used agent-principal language in works on political philosophy; and, in sociology, Swanson (1971) described collective society using such terms. But in none of these works or in any other before Ross and Mitnick was there an explicit proposal for, or an actual theory of, agency. In the early 1970s, agency theory was, of course, unknown in political science and sociology before Mitnick, and it was not possible to publish articles with this theory logic in journals in these fields. Reviewers wrote that they had never seen anything like it, and thus it clearly was not sociology or political science. As a result, Mitnick published his work on agency in articles and books nominally focusing on other topics. As noted above, he used an agency approach in part of his paper on the public interest in 1976. He applied agency to regulation extensively. Among other applications of agency theory, his 1980 book introduced the study of delegation as the creation of agents in government.

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His edited book on Corporate Political Agency (1993) included both applications of agency theory and basic theory about agency relationships developed in the context of corporate political activity. Agency did not enter political science in a major way until Moe's article in 1984; did not enter sociology similarly until Shapiro's article in 1987; and did not become prominent in management work until after Eisenhardt's article in 1989. In all cases, Mitnick's work was cited, but it had appeared so many years before that these authors took their primary direction from the then-popular streams on agency in economics. Moe had been aware of Mitnick's work as long ago as 1978; Shapiro had many of Mitnick's papers and did make important use of them in her article; Eisenhardt had many of Mitnick's papers, including his original papers, but apparently did not consult them and actually cited Mitnick's work inappropriately as an application in political science rather than as the origination of the field. Mitnick's original work on agency has indeed been cited (e.g., Cook 1982; Galaskiewicz 1985; Spulber 1989; Spulber and Besanko 1992; Macey 1992; Waterman and Meier 1998; Krause 1999; there are many more), but it has remained far less known, especially in economics, than the work that originated with Ross and, later, continued with Jensen and Meckling. Recently, in a major assessment in the Annual Review of Sociology, Shapiro (2005: 4.9, 4.12) noted that a general theory of agency emerged in political science (Mitnick 1973) at the same time that it did in economics (Ross 1973), apparently independently. In a series of papers spanning at least 25 years, political scientist Barry Mitnick broke the monopoly on agency theory enjoyed by the economics paradigm and offered an alternative to the assorted baggage that comes with it. Mitnick continued to publish work using agency as a key theory logic, and to expand the theory itself.9 Although he eventually secured a contract from Cambridge University Press to publish his work on agency, the fact of his origination of the theory of agency seems to have faded in academic memory even as works using agency theory became commonplace across the social sciences. Because of the prominence of the Annual Reviews, Shapiro (2005) may begin a pattern of recalling this work in other responsible reviews of the literature. The literatures uncertainty about the origins of agency theory is reflected in the fact that there is no standard citation to its origin. When work using transaction costs is done, for example, Oliver Williamson is cited appropriately as its modern originator. When applications of agency theory are published, however, citations are inconsistent: Sometimes Jensen and Meckling (1976) is cited, although what they originated was an influential application to the theory of the firm, not the agency approach itself. Frequently, though not always, Ross (1973) is cited, although he deserves to be in every first footnote because of his critical role in originating economic agency theory. Mitnick (1973, 1975b) is cited far less frequently, although he originated the institutional theory of agency, including some of agency theorys most basic and familiar concepts and logics, and was the first to actually make explicit applications of agency theory to social institutions. Often there are citations to scholars who advanced agency theory or who

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made contributions using agency in the field of the application. Sometimes there are citations to outstanding scholars who made basic contributions to some of the core logics that are frequently applied in analyses of agency relationships, such as formal analyses of the behaviors or effects of risk distributions, incentive systems, control failures, and the like (e.g., Holmstrm 1979). But there is an extensive history of work on such topics. The key argument missing from all earlier work is that a general, powerful theory that applies to agency relationships should be developed, and that such a theory can generate statements about behaviors across the institutional settings of this type, not merely in one case such as the business firm. And, in surprising number of cases, there is no citation at all, as if after thirty-plus years the concepts of agency had passed into the common language of scholarship. After Ross (1973), people thought in terms of modeling economic agency relationships, not just in terms of incentives or compensation systems, which were indeed part of Rosss analysis, and which many scholars had, of course, written about in the past. Part of the logic of agency costs, including the adaptation of institutions to agency failures that may be rationally tolerated or worked around, can now be inferred, for example, in brief remarks in Alchians (1965) and Alchian and Demsetzs (1972) works on the firm, but there is no recognition of this as a general component of the understanding of how agency institutions in general are designed and function until Mitnicks work. No one had offered that a theory of agency, utilizing, combining, extending, and applying insights that had appeared across literature in economics, public administration, and political science would be a powerful, new way of viewing a very large class of social phenomena until Ross and Mitnick proposed just that. Thus, by the logic of discovery, Mitnick's origination of agency is anchored in his original creation of the proposal to create a major, integrating theory with this focus, and to actually begin that work, with both presentations and publications of record. For years after it appeared, there was nothing in the literature that even remotely approached the explicit and extensive applications that were in his early papers and publications. His work was by far the first to introduce and develop many of the key institutional arguments by which we know it today, e.g., the argument that institutions are shaped by the rational choice of the principal to not create perfect agency, when such creation would not be worth it. He also was the first to publish a non-proceedings article in a regular social science journal explicitly on the theory of agency. And the record is clear that his work was spread even in its early days across three of the social sciences 2.3 Developments of the Principal Agent Theory The disciplinary origins of agency theory come from economics, more specifically information economics (Eisenhardt, 1989, p. 59). According to Moe (1984, p. 756) agency theory was initially developed to investigate more general questions of incomplete information and risk sharing. The works of Spence and Zeckhauser (1971), Ross (1973), and Arrow (1971), who are usually mentioned as the originators of agency theory, have been discussed by other authors (see Jensen, 1983, p. 334; Moe, 1984, p.

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756; Eisenhardt, 1989, p. 58). The work of Alchian and Demsetz (1972), which focused on property rights and addressed issues concerning contracts, shirking and monitoring of team production, has been influential in the development of agency theory (see Jensen & Meckling, 1976; Fama, 1980). Since its birth, the development of mainstream agency theoretical research has developed along two lines, which are usually referred to as the positive theory of agency (a.k.a. positivist stream) and principal- agent (Jensen, 1983, p. 334; Eisenhardt, 1989, p. 59; Douma & Schreuder, 2002, pp. 109-110). The works of e.g. Ross (1973), Harris & Raviv (1978), Shavell (1979) and Holmstrm (1979) can be considered as early representatives of principal-agent literature. The work of Jensen &Meckling (1976), and the works of Fama (1980), and Fama and Jensen (1983) were examples of the emerging positive (or positivist) stream (cf. Jensen, 1983, pp. 334-335). The two streams share a common unit of analysis, that is, the contract between the principal and the agent, and some of the common assumptions of agency theory. Jensen (1983, p. 334) argues that both literatures address the contracting problem between self-interested maximizing parties and both use the same agency cost minimizing tautology (although not necessarily stated in that form). According to Eisenhardt (1989, p. 59), the two streams share common assumptions about people, organizations, and information. Despite their common assumptions and interests, the streams also differ in many respects. The principal-agent literature is generally more abstract, mathematical and non-empirically oriented. Principal-agent researchers are concerned about the general theory of the principal-agent relationship, a theory that can be applied to lawyer-client, landlord-tenant, and employer employee and other agency relationships. Characteristic of formal theories, the principal agent stream involves the careful specification of assumptions, which are followed by logical deduction and mathematical proof. The main focus is in determining which form of the contract is the optimal one (Jensen, 1983, p. 334; Eisenhardt, 1989, p. 60). The other stream, the positivist literature, is generally non-mathematical and more empirical in its orientation. Positivist researchers have focused more on identifying situations in which the principal and the agent are likely to have conflicting goals and then describing governance mechanisms that limit the agents self-serving behavior. Positivist researchers have focused more exclusively on intra-organizational principal-agent relationships, especially shareholder-manager relationships (Jensen, 1983, p. 334; Eisenhardt, 1989, p. 59). The principal-agent stream has also been developed further in the field of organizational and management studies. Especially influential have been the works of Kathleen Eisenhardt (1985; 1988). Eisenhardt developed theoretical and empirical means to motivate the agent in engaging in desired actions and to reduce the likelihood of shirking. By following the ideas of Ouchi and Maguire (1975) concerning organizational control, Eisenhardt developed the famous taxonomy between behavior-based and outcome-based contracts. Further, Eisenhardt also introduced a subset of agency variables to predict whether the optimal contract is behavior-or outcome-based in a given situation (see Eisenhardt, 1989). The positive theory of agency seems to have connected to a broader body of theoretical work: Organizational Economics (see e.g. Barney & Ouchi, 1986;

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Donaldson, 1990a; Barney & Hesterly, 1996).3 In addition to agency theory, Organizational Economics (OE) is composed of transaction cost economics (see Coase, 1937; Williamson, 1975; 1985) and property rights literature (Alchian & Demsetz, 1972). Although some other contributions of OE exist (see Barney & Hesterly, 1996), agency theory and transaction cost economics are clearly its best-known components. As the name implies, OE basically applies different economic models and assumptions to the field of organization studies. The primary focus of OE has been in explaining the existence and form of complex organizations (Robins, 1992, p. 524). Organizational economists, such as Barney and Ouchi (1986, xi), denote OE as the study of organizations and organizational phenomena using concepts taken from contemporary organization theory, organizational behavior, and microeconomics. Again, some of the fierce proponents of OE go further by defining it as an analytical paradigm, a framework that addresses the key determinants of the shape and function of organizations (Hesterly et al.1990, p. 403, italics in original). Regardless of the questions concerning OEs status, the role of agency theory in organizational economics has been twofold. While it has shared some of the assumptions of other theories, such as the bounded rationality assumption from Oliver Williamsons transaction cost theory (Williamson 1975), it has also contributed to the OE field by introducing concepts such as the agency relationship and the agency problem, for example. In particular, Jensen & Meckling (1976) have provided new insights and understanding with regard to agency relationships inside organizations, by viewing an organization as a nexus of contracts between individuals, and by introducing the concept of agency costs. Although the differences between the positive theory of agency and principal-agent stream mentioned above are notable, it is also possible to see these streams as complementary to each other: Whereas positive theory may identify the behavior of the agent and the various contract alternatives available, the principal-agent stream may indicate which contract is the most efficient in any given situation (Eisenhardt, 1989, p.60). In addition to economics, the field of political science has been especially active in applying and developing agency theory. Political scientist Barry M. Mitnick was probably the first scholar outside the discipline of economics to recognize the value of the agency framework (see Mitnick, 1975). In the late 1970s, inspired by the work of e.g. Ross (1973), Susan Rose-Ackerman (1978) distinguished the chain of agency relationships in politics-bureaucracy relationships. In the early 1980s, the work of political scientist Terry M. Moe also made an important contribution in analyzing the theory in different public sector settings. His seminal article The new economics of organization (1984) has been widely cited by scholars of different disciplines, including those in the field of economics (see e.g. Eggertsson, 1990) 2.4 Agency relationships Agency relationships are a general phenomenon. According to Ross (1973, p. 134), The relationship of agency is one of the oldest and commonest codified modes of social interaction and Arrow (1985, p. 37) considers agency relationship as a pervasive fact of

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economic life. Jensen and Meckling (1976) have also highlighted the general nature of agency relationship by the following arguments: The problem of inducing an agent to behave as if he were maximizing the principals welfare is quite general. It exists in all organizations and in all cooperative efforts at every level of management in firms, in universities, in mutual companies, in cooperatives, in governmental authorities and bureaus, in unions, and in relationships normally classified as agency relationships such as is common in the performing arts and the market for real estate. (Jensen & Meckling, 1976, p. 309.) In the broadest sense, whenever one party (the principal) depends on the action of another party (the agent), agency relationship arises (Pratt & Zeckhauser, 1985, p. 3). The basic reason for establishing an agency relationship is usually that the principal needs a certain task to be performed. The principal acquires the services of the agent typically because the agent possesses those skills and abilities that are needed for performing the task. The principal himself may either lack these skills and abilities or he is less effective in performing the tasks than the agent (Petersen, 1993, p. 278). 2.5 Types of Agency Relationship In most contexts agency relationships are reciprocal (e.g. in the patient doctor relationship), but they also could be coercive (e.g. in the master slave relationship). They often exist in private corporations and the market environment, but they also can be found in public bureau and hierarchical environments (Lassar & Kerr, 1996, p. 615; Worsham et al., 1997, p. 430; cf. Moe, 1984, p. 755; Eccles, 1985, p. 159, p. 167). Traditionally, agency relationships have been considered as contractual relationships (see Jensen & Meckling, 1976; Fama, 1980; Fama & Jensen, 1983). The contract was the central concept for the early agency theorists because it distinguished agency theory from classical and neoclassical economics, in which market forces act as a disciplining mechanism on the owner entrepreneurs who actively manage firms (Tosi et al., 1997, p. 584). In these contexts, contracts were broadly and vaguely understood to be governance mechanisms ranging in character from formal to informal, explicit to implicit, and objective to subjective (Barney & Ouchi, 1986, p. 211). Regardless of its character, the main purpose of the contract has been in (a) setting the tasks for the agent, and (b) introducing the means through which the agent will be compensated (Perrow, 1986, p. 224; Mason & Slack, 2003, p. 40). Thus, the contract in the agency relationship can be understood to be an instrument enabling different forms of co-operation and control between the principal and the agent. In fact, some scholars including Eisenhardt (1989, p. 58) and Bergen et al. (1992, p. 1) have seemingly interpreted the contract to be more like a metaphor of an agency relationship, not as a specific and detailed construct that should be rigorously operationalized. Agency relationships can range from single-principal-single-agent relationships to more complex multiple-principal-single-agent or single-principal- multiple-agent relationships (cf. Waterman & Meier, 1998, p. 178-180; Mason & Slack, 2003, p. 38). For example, one landlord (the principal) may have only one tenant (the agent), one car repairer (the agent) may have number of clients (principals) and the employer (the principal) may employ number of employees (agents).

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Also, principals and agents may have dual roles in a way that principals can act simultaneously as some other principals agents, and agents as some other agents principals. For instance, the chain of representation in parliamentary democracies can illustrate this aspect in following way: the legislators (parliament) are the agents of the citizenry, but also the principals of the government, which they elect. Likewise, the government is the agent of the legislators, but also the principal of the national bureaucracy. The national bureaucracy, in turn, is the agent of the government, but also the principal of the regional or local agencies (Vedung, 1997, p. 107) 2.6 Levels of Agency Relationships Agency relationships can be distinguished at a range of levels of human co-operation, from the levels of individuals, groups, or organizations (Smith & Bertozzi, 1998, p. 326). Traditionally, agency theory has been focused on examining the intra-organizational relationships between individuals (e.g. shareholder-manager, employer-employee) or organizational groups (shareholders-management teams). In addition to these intraorganizational analyses, a range of inter-organizational relationships has also been examined as agency relationships. Various scholars outside organizational economics have already used inter-organizational agency setting in their studies (see e.g. Ferris, 1991; Braun, 1993; Broadbent et al., 1996; Lassar & Kerr, 1996; Ferris & Graddy, 1998). In these studies, the organizational features of organizations acting as principals and agents have been bypassed and the main focus has been on examining the agency relationship and its behavioral effects on the actions of the principals and agents. This implies that neither the purpose nor the analysis of these studies have required exact definitions of what constitutes an organization or an organizational principal and that the assumption of organizational actors as principals and agents has mainly been taken for granted. Any arguments or analyses on why organizations could or could not be considered as principals and agents have therefore been lacking. It seems that early agency theorists have not yet clearly defined how the concept of organization should be understood. As the theory originates from economics, especially the versions close to Organizational Economics, applications of the theory have relied on methodological individualism for their organizational definitions and analyses (Donaldson 1990a, p. 371). As the name implies, methodological individualism takes an individualistic perspective of organizations. From this perspective, organizations are seen principally as aggregations of individual preferences and actions, perhaps even only as a nexus of contracts (Jensen & Meckling, 1976, p. 310; Pfeffer, 1997, p. 45) or institutional arrangements that govern the collectivity (Hesterly et al., 1990, p. 405). According to this perspective, the ultimate participants in organizational activity are individual human beings, who are and whose actions eventually are the units of all analysis. In this meaning, organizations are not individuals, they do not have their own preferences,

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motivations or intentions, and they do not exercise choice in the conscious and rational sense that is attributed only to individual people (Jensen & Meckling, 1976, p. 311; Jensen, 1983, p. 327). The organization is essentially a structure designed to harmonize a set of efforts of a group of people, but it can also be a legal fiction (Jensen & Meckling, 1976, p. 311), or a fictional person who can acquire, hold and dispose of property in its own right (Casson, 1997, p. 79). However, from the perspective of methodological individualism, the construction named firm or organization itself does not have a real personality independent from its individual members People are fundamental first in the sense of being indivisible decision makers and actors; it is people not organizations who actually decide, vote or act. The actions of individuals determine the behavior and performance of organizations. Furthermore, only the needs, wants, and objectives of individuals have ethical significance. Finally, it is the people who ultimately create and manage organizations, judge their performance, and redesign or reject them if this performance is found inadequate. (Milgrom & Roberts, 1992, p. 21.). On the other hand, understanding the organization as a principal or agent seems not to be a problem when the organization and its actions are explained through the actions of its individual members: Parenthetically, that organizational economics adopts a reductionist point of view does not mean that this view cannot be applied in the analysis of organizational phenomena. For some research questions, the theoretical assumption that firms have a goal or a purpose may fruitfully generate important Insights Even though organizational economists might ultimately attempt to explore the individualistic underpinnings of these aggregate phenomena, such research does not deny the value of a holistic simplifying assumption in generating the insight in the first place. (Barney, 1990, pp. 386-387.) It is possible to suggest that the theorys applicability from the original intraorganizational level to the inter-organizational level becomes a matter of concern only if the basic assumptions, concepts and conclusions derived from the original setting no longer hold in the inter-organizational setting. For this reason, the most crucial requirement for understanding organizations as principals and as agents requires the acknowledgement of some kind of organizational boundaries and set of purposes. This is because at the individual level, principals and agents are differentiated from other individual principals and agents by their observable boundaries and purposes. Therefore, the acceptability of organizational principals and agents requires that they have identifiable legal, economic and / or socio-cultural boundaries and agreed purposes so that they can be differentiated from other individuals, groups or organizations. Nevertheless, from the perspective of methodological individualism, these purposes (and the actions based on them) are to be considered only as aggregations of the preferences and actions of the individual member of an organization. Assuming the principals and agents to be organizations do not require an understanding

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of them as single-minded and homogenous entities with human characteristics. For this reason, there is no need to exclude the assumptions concerning intra-organizational differences of interests, goals and actions of individuals. For example, a human principal may also have a number of different and competing ideas on how to proceed in a certain situation with his human agent. Still, he has to choose some of these ideas to put into practice and has to abandon others. Equally in organizations, individual members of an organization may have different preferences, but only some of them will be put into practice as the aggregated will of the whole organization. 2.7 Assumptions about Agency Relationships The literature on agency theory presents a number of behavioral assumptions concerning the principal, the agent, and the agency relation Agency ship. It seems that some of these assumptions depend on different disciplinary and paradigmatic approaches, and they may even be contradictory. For instance, the positive agency theoretical literature usually shares the assumption of bounded rationality with transaction cost theory (Barney &Ouchi, 1986, p. 205; Eisenhardt, 1989, p. 64; Charreaux, 2002, p. 253). With bounded rationality, human behavior is assumed to be intensely rational, but only limitedly so (e.g. Simon, 1957, p. xxiv). When individuals are bounded rational, they recognize that they cannot possibly foresee all the things that might concern them. They understand that communication is imperfect and that understandings are often flawed, and they know that they are not likely to find the mathematically best solution to difficult problems. They act intentionally though, trying to do the best they can, given the limitations under which they work (Milgrom & Roberts, 1992, pp. 129-130). On the contrary, in the more formal, mathematically oriented principal-agent literature, individuals are assumed to be perfectly rational and to have unlimited computational abilities. Further, it is assumed that they can anticipate and assess the probability of all possible future contingencies (Baiman, 1990, p. 342). The principal and the agent are considered to be self-interested actors. Additionally, some of the agency theorists postulate principals and agents as utility maximizers whereas others do not (explicitly) make such an assumption. The utility maximization assumption is especially important for mathematically oriented principal agent researchers, because it allows different situations to be modeled and predicted mathematically in a way that would not be otherwise possible (Hendry, 2005, p. 57). Whether the agents are considered as utility maximizers or not, the assumed selfinterest of the agents drives them act opportunistically towards their principal (cf. Barney & Ouchi, 1986, p. 205). According to Oliver Williamson (1985, p. 47), opportunism refers to the incomplete or distorted disclosure of information, especially to calculated efforts to mislead, distort, disguise, obfuscate, or otherwise confuse. It is selfinterest seeking with guile which includes but is scarcely limited to more blatant forms, such as lying, stealing, and cheating (Williamson, 1985, p. 47). Some agency theorists have also made assumptions about the risk preferences of the principal and the agent. The risk

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preference can be than security. A risk-averse actor prefers security and therefore seeks some guarantee for the attainment of desirable outcomes. A risk neutral actor, on the other hand, is indifferent to adventure or security (Bergen et al., 1992, p. 4; see also Pratt, 1964; Arrow, 1971). Usually it is assumed that the principal is neutral towards the risk and the agent is averse to risk. The rationale is that the agents, who are usually more unable to diversify their employment, are likely to be more risk-averse than the principals, who are usually more capable in diversifying their investments (Eisenhardt, 1989, pp. 60-61; Bergen et al., 1992, p. 4; Radner, 1992, p. 1406). One important and widely accepted assumption is that agents differ in their types. The type of agent may refer to such things as whether the agent is careful versus careless, productive versus unproductive, talented versus untalented, trustworthy versus untrustworthy, industrious versus lazy, and so forth. In short, it says something about the agents willingness and capacity (i.e. ability) to perform the tasks agreed on. (Petersen, 1993, p. 278.) It is also generally assumed, that in addition to the agents actions (a.k.a. effort), environmental factors influence the outcome of the agency relationship (see e.g. Harris & Raviv, 1978, p. 21; Shavell, 1979, p. 55; Arrow, 1985, p. 37; Petersen, 1993, p. 278). The outcome is usually somehow observable to both to the agent and the principal, and it could also have many facets, such as quality and quantity. It can be, for example, the number of shoes produced by a factory worker, the volume of sales generated by a department store salesperson, the success of a surgical procedure, and so forth. Environmental factors (a.k.a. random factors) such as economic conditions in the market, competitors actions, and the weather are issues or conditions that are customarily beyond the agents and principals control. (Bergen et al., 1992, pp. 3-4; Petersen, 1993, pp. 278 279.) Most of the agency theoretical literature adopts two very important assumptions concerning the agency relationship. There must be (a) informational asymmetries and (b) goal conflicts simultaneously present in the agency relationship (e.g. Moe, 1984, p. 754; Eisenhardt, 1989, p. 58; Barney & Hesterly, 1996, p. 125; Waterman & Meier, 1998, p. 177). Informational asymmetries can simply be considered as a claim that an agent possesses more or better information about the details of individual tasks assigned to him, his own actions, abilities and preferences (cf. Eggertsson, 1990, p. 41). The level of informational asymmetries does not need to be stable; it can vary from one situation to the next. The basic requirement is though, that the principals have to face difficulties in acquiring the information possessed by the agent. The other assumption, of goal conflicts, can be understood as a situation where the principals and the agents desires and interests concerning certain ends are in conflict with each other and that they would therefore prefer different courses of action. From the perspective of agency theory, goal conflicts arise because of the agents selfinterest and the tendency to maximize or pursue his individual utility. Conflicts between the principals and the agents goals do not have to be permanent or constant, but there

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must be a certain potential for them to occur (Milgrom & Roberts, 1992, p. 185). 2.8 The Roles of Agency Theory Management Agency theory has become a cottage industry that explores every permutation and combination of agency experience in the corporate form. Because the work is largely empirical, it by necessity relaxes some of the assumptions of classic agency theory in economics and business management even in the management literatures, specialized academic and applied practitioner journals, the business press, even corporate proxy statements by the early 1990s, representing a new form and becoming the dominant institutional logic of corporate governance (Zajac &Westphal 2004). Corporations announced the adoption of new policies, explicitly invoking agency theory buzzwords about aligning incentives, discouraging self-interested behavior by managers, and reducing agency costs. Indeed, some adopted new policies that embraced an agency rationale without bothering to implement them, simply jumping on the bandwagon of a socially constructed institutional logic that bestowed increased market value on symbolic declarations alone (Zajac & Westphal 2004). Despite the fascinating case study in social movements (Davis & Thompson 1994), the diffusion of innovations, and the sociology of knowledge that these developments offer, they also had a significant impact on the intellectual agenda of the academy, spawning a massive empirical literature in management and organizational behavior. Agency theory has become a cottage industry that explores every permutation and combination of agency experience in the corporate form. Because the work is largely empirical, it by necessity relaxes some of the assumptions of classic agency theory in economics and business management. The most popular stream of literature focuses on incentive alignment, particularly compensation policies. Empirical studies consider the types and correlates the literature also includes studies of the process and costs of searching for agents, especially in light of the tensions posed by adverse selection. Another major body of scholarship considers the agency problems, agency costs, efficacy, and trade-offs of different control mechanisms as they intersect and vary by Length of principal-agent relationship; Organizational structure and form (e.g., headquarters and subsidiary, outsourcing) Characteristics of industries, organizations, and employees (e.g., technologies, Product demand, diversification, venture capitalist-entrepreneur relationships, Family firms, cultural distance between sites, employee education, Skill levels, amount of specialized knowledge, autonomy, etc.);

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Programmability of the task, or how well the required behaviors can be Precisely defined (Eisenhardt 1989); and Organizational environments (e.g., turbulence).

Also coursing through this literature is a debate, sketched earlier, between those who adopt the skeptical, even paranoid, assumptions of agency theory and the costly control mechanisms it propounds and those who have a more hopeful view of human capacities for other-regarding behavior and altruism and argue that agency costs can be mitigated by organizational structures that foster reciprocity, cooperation, embeddedness, and trust (Donaldson 1990, Wright&Mukherji 1999). Political Science In exploring the delegation of power and authority in political and government institutions and international organizations, political scientists take agency theory outside of the economic marketplace and the constricting web of assumptions that shroud the economic theory of agency. The political system can, of course, be understood as a complex network of principal-agent relationships compose of citizens, nation states, elected officials, lawmakers, members of the executive branch, administrative agencies, courts, international organizations, ambassadors, bureaucrats, soldiers, police officers, supervisory officials, civil servants, patronage appointees, and even those who monitor other agency relationships inside political institutions and in the market. These actors concurrently play principal and agent roles within and across political organizations. A general theory of agency emerged in political science (Mitnick 1973) at the same time that it did in economics (Ross 1973), apparently independently. As we have seen, the latter took off spectacularly, becoming quickly institutionalized in an academic literature, specialty journals, and corporate ideologies and practices The former languished (Moe 1984), developing belatedly as rational choice theory made inroads into political science. As a result, agency theory in political science borrows heavily from the economics paradigm rather than the more sociological conception offered by Mitnick (1973) or even classic works, such as Weber on bureaucracy (Kiser 1999). The vague outlines of the agency paradigm in political science are the same as those in the classic version: Principals delegate to agents the authority to carry out their political preferences. However, the goals of principals and agents may conflict and, because of asymmetries of information, principals cannot be sure that agents are carrying out their will. Political principals also face problems of adverse selection, moral hazard, and agent opportunism. So principals contrive incentives to align agent interests with their own and undertake monitoring of agent behavior, activities that create agency costs. The details are quite different, however, for many of the reasons considered earlier. Political scientists assume multiple agents and principals; heterogeneous preferences or goal conflict and competition among principals and among agents as well as between

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them; problems of collective action; a more complicated palate of interests and therefore different incentives mobilized to control them; varying sources of and mechanisms to mitigate informational asymmetries; an active role for third parties (interest groups, regulated parties, etc.); and a dynamic playing field on which relationships unfold and are transformed. Political scientists also consider a more diverse set of scenarios for delegating power beyond those inherited from the economics paradigm. Principals ma delegate to another to enhance the credibility of their commitments, for self-binding (to ensure their long-term resolve in the face of immediate temptations), or to avoid blame for unpopular policies. These scenarios call for a very different agency contract. Instead of providing incentives and sanctions to align the interests of agents with their own, principals seeking credibility from their agents select agents operating at arms length, with very different policy preferences, and confer considerable discretion and autonomy to them. These agency contracts grant independence while still seeking to insure accountability (Majone 2001). Early literature in political science on the iron law of oligarchy, the iron triangle (between Congress, regulatory agencies, and regulated interests), regulatory capture, and bureaucratic drift all give voice to some of the intrinsic difficulties of principal control in political institutions. More recent work employing an agency theory perspective ranges from appellate review of lower court decisions to political corruption and presidential decisions to use force. The largest literatures examine state policy implementation, the relationship between elective institutions and administrative agencies (especially legislators and bureaucrats), and government regulation. Principal-agent perspectives are also commonplace in examinations of international organizations (e.g., central banks, international courts, the European Union) in the literature on comparative politics and international relations. Political scientists devote far more attention than economists to the details of how principals control agents. There is some work on the selection and recruitment of agents, the role of patronage political appointments, and the impact of civil service requirements on adverse selection and more on how principals specify their preferences. A body of work considers statutory control (i.e., detailed legislation) and how lawmakers craft legislation to restrict the discretion of those charged with its implementation, specifying administrative structures and procedures to constrain the decision-making process (McCubbins et al. 1989). There are literatures on political oversight and monitoring, including ways in which principals opt for reactive over proactive oversight, relying on third-party monitoring by affected interest groups or the targets of their legislation to detect and report on noncompliance (so-called fire alarms or decibel meters). There is more attention in political science than in economics to the role of sanctions budget cuts, vetoing rules or agency actions, reversing court decisions firing officials or voting them out of office, requiring agency reauthorization or threatening recontracting, etc. perhaps because, as

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noted earlier, it is far less easy to align incentives without the financial inducements that flow through economic organizations. The literature also considers the matter of agency costs; when they are too high, principals may decide not to squander resources on them (Mitnick 1998, Banfield 1975). Because politicians may not directly feel the consequences of self interested, opportunistic agents shirking or undermining their interests (what political scientists call slack, slippage, or bureaucratic drift), the costs of which are generally passed along to the public, monitoring activities may be more lax in political arenas (Waterman & Meier 1998). Law Long before there was a theory of agency, there was a law of agency. Indeed, it was not until the twenty-first century that the Restatement of the Law, Agency (American Law Institute 2001) replaced master/servant with employer/employee. The law of agency encompasses the legal consequences of consensual relationships in which one person (th principal) manifests assent that another person (the agent) shall, subject to the principals right of control, have power to affect the principals legal relations through the agents acts and on the principals behalf (American Law Institute 2001, p. 1). Agency doctrine defines the legal obligations that principals have with third parties for action that agents took on their behalf. The principal, for example, may be bound to contracts and transactions made by the agent and may be vicariously liable for some instances of the agents misconduct (DeMott 1998, p. 1038). Because principals will be held responsible for the actions of their agents, the law also attends to the sources of agent authority, clearly demarcating what constitutes an agency relationship, the rights of principals to control their agents, and the fiduciary duty and other obligations that agents owe their principals (Clark 1985). Agency theory borrows jargon from agency law, but adopts neither its definition nor its central focus. The legal definition of agency is much more narrow even than that employed in the economics paradigm of agency theory, let alone that found in the other social sciences. Agency does not encompass situations in which the agent is not subject to a right of control in the person who benefits from or whose interests are affected by the agents acts, who lacks the power to terminate the agents representation, or who has not consented to the representation (American Law Institute 2001, p. 2). Generally, the alleged agent and principal have met each other face to face, or have talked on the telephone, or have otherwise communicated with each other in a specific, individualized way. Courts trying to determine the scope of their relationship often scrutinize the actual course of dealings between the particular parties and try to determine what their actual understanding of their particular relationship was (Clark 1985, p. 58). The relationship between a corporations shareholders and its directors, for example, does not fall within the legal definition of agency, notwithstanding the centrality of this relationship in economic agency theory. Principal control is critical in the law of agency because of its focus on third parties and

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the concern that when third parties make agreements with agents or are hurt by agents, their principals will be bound or held responsible. But it is the control itself that the social sciences make problematic. Therefore, it cannot be defined away by looking only at the point along a continuum where control is absolute. Moreover, central questions in the social sciences about the nature of the contract between principal and agent, the mechanisms by which the former control the latter, and strategies to contain agency costs are rather peripheral in the law of agency. Still, when the two paradigms do intersect, the law of agency provides rich grist for the social scientists mill for example, when legal scholars look to the mechanisms by which principals select their agents; the private norms, instructions, and messages the principals convey; the nature of the incentives they offer; and the care they take to monitor the behavior of agents to determine whether corporations should be held vicariously liable for the criminal conduct of their employees (DeMott 1997). The law offers normative understandings of agency relationships and lots of data (if tainted by selection bias), especially when they fail. But it offers little else. Sociology Although economists may speak of the agency problem, agency is in fact a solution, a neat kind of social plumbing. The problem is the ancient and ineluctable one of how to attain and maintain control in order to carry out definite, yet varying purposes (White 1985, p. 188). In his comparative analysis of agency theory applications to state policy implementation in economics, political science, and sociology, Kiser (1999) observes that, compared to the other two disciplines, the use of agency theory in sociology is in its infancy and comes from a rather different intellectual genealogy (p. 162), largely the work of Weber (1924/1968). [See Kiser (1999) for an illuminating analysis that traces the linkages between abstract components of classic agency theory and Webers work on the relationship between rulers and their administrative staff. Empirical work in sociology that explicitly adopts an agency theory perspective (aside from that described earlier in the organizational behavior and management literatures) can be found in the most unexpected of placesin qualitative comparative historical sociology. In imaginative and richly textured case studies of such things as European colonialism in seventeenth and eighteenth century Asia, Chinese state bureaucratization that occurred two millennia before any of the European states, early modern tax farming, and types of corruption in pre modern Asian tax administration, we learn about the tensions between principals and agents, conflicting interests, opportunism, informational asymmetry, agent selection, monitoring, sanctions, incentives, and agency costs (Adams 1996, Kiser 1999, Kiser & Cai,2003). This work links social structure to types of agency relations, and it demonstrates how different combinations of recruitment, monitoring, and sanctioning practices yield different administrative systems. This literature is certainly a far cry from the abstract mathematical models of principal-agent theory in economics. It is puzzling that agency theory is not invoked elsewhere across the sociological landscape in places one would

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think would be more hospitable. Perhaps, like me, few sociologists feel comfortable putting the words agency and theory side by side and find the classic paradigm, its assumptions, and the research questions it inspires off-putting and simplistic. But that has never been our only choice. As long as there has been an economic theory of agency there has been a more sociological alternative. In a series of papers spanning at least 25 years, political scientist Barry Mitnick broke the monopoly on agency theory enjoyed by the economics paradigm and offered an alternative to the assorted baggage that comes with it. Agency, he argued (Mitnick 1998, p. 12) is simply a general social theory of relationships of acting for or control in complex systems. Agency relationships have two faces, Mitnick observed: the activities and problems of identifying and providing services of acting for (the agent side), and the activities and problems of guiding and correcting agent actions (the principal side). Of course, both faces of agency entail costs and at some point it does not pay for principals or agents to perfect their behaviors. So perfect agency is rare, and deviant behavior is likely to persist and be tolerated. Agency theory, then, becomes a study in the production, the persistence, and the amelioration of failures in service and control (Mitnick 1998, p. 12), a kind of Murphys Law (Mitnick 1992, p. 76). Mitnicks work repeatedly shows the links between agency theory and sociological literatures from exchange theory to norms, networks, authority, organizations, social control, regulations, social cognition, and so on. Yet it, too, is rarely cited in sociological literature. The problem may be that acting for relationships are too general, embracing too much of what is enacted on our turf. Perhaps sociologists have been studying agency all along and just didnt know it. In the remainder of this essay, I focus on several sites across the social landscape where making agency relationships problematic seem likely to provide the most theoretical purchase. Agency or acting for relationships arise from a number of sources, including: 1. The division of labor; we simply do not have time to do everything ourselves (even hunting and gathering), and complex tasks often require more that one actor [Mitnick (1984) calls this practical or structural agency 2. The acquisition of expertise or access to specialized knowledge Mitnick (1984) labels this contently agency 3. The bridging of physical, social (e.g., brokering or intermediation), or temporal distance [Adamss (1996) study of colonialization provides an example of the challenges of the former; for the latter, see Majones (2001) discussion of time-inconsistency]; and 4. The impulse to collectivize in order to enjoy economies of scope and scale or protection from risk [Mitnick (1984) calls this systemic or collective agency]; many of these relationships (pensions, insurance, investments, etc.) are what I have called futures transactions that demand that commitment be conferred far in advance of payoff without any necessary confirmation during the interim that the return on investment will ever be honored (Shapiro 1987, p. 628). These varied occasions for agencyespecially the last three, in which a formidable physical, social, temporal, or experiential barrier separates principal and agentpose different agency problems. Several exacerbate problems of

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asymmetric information; others contribute to adverse selection; some create collective action problems among multiple principals; others provide easy cover for moral hazard and opportunism Professions The assumptions of the principal-agent paradigm are stretched where principals seek out agents for their specialized knowledge. Sharma (1997) observes that run-of-the-mill information asymmetry (not knowing what the agent does) is exacerbated in encounters with professionals by knowledge asymmetry as well (not knowing how the agent does a job). Adverse selection is a special problem because principals are unable to evaluate the skills of prospective agents. Principals also have a difficult time specifying an agency contract because they may not know what expert services are required or how much of them, what procedures ought to be followed, or what criteria are appropriate to limit agent discretion. They also have difficulty evaluating the quality of service because indeterminacy intrinsic in highly specialized tasks (Sharma 1997, p. 771). Some patients get better despite their physicians; the clients of superb lawyers sometimes lose; and bright, curious, conscientious students may become great sociologists despite incompetent or opportunistic professors. Professions provide the solution to these agency problems. They boast careful and competitive selection procedures. They offer training and credentialing, licensing, recertification, and mandatory continuing education to solve the principals problem of adverse selection. They may even establish protocols or specify best practices to limit agent discretion. They create ethics codes to curb the self-interest and opportunism of practitioners. Because principals are unable to determine when they have received exceptional or substandard service, professions self-regulate in varied settings (among peers, within service organizations, within professional associations, and by disciplinary bodies). And professions often offer or promote malpractice insurance to protect principals from the errors or misdeeds of honest and incompetent agents alike. Insurers often provide incentives, stipulate mandatory procedures, and provide loss prevention services to their insured adding yet another level of regulation (Heimer 1985, Davis 1996). Professions, then, are social devices to limit agency costs. Finance In Finance perspective, refers to a practice where one party represents another in the transaction of activities (Nemmers, 1990). With respect to corporate control, agency refers to management's representation of the board of directors in the conduct of a firm's business, and to the representation of stockholders in the corporation by the board of directors in the conduct of the firm's business (Alchian, and Woodward, 1988). PrincipalAgent theory in corporate control and corporate financial management. Specific interest is directed toward the effects of agency theory on dividends, capital structure, capital

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budgeting, and mergers. Some theorists, researchers, and observers contend that evolution in the contemporary financial environment have created conflicts between shareholders and their agents, wherein shareholder interests are no longer always accorded preference (Morck, 1989). Others, however, contend that economic agency is an efficient form of organization, because a corporation has no "owners in a meaningful sense" (Fama, 1980, 288). The corrective likely lies at some point between these two views. Communication between corporate management and shareholders is also an important part of agency. Among other things, agency theory holds that a conflict may exist between objectives of (1) maximizing shareholder wealth, and (2) maximizing management's compensation (Barnea, Haugen, and Senbet. 1981) Human Resource The recent shift of the HRM field toward a more macro orientation has resulted in significant and important contributions to the field. However, as a function of the "newness" of this area of study, the work has been somewhat limited in its development of an underlying construct. Rather than considering an organizational level "people management" construct, to date, researchers have emphasized the activities of the HRM department. These HRM strategies or "bundles" of practices may represent something that occurs at the organizational level, or they may not. As a result, we are still not sure what strategic human resource management really represents, which leads to a number of serious problems in the areas of theory development and measurement (Dyer and Kochan, 1994). The use of Principal-Agent theory and the sample of IPO firms lead to an organizational level conceptualization whereby administrative HRM is but one of three forms of control that can be manifested in organizations. Although the field of HRM is changing rapidly and many researchers are calling for a more strategic function, many HRM departments still adhere to a bureaucratic control model in which administrative activities are paramount (Beer, 1997; Mohrman, Lawler, & McMahan, 1996; Golden & Ramanujam, 1985). This administrative form of HRM is consistent with bureaucratic control as suggested by agency theory. In this study, we assess the effect of this "older" form of HRM on firm performance. This will, in turn, have implications for the study of the more strategic mode of HRM that is currently being proposed by many HRM strategists (e.g. Ulrich, 1997). Corporate Governance In Corporate Governance. It begins with the influential role that agency theory has played both in the conception and reform of corporate governance. Its grounding assumption of self interested opportunism leaves little or no room for ethics beyond what pays. This conception is then contrasted with a Foucauldian view of governance in which ethics is explored in terms of how an ethic of shareholder value has been promulgated in the last decade. The third section of the paper explores the contemporaneous explosion of interest in corporate ethics and social responsibility and suggests that there is a nascent

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disciplinary regime being assembled which may redefine the terms of shareholder value to include environmental and social performance. What is uncomfortable about these accounts of how an ideal of both shareholder value and responsibility is made to play upon the minds of directors is that ethics comes to be understood and practiced in terms of how the self is seen the ethics of narcissus. The final concluding part of the paper suggests that ethics, following Levinas, should be understood in terms of sentience and the responsibility for my neighbor that this assigns. Such a view of ethics refutes the individualism that agency theory take as a given of human nature, and Foucauldian analysis suggests is the product of disciplinary processes. Its grounding in sentience and proximity however offer it only a local role in corporate governance. (Dyer and Kochan, 1994). 2.9 Corporate Considerations Corporations enjoy four major benefits over other organization forms such as limited liability, permanency, transferability of ownership, and access to capital. These benefits, however, are available because the corporate structure separates ownership from control. Stockholders, the owners of a corporation, do not directly control the interests of a firm. They hire managers to act on their behalf, the classic principal-agent relationship. However, the relationship is actually a bit more complicated. The owners do not hire the employees of a company themselves. They actually hire top managers, human resources department, and others to hire people to act on behalf of the owners. This complexity can be illustrated further with the set-of-contracts theory of corporate structures. This theory states that organizational relationships are complex with many potentially conflicting legal and moral obligations to stakeholders. The ability to ensure that principalrelationships positively impact each stakeholder rests on the individual relationships that make up the entire system of agency created by the complexity of corporate relationships.

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Chapter 3 3.1 Principal-Agent Problem A disconnection or conflict between the objectives and goals of the principal and those of the agent authorized to represent the principal. The principal-agent problem arises because an agent is given the responsibility and authority to take actions that affect both the principal, but can also affect the agent. This problem is common in corporate management, where the principal is shareholders and the agent is managers. It is also common in government, where the principal is the public and the agent is elected leaders. The principal-agent problem occurs when one person (the principal) authorizes another person (the agent) to act on their behalf. But the agent then undertakes actions that are not necessarily in the best interests of the principal, but are in the best interests of the agent. In particular, the agent might pursue the satisfaction of personal utility, which conflicts with the maximization of utility of the principal. These examples illustrate the principalagent problem. This is the problem of designing mechanisms that will induce agents to act in their principals' interests. In general, unless there is costly monitoring of agents' behavior, the problem cannot be completely solved. Hired managers (like hired gardeners) will generally wish to pursue their own goals. They cannot ignore profits, however, because if they perform badly enough they will lose their jobs. Just how much latitude they have to pursue their own goals at the expense of profits depends on many things, including the degree of competition in the industry and the possibility of takeover by more profit-oriented management. 3.2 Agency problems The existence of informational asymmetries and goal conflicts can be considered as the spark plugs of agency theory (Waterman & Meier, 1998, p. 177). Taken together, these two conditions constitute the agency problem the possibility of opportunistic behavior on the agents part that works against the welfare of the principal (Barney & Hesterly, 1996, p. 125). Clearly, if there were no goal conflicts the existence of informational asymmetries would not matter and the agent would automatically choose the actions which would accord with the preferences of the principal. Indeed, the assumption and existence of goal conflict is necessary for agency theory. If the utility functions of self-serving principals and agents coincide, there would be no agency problem (Davis et al., 1997, p. 22). Similarly, if the information available to both the principal and the agent were to be the same, the conflicts of interest would not matter since the principal could immediately detect any opportunistic behavior on the part of the agent (Ricketts, 2002, pp. 46-47). Agency theory suggests that at least two different forms of agent opportunism exist: precontractual (ex-ante) opportunism and post contractual (ex-post) opportunism (Milgrom & Roberts, 1992, p. 150; p 167; Williamson, 1985, p. 47; Barney & Ouchi, 1986, pp. 439-440). These two specific aspects of the agency problem are known as adverse

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selection and moral hazard problems (e.g. Arrow, 1985, p. 38; Eisenhardt, 1989, p. 61; Petersen, 1993, pp. 280-281).6 Given the agency problems described, it can be assumed that principals will not delegate tasks to agents unless they find some important reasons to do so. However, when these important reasons exist and an agency relationship is to be established, the following two normative questions can be formulated: How can a principal detect the right type of agent for accomplishing a task? How can a principal make the agent behave according to the principals goals? The first question refers to the problem of adverse selection, the second question to the problem of moral hazard. 3.3 The Problem of Adverse Selection The problem of adverse selection addresses the problems that arise because of informational asymmetries which occur before the principal enters into an agency relationship with the agent. The principal is assumed to know the nature of the tasks the agent should perform and the personal characteristics needed to perform those tasks successfully (Bergen et al., 1992, p. 6). However, in situations of adverse selection, problems evolve from the principals uncertainty regarding the agents true type. The problem of adverse selection can be developed when the agent has private information about his type that the principal cannot obtain freely. This private information together with the agents self-interest may create incentives for agents to misrepresent themselves opportunistically as something that in reality they are not (cf. Barney & Ouchi, 1986, pp. 439-440.) In practice, the problem of adverse selection may take place, for example, in job markets. Job applicants usually differ in their types and employers do not always discern the job applicants true type. Employers, for instance, may be unable to observe job applicants intrinsic productivity, and cannot rely on prospective workers pronouncements regarding their own attributes since all workers tend to claim that they are highly able. Hence, employers may end up hiring employees of the wrong type. Similar problems may arise in any buyer seller situation. If it is impossible for a buyer to observe the quality of a particular good at the time of purchase, sellers may be tempted to lower the average quality of the goods and sell them at higher price than the true quality of the goods would justify (Brown & Sessions, 2004, p. 59). Without any countermeasures to reduce informational asymmetries, the adverse selection problem may lead to a lowering of the average quality of agents or of the products they are offering. High quality agents may want to withdraw themselves from markets if their quality is impossible to recognize without additional cost. This problem was first highlighted by Akerlof (1970), who showed that the process would continue until only the lowest quality agents were available in the market. Akerlof used the example of a second-hand car market, where information asymmetries are usually high: the owner of a used car is better informed about its quality than a potential

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buyer who is often unable to discern whether the car is a low-quality lemon or a highquality peach. The more lemons there are on the market, the lower the average quality and the market price for all cars will be of both good and bad quality cars. Faced with such a situation, the owners of good quality cars may find it unattractive to sell their cars and they may withdraw them from the market. (Brown & Sessions, 2004, pp. 59-60.). Expanding effort and attention may reduce sometimes the information asymmetries responsible for an adverse selection problem. This can be carried out through mechanisms called screening and signaling (e.g. Bergen et al., 1992, pp. 6-7; Milgrom & Roberts, 1992, pp. 154-159; Ricketts, 2002, pp. 32-33). The major difference between them depends on whether it is the agent or the principal who makes the first move. In screening, the principal makes the first move and chooses to implement some set of information-gathering procedures in order to determine accurately a potential agents true type (e.g. Bergen et al., 1992, p. 6; Milgrom & Roberts, 1992, p. 156). For example, an employer may use job interviews and probationary periods in order to learn about a job applicants true type. Additionally, he may require letters of recommendation or he may track down the applicants previous employers in order to find out if they had been satisfied with the job applicants work contribution (Bergen et al., 1992, p. 6; Petersen, 1993, p. 280). Screening is most likely to be an efficient solution when it is relatively easy for 21 the principal to obtain information about the types of potential agents. Hence, screening is most likely to be used extensively when measures of agents types have proven to be valid predictors of their future performance and when those measures are obtained by the principal with relatively little effort or expense. Even when screening is very costly, it may still be the best solution for adverse selection problems if the consequences of a hiring a bad type of agent would be even more costly to the principal. Such is likely to be the case in situations where differences in the type of agent can have a substantial impact on the outcome desired by the principal. (Bergen et al., 1992, p. 6.) In signaling, agents themselves make the first move by adopting behavior that reveals their private information. Given that the agent knows he has certain desirable capabilities, and that it is to his advantage to be offered a contract, the agent may engage in actions aimed at signaling to the principal that he is the type of agent the principal is seeking (Bergen et al., 1992, p. 6). For instance in job markets, job applicants signal their private information to the labor force-seeking employer e.g. by presenting references from former employers, and diplomas or other educational achievements (Spence, 1973, p. 357). The employer could interpret these expressions as signals of the job applicants true type. On the other hand, it is also possible that the agent can find it in his self-interest to send the principal false signals. This would be the case if the benefits or utility the agent can derive from misleading the principal exceed the costs of engaging in the action necessary to send a false signal. Therefore, for an action to provide a signal that is reliable from the principals perspective, it must be more costly to pursue for a bad quality agent than it is

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for a good quality agent. In another words, to be effective, signaling must not only be incentive-compatible for agents of the desired type to be engaged in signaling, but also incentive-compatible for inappropriate types of agents to avoid the signaling. (Bergen et al., 1992, pp. 6-7.) For instance, a company that desires a technically competent and knowledgeable sales force might require a lengthy and rigorous training period for all new recruits. Potential employees who lack the necessary technical competencies or the motivation to acquire the desired knowledge could self-select themselves out of a relationship with the company by not applying for the job or by dropping out before completing the training. On the other hand, the employees who possess the technical competencies and good motivation can signal their type by completing the training. Another example could be found from pay systems. Paying a wage that is based solely on measured performance is likely to attract the most productive job applicants and to discourage the least productive, to the employers benefit. (cf. Bergen et al., 1992, p. 7; Milgrom & Roberts, 1992, pp. 156-157.) 2.3.2 The problem of moral hazard Once the principal has chosen an agent to perform a task, the next problem for the principal is to get the agent to perform this task in the way preferred by the principal. This post-contractual agency problem of moral hazard may arise in situations where the principal cannot directly observe the agents actions and where the self-interested agent pursues his private goals at the expense of the principals goals (Barney & Ouchi 1986, 440; Milgrom & Roberts, 1992, p. 167; Petersen, 1993, p. 281, p. 284.) Indeed, when it is difficult for a principal to monitor the agent, the moral hazard problem assumes that there is a tendency for an agent to produce poor quality / quantity outcomes or to exercise too little effort, care or diligence in providing the outcomes (cf. Milgrom & Roberts, 1992, p. 167). Concrete aspects of the moral hazard problem may include shirking or other forms of private utility-generating actions, which are not in the best interests of the principal. These could include e.g. the following: taking home company stationery for personal use, printing or making photocopies of personal documents at the office, making personal calls during office hours, charging cell phone batteries in the office, surfing the internet for private matters during office hours, requesting and purchasing state of the art equipment even though the basic equipment would be sufficient, and giving projects or contracts to friends and relatives even though there would be more competitive providers available (Tan, 2003). Self-interest can also make the agent reluctant to share performance information with the principal, or even worse, to motivate the agent to send wrong information to the principal (Bergen et al., 1992, p. 3; Milgrom & Roberts, 1992, p. 167). Moral hazard problem occurs, for instance, when a highly skilled laboratory researcher works on a new per Agency

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personal business idea on company time, but the work is sufficiently complex that the superiors cannot detect what he is actually doing; or, when managerial employees exaggerate the difficulty of their assignments in order to make their performance appear more impressive. (Eisenhardt, 1989, p. 61; Milgrom & Roberts, 1992, pp. 169-170.) The principal has two basic options in seeking to control moral hazard in terms of the contracts to be agreed upon: behavior-based contracts and outcome-based contracts (Eisenhardt, 1985, p. 163; 1988, p. 490; 1989, pp. 59-60). When choosing behavior-based contracts the principal chooses to monitor the agents behaviors (actions) and then reward those behaviors. The basic idea behind monitoring is to decrease the information asymmetry between the principal and the agent. The argument is that monitoring procedures are likely to inform the principal about how the agent is actually behaving, and therefore they are likely to curb agent opportunism because the agent will realize that he cannot deceive the principal without the risk of getting caught (Eisenhardt, 1989, p. 60). Thus, a natural solution for the principal is to invest resources into the monitoring of the agents actions (Holmstrm, 1979, p. 74). These investments may include reporting procedures, budgeting systems and field observations, etc. (Eisenhardt, 1989, p. 61; Bergen et al., 1992, p. 4). An example of a behavior-based contract could be the creation of a supervisory role by the management (the principal) to monitor the behavior of those workers (the agents) paid an hourly rate (Sharma, 1997, p. 761). In some situations, the monitoring procedures may be too expensive or difficult to be worthwhile. In these situations, the other option, namely outcome-based contracts, could be a more logical choice for the principal. As the name implies, outcome-based contracts compensate agents for achieving certain outcomes. As a concrete example, reward schemes such as piece-rate salaries or straight commissions can be considered as forms of outcome-based contract. Outcome-based contracts are considered to be effective in curbing the possibility of an agent acting in an opportunistic way. The rationale is that such contracts are likely to reduce goal conflict because they motivate the agent to pursue outcomes that are incentive compatible with the principals goals. Therefore, the contract should be designed in a manner that the actions with the highest payoff to the agent are also those actions that are most appropriate from the principals viewpoint. For instance, if the goal of a company is to increase sales volume, offering a commission would be one way to make increased volume a more incentive compatible outcome for the salesperson. (cf. Eisenhardt, 1989, pp. 59-60; Bergen et al., 1992, pp. 4-5.) On many occasions, outcome based contracts can be considered to be the first-choice of the principal. However, the problem with an outcome based contract is the risk-premium which more risk-averse agents may demand for bearing the risk of outcome uncertainty. From an agents perspective, the outcome-based compensation is more insecure than the compensation based on his behavior. Thus, an outcome-based contract is efficient only when the cost of transferring the risk to agent (risk-premium) is less than the costs of

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monitoring the agent. When agent behavior can be monitored at reasonable cost, behavior-based contracts are more efficient because they allow the principal to avoid the need to pay the agent a risk premium (Lassar & Kerr, 1996, p. 615). This assumption implicitly presumes that there is a scarcity of agents and that the agents have an exit option if they are not satisfied with the principals contract offer. According to mainstream agency theorists, if an agent does not like the terms of a contract offered by a principal and the governance structures of that contract, he can always seek a better alternative from elsewhere. If there is a shortage of agents (or principals), the principals (or the agents) will be compelled by market forces to adopt a more acceptable form of contract or its governance structures. Thus, the relative power in contracting for both parties is also dependent on the supply and demand of principals and agents. Therefore, the issues related to risk are most relevant in markets (or market-like situations), where principals and agents have freedom of entry into and exit from agency relationships. However, in situations where there is a shortage of agents or where there exists no exit option for the agent, risk preferences lose their significance (cf. Hill & Jones, 1992, p. 135.) 3.4 Agency Cost and Variables The central challenge for principals is to structure their relationships with their agents to maximize control under limited budget constraint (cf. McLendon, 2003, p. 174). For this challenge, agency theory presents the two inter-related concepts of agency costs and agency variables. Jensen and Meckling (1976) were first to give definition to agency costs, which they considered as the sum of (1) monitoring expenditures by the principal, (2) the bonding expenditures by the agent, (3) the residual loss (Jensen & Meckling, 1976, p. 308). Since this classical definition, the concept of agency costs has been defined on several occasions in more or less the same manner. For example, agency costs have been considered to include losses to the principal because the agent does not act in the principals interests and the cost of monitoring the activities of the agent (Tosi & GomezMejia, 1989, p. 171), costs of monitoring, motivating and ensuring the commitment of the agent (Nilikant & Rao 1994, p. 653), costs of investments in monitoring systems and costs of transferring risk to the agent in the form of outcome based incentives (Lassar & Kerr, 1996, p. 614), costs of agency relationship (Beccerra & Gupta, 1999, p. 184), and the costs of all activities and operating systems designed to align the interests and actions of agents with the interests of the principal (Chrisman et al., 2004, p. 335). Regardless of these definitional differences, in the broadest sense agency costs can be understood to be the total costs of dif-ferent contracting choices, i.e. costs resulting from neutralizing information asymmetries (behavior-based contracts) and goal conflicts (outcome-based contracts) plus the costs resulting from agent opportunism, i.e. the loss

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borne by the principal which is caused by the agent acting in his own interest at the expense of the principal. The other concept, agency variables, is related only to the postcontractual situation and to the problem of moral hazard. Agency variables describe the levels of different internal and external conditions connected to the agency relationship that may have implications for agency costs and contract choice. In other words, agency variables are believed to be able to predict the most efficient contracting choice for a given situation. Although the exact number of agency variables has varied in different research settings, at least five variables (A-E) can be identified (cf. Eisenhardt, 1989, pp. 60-63). Variable A: Outcome measurability. The outcome measurability refers to the extent that the outcomes of the tasks are measurable. Some agency relationships may consist of tasks that produce simple and measurable outcomes, whereas other tasks do not produce easily measurable outcomes. Low-measurable tasks are of many facets, which require a long time to be completed, involve joint or team effort, produce soft, intangible outcomes. Low outcome measurability makes the use of outcome based contracts more difficult and costly. Variable B: Outcome uncertainty. Outcome uncertainty as an agency variable refers to the extent to which the agents actions have impact on the outcome of his tasks. The extent of the level of outcome uncertainty may depend on the nature of the agents work, on environmental factors, or both. High outcome uncertainty makes the use of outcomebased contracts ineffective, since an agents effort will have only limited impact on the outcome. It also makes outcome-based contracts more costly, since it becomes more expensive for the principal to pass the risk on to the agent. Variable C: Task programmability. The variable of task programmability can be defined as the degree to which appropriate behavior and actions by the agent can be specified and verified. It is proposed that the behavior of agents engaged in more programmed jobs is easier and cheaper to Observe and evaluate than in the case of non programmable tasks. Programmed tasks reveal more easily agents effort and behavior thereby reducing informational asymmetries. On the other hand, complex and unstructured tasks are likely to be more difficult and expensive to monitor. Variable D: Goal conflicts. The variable of goal conflicts refers to the extent to which the interests, wants and needs of the principal and agent are in conflict with each other. If there are no goal conflicts, the agent will behave as the principal would like, regardless of whether the agent is controlled or not. As goal conflicts increase, there is greater potential for agent opportunism to occur. Variable E: Length of agency relationship. When the principal and the agent engage in a long-term relationship, it is likely that the principal will 27 learn different things about the agent, and so will be able to assess the agents behavior more readily and cheaply. Conversely, in short-term agency relationships, informational asymmetries between principal and agent are likely to be greater, since the principal is less familiar with the

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agents behavior and work habits. Agency Variable A. Outcome Measurability Behavior Based Contract is Outcome Based Contract is efficient when: efficient when Low High Low Low High Short

B. Outcome Uncertainty High C. Task Programmability High D. Goal Conflicts Low E. Length of Agency Long Relationship (Source: Adapted from Lassar & Kerr ,1996, p. 616) Table 1.1

Table 1.1 lists the agency variables presented above and their influence in predicting the principals preferred contract choice. The prediction derived from variable (A) states that when outcome measures are unclear or where the principal is willing to invest in monitoring systems, the principal usually offers behavior-based contracts. Conversely, when outcomes are measurable, and where the principal is unwilling to invest in monitoring, he will use outcome-based contracts. (Eisenhardt, 1989, p. 62; Petersen, 1993, p. 281.) The prediction derived from variable (B) proposes that when outcome uncertainty is high and when the principal is willing to invest in monitoring, the principal will prefer behavior based contracts. This is because of the cost of transferring the risk to the agent. In addition, if the variation in the agents actions has little impact on the outcome, there is no point in basing the contract on outcomes, as the extra effort needed to produce a small increase in outcome may be considerable (Eisenhardt, 1989, p. 61; Petersen, 1993, p. 281). However, if outcome uncertainty is low and the principal is not willing to invest in monitoring procedures, he will choose outcome-based contracts. According to the prediction of variable (C), task programmability is negatively related to behavior-based contracts and positively related to outcome-based contracts. The rationale behind this prediction is that the low programmability also implies more costly and difficult monitoring. Therefore, it is predicted that when task programmability is low and the principal is not willing to invest in monitoring, he will choose outcome-based contracts. Likewise, if the task programmability is high, and the principal is willing to invest in monitoring, the principal will choose behavior- based contracts. Variable (D) implies that when the goal conflicts are low and when the principal is willing to invest in monitoring arrangements, he will choose behavior-based contracts. If goal conflicts are high, and if he is not ready to establish stringent monitoring, he is likely to choose outcome-based contracts. Lastly, variable (E) refers to length of agency relationship. It predicts that in when an agency relationship will last or has lasted a long time, and when principal is ready to invest in monitoring procedures, he will choose behavior-based contracts.

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Likewise, when an agency relationship is established on a short-term basis, and where the principal is not willing to invest in monitoring procedures, outcome-based contracts become more beneficial to the principal. Agency variables present their predictions in a form of ideal contract choice Nevertheless in real contracting situations; the two contracting options do not need to exclude each other. On the contrary, the logic of both types of contracts can be used simultaneously in a manner where they support each other. It is possible for the principal to pay a small Fee to the agent, which is independent of the outcome, plus a reward, which depends on the outcome. In these cases, the behavior-based contracts protect the agent against outcome uncertainty whereas an outcome- based contract provides incentives to work harder. For example in professional ice hockey, players are sometimes paid a base salary plus bonuses on the basis of achieving certain performance outcomes, such as meeting a certain goal target during the season. (Petersen, 1993, p. 282; Mason & Slack, 2003, p. 41.) 3.5 Government Inefficiency The study of public choice reveals that this disconnection between a principal and a designated agent is a one source of government inefficiency. The principal in this case is society and the agent is a political leader. The principal-agent problem arises because political leaders are prone to maximize their own personal utility rather than doing what might be best for society. 3.6 Maximizing Utility The key to the principal-agent problem is that principals and agents are people; people who seek to maximize utility. As people, they prefer more to less. To satisfy unlimited wants and needs these people take actions and make decisions that generate as much utility as possible. The more, the better. The most, the best. This is the idea of utility maximization.directors, managers and employees of business corporations are supposed to use their delegated authority to maximize the total financial returns from the business to its owners, the shareholders. Physicians, nurses, clinical psychologists, teachers, lawyers, CPAs, financial advisors and other service-oriented professionals are supposed to use their specialized knowledge and skills solely in the best interests of the patients, students or clients who have placed themselves (and some of their resources) in professional hands in exchange for the professionals' promises to act on their behalf. Government officials, judges and politicians in countries embracing the concept of popular sovereignty are instructed to use the power granted them to make public policy decisions that further some reasonable concept of the public interest (usually conceived as the common interests of their constituents or of the country's citizenry at large). Trustees, managers, and employees of non-profit charitable institutions are supposed to use their control over their organization and its resources to promote the general purposes for which the institution was chartered and endowed. Yet if agents are really to perform consistently in the manner they are supposed to do (that is, in the interests of other people), they will need to be suitably motivated by some combination of material incentives, moral incentives, and/or coercive incentives that will make it seem worth their 41

while to attend faithfully to their service obligations and fiduciary duties. The more autonomy that agents have to have in order to do their particular kind of work effectively and efficiently, the less useful coercive sanctions are likely to be, and the more important it becomes for agents' moral and material incentives to be appropriately aligned with their broader obligations to their principals. That is, organizations need to be structured in such a way so the agent will expect that diligently serving the interests of his or her principals will also be in his or her own long-run best interests. In order to accomplish this, the principals need to be reasonably clever in setting up the initial rules of the game that are set in the employment contract, sufficiently vigilant in keeping track of their agents' quality of performance over time, and willing to bear at least some minimum level of agency costs in order to provide the necessary incentives. 3.7 Distorted Bonus Bonanza A bonus culture that effectively espoused excessive risk-taking did not help. The potential for upside gains were significant and the downside costs negligible, or so it seemed (Sidelsky 2009). As noted by Krugman (2008) in the New York Times, The pay system lavishly rwards the appearance of profit, even if that appearance later turns out to have been an illusion. Variable pay packages that tied managerial wealth to the wealth of shareholders were commonplace. Rajan noted back in 2005 that these created distorted incentives and promoted risk taking, even proclaiming that they may create a greater probability of catastrophic meltdown p.318). Lord Turner, head of FSA, would later support Rajan in claiming that the bonus culture indeed had an effect on the financial crisis (BBC 2010). Their arguments were also supported academically by Bechmann and Raaballe on a sample of Danish banks (2010). Rajan (2005) and Blundell-Wignall et al. (2008) argued that the inherent problem of incentive schemes was that they were not risk adjusted, effectively accentuating risk-taking behavior. The hefty bonuses accumulated by bank managers were also targeted for criticism in the post-GFC finger-pointing game, as politicians either questioned or sought regulatory action on bonus levels (Arentoft 2010, Condon 2010). However Sidelsky (2009) contended that bankers, though also self-interested, acted largely in accordance with the adage of the system profit maximization 3.8 Corporate Governance Failure Closely related to the issue of bonus schemes is the perspective that contemporary CG has failed in safeguarding the firm (Jickling 2010, Blundell-Wignall et al. 2008). Foong (2009) also pointed to weak CG mechanisms to explain the effectual failure of the market. OECD (2010) provided similar critique, describing a system that failed to provide and cultivate sound business practices. Professor Hasung Jang posited that like the 1997 Asian financial crisis, shortcomings in CG was a root cause of the GFC (Jang in Sharma 2008). Others point specifically to the general ineffectiveness of boards to stem incessant risk-taking behavior (Dobbin et al. 2010, Abdullah 2006).

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The governance best practices that may have failed, the distorted bonus culture and the greedy manager share common ground through the perspective of agency theory, a facet that remains unaddressed by regulators.

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Chapter 4 Ethical implication of Principal Agent Theory 4.1 What ethical issues can arise with Agency Theory? The ethical issues that can arise due to the agency theory are of two types. Firstly, the ethical issues arise due to the differences in the objectives of the principal and agent conflict. Secondly, the ethical issues arise due to the plans of the agent, which are not known to the principal. It arises due to the differences of the principal and agent's perception towards the assessment of risk. We can consider the example as follows: If the strategy of the manager proves to be effective, then the shareholders will enjoy higher returns on their investment. If the risk evaluation of the manager goes wrong, then the shareholders will not face more loss due to the limited liability, but the manager will have to face losses. Such a situation can be avoided by utilizing hedging process for the activities of the shareholders. 4.1 Agency and Ethics Since agency relationships are usually more complex and ambiguous (in terms of what specifically the agent is required to do for the principal) than contractual relationships, agency carries with it special ethical issues and problems, concerning both agents and principals. Ethicists point out that the classical version of agency theory assumes that agents (i.e., managers) should always act in principals' (owners') interests. However, if taken literally, this entails a further assumption that either (a) the principals' interests are always morally acceptable ones or (b) managers should act unethically in order to fulfill their "contract" in the agency relationship. Clearly, these stances do not conform to any practicable model of business ethics. A familiar real-life example is large corporations' layoff dilemma. Conventional wisdom holds that investors are rewarded when companies thin their employment rosters because operating costs are lowered, in theory leading to greater profits. This expectation is often made explicit in news reporting surrounding a downsizing episode; the reports highlight whether investors seem pleased or displeased with an announcement of a mass layoff, and the often-stated assumption is that corporate management has undertaken the layoffs in part, if not in whole, to please shareholders and enhance their wealth. In this instance it is obvious that shareholders' interests are advanced to the detriment of at least one other constituency, namely the employees. In such cases, observers question whether it is ethical to serve the principals' interests when those actions harm a large number of people, and whether the benefits shareholders receive are commensurate with the harm inflicted on the laid-off employees. Along the same lines, others have noted that traditional agency theory makes little mention of what obligations, moral or otherwise, principals have to their agents. The emphasis lies almost exclusively on what agents should or must do for the principals,

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relying, in turn, on a vague assumption that principals will compensate agents adequatelyeven more than adequatelyfor their services. Some ethics scholars argue that principals have obligations as well. In the example above, some would argue that not only is it unethical to harm employees to obtain improvements (often marginal) in shareowners' wealth, but also that the shareholders have moral obligations directly to the employees as an extension of the ethical employer/employee relationship (i.e., not to harm them arbitrarily, among other obligations). This ethical problem is only complicated by the reality that, as noted above, principals are often institutions rather than individuals. Meanwhile, consistent with the conventional formulation of the theory, agents are seen as having ethical duties to the principals. If managers act in self-interesta rather negative assumptionand it fails to serve the best interests of the shareholders, they may, according to some views, have fallen short on their ethical responsibilities. (Kleiman, 2000) In a larger sense, some see the traditional agency model as a simplistic, even deceptive, justification for traditional economic power relationships, specifically that large wealth holders can extract concessions from weaker economic beings. Certain scholars have argued that from a broader social perspective, there are many kinds of principal-agent relations, and included among these is the fact that shareholders may be seen as agents to managers, employees, and the broader society. 4.2 Conflict of interest Conflict of interest arises whenever the personal or professional interests of a board member are potentially at odds with the best interests of the nonprofit. Such conflicts are common: A board member performs professional services for an organization, or proposes that a relative or friend be considered for a staff position. Such transactions are perfectly acceptable if they benefit the organization and if the board made the decisions in an objective and informed manner. Even if they do not meet these standards, such transactions are usually not illegal except for private foundations. They are, however, vulnerable to legal challenges and public misunderstanding 4.3 Moral Hazard Moral hazard is a situation where there is a tendency to take undue risks because the costs are not borne by the party taking the risk. A moral hazard may occur where the behavior of one party may change to the detriment of another after a transaction has taken place. For example, a person with insurance against automobile theft may be less cautious about locking their car, because the negative consequences of vehicle theft are now (partially) the responsibility of the insurance company. A party makes a decision about how much risk to take, while another party bears the costs if things go badly, and the party insulated from risk behaves differently from how it would if it were fully exposed to the risk. Moral hazard arises because an individual or institution does not take the full consequences and responsibilities of its actions, and therefore has a tendency to act less

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carefully than it otherwise would, leaving another party to hold some responsibility for the consequences of those actions. Moral hazard occurs when a competent agent is selected, but then fails to perform according to the contractual agreement (Holmstrom, 1979). The principal then has sunk costs of selection and further costs associated with lack of adequate performance. Agency theory has two remedies for the moral hazard problem. Both remedies have sunk costs associated with negotiating and developing a suitable contract. In addition, each remedy has its own unique costs. The first remedy is the design of behavior-based contracts that monitor the ongoing actions of the agent. The distinct costs involved are those needed to effectively monitor the agent's behavior including, i.e., accounting measures specific to agent action, increased surveillance, or other such means. The second remedy is the design of outcome-based contracts that measure whether the agent accomplishes the results specified in the contract. The costs involved are those needed for accurate measurement of outcomes. As in adverse selection, the moral hazard problem requires the premise that all information is available as long as the principal is willing to pay the costs associated with obtaining the information. If we momentarily assume that the information required to either monitor agents' behavior or measure outcomes is not available, then the information as a commodity premise, again, is only contingently valid. The assumption is supported if, and only if, all information is available for purchase. (I will return to the specifics of this argument in a later section). Table 2 summarizes the premises, costs, and contingent validity of the adverse selection and moral hazard problems. 4.4 Tacit Information Tacit information, "the means by which explicit knowledge is captured, assimilated, created, and disseminated" (Fahey and Prusak, 1998: 268), is difficult to measure (Nahapiet and Ghoshal, 1998) and codify (Leonard and Sensiper, 1998). Tacit information "is subconsciously understood and applied, difficult to articulate, developed from direct experience, and is usually shared through highly interactive conversation, storytelling, and shared experience" (Zack, 1999: 46). The point to emphasize is that tacit information resides in the mind of individuals and in organizational processes, but it is not explicitly available to all members of a firm (Nonaka, 1994). This presents problems associated with the inability to inventory and quantify tacit information. Codified information, on the other hand, is definable, transmittable to others, and can be stored and inventoried (Kogut and Zander, 1993). Compared to tacit information which is " ... inseparable from the individuals who develop it ... " (Fahey and Prusak, 1998: 266), codified information is more easily assessed and evaluated for both quantity and quality. Agency theory's premise that information is a commodity that can be purchased is difficult to reconcile with the tacit information literature, but on the other hand, much information is available to those willing to pay for it. In addition, even tacit information

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may, in certain instances, be measured using process or task outcomes as proxies. However, it is difficult to extend the reach of purchase price to all information in all circumstances. Furthermore, it is unlikely that satisfactory proxies may be found for all forms of tacit information. When agency theory relies on tacit information to prevent adverse selection, then one must assume that all relevant information is available for purchase. One must further assume that information that is " ... inseparable from the individuals who develop it ... " (Fahey and Prusak, 1998: 266) must somehow be made available, at least if principals are willing to pay enough for the information. For this to be true, those who possess tacit information must be both willing and able to explicate it sufficiently so that the information is understandable and measurable. If the information cannot be adequately defined or explained, it would be difficult to put a price on that which can be neither seen nor measured. Thus, we are left with the option to substitute proxies for the required information. If this can be done, then agency theory's presumption of information as a commodity is left intact and unscathed. If not, the robustness of the theory under these circumstances should be questioned. 4.5 Trust The absence of trust in the Principal-Agent theory reflects a common assumption in economics that trust behavior is irrational 23. Such a view is most clearly expressed by Oliver Williamson who defines opportunism as self-interest seeking with guile 24. He maintains that parties to a transaction will seek to take advantage of each other by not revealing private information or by breaching the contract whenever it is to their personal advantage to do so, provided that it is difficult to prove such transgressions to a court (Williamson, 1975, 1979: 22, 3 and 1985) 25. Williamson argues that trust must be excluded from economic models: It is redundant at best and can be misleading to use the term trust to describe commercial exchange for which cost-effective safeguards have been devised in support of more efficient exchange. Hidden information: the agent obtains better information about aspects relevant to the principal. For example, the manager in charge of sales in a particular region is likely to acquire a better knowledge of the market than his superiors. Hidden action agent undertakes an action that affects the principal's utility and this action is difficult to monitor for the principal. For example, the amount of effort or the quality of work put in by an employee is difficult to monitor directly and the principal has to rely on results of the employee's work (e.g, output produced, the number of breakdowns/repairs on manufacturing equipment etc.). Another example we will see in lecture 8: the bank handing out credit may not be able to assess the riskiness of the project chosen by the creditor.

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4.6 Logical Inconsistency A characteristic of sound theory is logical consistency (Wilkinson, 1999). For example, when two different characteristics of a theory are inconsistent, then either (1) one is incorrect, (2) both are correct but only in certain circumstances, or (3) neither is correct. This section evaluates the logical inconsistency between outcome uncertainty and agency theory's information as a commodity premise by returning to the outcome uncertainty argument. Outcome uncertainty describes situations where the results of an activity are known to neither the principal nor agent (Eisenhardt, 1989). Uncertain outcomes, in part, determine whether goal alignment between the principal and agent is better achieved through a behavior-based contract or an outcome-based contract. As explained previously, contract development is straightforward if all outcomes are known. When outcomes are known, a behavior-based contract should be used to govern the principal-agent relationship. A behavior-based contract focuses on monitoring the behavior of the agent to guard against moral hazard. If the moral hazard problem can be controlled through agent monitoring, the likelihood that the desired, known outcomes will be accomplished is increased (Arrow, 1985). However, if it can be logically demonstrated that inconsistencies between outcome uncertainty and the information as a commodity assumption exist, either outcome uncertainty or the information as a commodity assumption is incorrect, both are correct but only in certain circumstances, or neither is correct. The position that will be established is the second--both are correct but the information as a commodity premise is only valid in certain circumstances. In other words, the challenge is not to the fact that outcome uncertainty is present in numerous principal-agent relationships, but that when it is present, the information as a commodity premise is logically inconsistent. First, we must carefully consider the definition of outcome uncertainty. One of the first to do so was Knight (1921), who examined the distinctions between risk and uncertainty from an economic perspective. "It is unnecessary ... that particular occurrences be foreseeable, if only all the alternative possibilities are known and the probability of the occurrence of each can be accurately ascertained" (Knight, 1921). Outcome uncertainty is a condition in which outcomes--alternative possibilities--are not known and therefore it is not possible to assign probabilities to the outcomes (Leroy and Singell, 1987). When alternative possibilities are known and it is possible to assign probabilities to those possibilities, there is no longer outcome uncertainty, but rather risk (Barzel, 1987). While sharing certain features in common, risk and outcome uncertainty are fundamentally different constructs. Risk assigns probabilities to possible alternative outcomes (Friedman and Savage, 1948). Outcome uncertainty cannot foresee all of the possible alternatives; thus, probabilities cannot be assigned. This presents a logical inconsistency. When outcome uncertainty is present in the principal-agent relationship, by definition, outcomes are unknown. If all likely outcome possibilities are known and it is possible to assign probabilities to each of these, there is

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no longer outcome uncertainty, but rather risk. Inherent in outcome uncertainty is a lack of information concerning alternative outcomes. On the other hand, inherent in the information as a commodity premise is that all information can be purchased. If all information can be purchased, alternative possibilities concerning outcomes can be discovered. Therefore, there can be no outcome uncertainty if the information as a commodity assumption is valid in these situations, but prima facie, outcome uncertainty is evident in many agency relationships. The burden of proof therefore rests on the information as a commodity premise. When outcomes are uncertain (as they frequently are in agency relationships and particularly in outcome-based contracts), the information as a commodity assumption is only contingently valid. The robustness of agency theory is dependent on whether the implications of this logical inconsistency lead to the wrong decision with regard to agent selection and agency contract design.

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Chapter 5 Lessons from Literature Reviews 5.1 Summary, Theoretical Implications and Future Research Directions Agency theory or the Principal-Agent theory is a useful concept for viewing the relationship between principals and agents in a numerous contexts. This paper is certainly not an attempt to cast doubt on the valuable insights that have been provided to the management, marketing, and economic literature though the lens of this theory. However, a theory is only as strong as its underlying premises and its logical consistency (Wilkinson, 1999). However, logically testing a theory's premises does not necessarily weaken the theory. Rather, theory may be strengthened when one is aware of the challenges to robustness that exists when premises are violated, thus allowing for correction of the threat to robustness. This research paper suggested that one of the premises of agency theory, the information as a commodity, is valid only when all information is known and that, when information is tacit, there are circumstances when it can be neither known nor purchased. This occurs when (1) suitable proxies for the tacit information cannot be found or (2) the source of the tacit information is unable to adequately express the information in a way that the information can be measured. When agency relationships are considered, principals weigh the costs against the benefits of gathering the information needed to make the correct decision about agent selection and contract design. Specific remedies for the adverse selection and moral hazard problems are dependent on the premise that relevant information is available for purchase. When this information is tacit, agency theory may not be robust to violation of this assumption. If assumption violation decreases the robustness of agency theory, then agency theory should be considered contingently valid and steps taken to mitigate the damage that my result from incorrect conclusions. Thus, the contingent validity of agency theory depends on the nature of the situation. If the correct decision can be made without obtaining the tacit information relative to the decision, then the theory is robust to violation of the information as a commodity assumption. On the other hand, if violation of the premise leads to incorrect decisions (adverse selection or moral hazard), then the robustness of agency theory should be reevaluated. When incorrect decisions are made due to violations of the information as a commodity premise, agency theory must again be considered only contingently valid. In addition, a logical inconsistency between the information as a commodity assumption and outcome uncertainty has been discussed. In these situations, the robustness of agency theory is dependent on whether the implications result in a less than optimal contract design. There are managerial implications when agency theory is not robust to violation of the information as a commodity premise. These implications may be grouped into (1) the contract design and, (2) the adverse selection and moral hazard problems. First, the contract design problem suggests that primarily two types of contracts (or a mixture of these types) can be used in the agency relationship--behavior-based and outcome-based (Brown-Johnson and Droege, 2004). Prior research has suggested that behavior-based

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contracts are preferred when there is a risk that the agent may shirk his or her contractual obligations (Fama and Jensen, 1983). Outcome-based contracts are preferred when there is a high degree of outcome uncertainty and, in these situations, are intended to align the goals of the agent with those of the principal (Jensen and Meckling, 1976). Accurate information is required to make correct decisions in both cases. When accurate information is unavailable, managers must consider that an incorrect decision may be made regarding agent selection and contract design. A risk associated with incorrect decisions should be factored into the costs tied to this possibility. Adding a risk premium when needed information is unavailable will decrease the amount the principal should be willing to pay the agent, thus affecting principal-agency contract negotiations. Second, adverse selection and moral hazard problems are affected by the inability to purchase the information needed to prevent the occurrence of these situations. Ex ante information is required to prevent adverse selection; ex post information is used to monitor for moral hazard. As in the contract design problem, the implications of selecting the wrong agent (the adverse selection problem) or the failure of specific performance by the agent (the moral hazard problem) must be clearly understood in assigning an appropriate risk premium in lieu of obtaining the needed information. The risk premium, by decreasing the amount the principal is willing to pay the agent, will partially mitigate the risk of adverse selection and moral hazard. (assuming labor market parity is maintained). Similarly, agency theory's robustness is challenged with respect to the contingent validity of the information as a commodity assumption in the presence of outcome uncertainty. The wrong managerial decision may result in less than optimal contract design. Clearly, much research has focused on the agency relationship. However, future research should look at agency theory's underlying premises to determine the robustness of the theory when these premises are violated. For example, one such premise is the risk-aversion of the agent. In agency theory, the agent is presumed to be risk-averse while the principal is presumed to be risk-neutral (Eisenhardt, 1989). Risk aversion describes the tendency for the agent to avoid risk and opt for the safer route when such a route is available. "A risk-averse individual prefers security and therefore seeks some guarantee of the attainment of desirable outcomes or insurance against the occurrence of undesirable outcomes" (Bergen, et. al., 1992: 4). The assumption of risk-averse agents and risk-neutral principals is, in part, the basis upon which goal discrepancy between agent and principal is founded. If it is discovered that agents are not risk-averse or are only risk-averse in certain situations, then the risk-averse agent presumption is should attenuate managerial decisions regarding agent contracts. Eisenhardt (1989) suggests that firms choose the least costly alternative between behavior control (behavior-based contracts) and outcome measurement (outcome-based contracts). However, this too is based on the presumption of a risk-averse agent. If future research relaxes the assumption that agents differ in their risk preferences, some having a propensity to accept risk and others being risk-averse, then the least costly alternative changes as the agent's risk preferences change. The agent will be willing to accept more risk, thus alleviating the principal of a portion of the risk burden if the agent is not riskaverse. Further, if a risk-averse agent requires a risk premium in exchange for acceptance of risk, then the agent's perception of risk will determine, in part, the cost to the principal

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of the risk premium. If the agent is not risk-averse, then the principal's risk premium expense may decrease. 5.2 Conclusion The preceding discussion has examined very different strategies for employing agency theory that have been raised by business ethicists. The use of agency theory bring to the fore two sets of ideas that ethicists have traditionally been very uncomfortable with, first, the economic model of rational action, and second, the doctrine of shareholder primacy and the obligation to maximize profit. With regard to the first, I have suggested that business ethicists have been at least partially justified in their reservations. The economic model is based upon an inadequate conception of rational action, precisely because it classifies an important category of moral action as irrational. Indeed, it classifies all genuine rule following as irrational, and is therefore unsuitable for use as a general theory of rational action. Sophisticated practitioners of agency theory are familiar with these limitations, but a large number of enthusiasts are not. Thus agency theory can serve as a source of considerable inadvertent mischief when treated as an accurate representation of reality. I have therefore encouraged a critical use of agency theory, in which principal-agent analysis is used to provide, not a model of how firms actually work, but rather a set of instructive parables, allowing us to see more clearly what the world of business would be like in the absence of business ethics. In this respect, the most important use of agency theory lies in its role in combating the widespread perception that business operates outside the sphere of moral evaluation and constraint. By operationalizing a certain form of moral skepticism, one that denies that there are any genuine moral rules or deontic constraints, game theory in general, and agency theory in particular, shows what the consequences of generalized immorality would be. From this, we can extract both a normative and an empirical lesson: first, that the consequences would be unappealing, insofar as it would lead to the collapse of many mutually benefits l forms of cooperation; and second, that people are a lot more moral even in the world of business than we are sometimes inclined to believe. Agency theory allows us to see that in many cases, the alternative to ethical business enterprises is not the presence of unethical business enterprises, but rather the absence of any enterprise at all. With regard to the doctrine of shareholder primacy, and the extent to which agency theory encourages this perspective, I have tried to emphasize that no simple connection exists between the two sets of ideas. Nevertheless, when employed cautiously, with due attention to the institutional context in which the firm operates, it is possible to use agency theory as the basis for a plausible shareholder-focused conception of business ethics. Agency theory can be used to show how the owners of a firm are in a uniquely vulnerable position with respect to the manager, and therefore why a fiduciary relation is justifiable in this case. So while a commitment to agency analysis neither entails a commitment to the doctrine of primacy, the gain in conceptual clarity afforded by the agency perspective does provide a powerful source of arguments in favor of that doctrine. Agency theory can be used to show how the shareholder is in a uniquely vulnerable position with respect to the manager, and therefore why a fiduciary relation is

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justifiable in this case. So while a commitment to agency analysis neither presupposes nor entails a commitment to the doctrine of shareholder primacy, the gain in conceptual clarity afforded by the agency perspective does provide a powerful source of arguments in favor of that do. The bottom line, however, is that the agency problem can never be 100% solved in a world where virtually everyone has a healthy regard for their own self-interest and the relevant information for evaluating performance is imperfect, costly to obtain and unequally distributed between the agent and his principals. Indeed, rational principals will only pursue the available techniques for control to the point that the marginal increment in agency costs rise to equal the marginal benefits to them of the additional increment in faithfulness that they produce. (That is to say, sometimes it is cheaper for principals to endure a certain amount of dereliction of duty by their agents than it is to pay for the precautions needed to prevent or punish it.) In some kinds of institutions especially those where results are not readily measurable with much precision, those where the nature of the agents' work is such as to require a very high degree of expert judgment, those where lines of responsibility and authority are very complex, those where agents work individually in widely dispersed work places, those where the agent's activities necessarily involve a lot of judgment calls to cope with rapidly changing circumstances and highly uncertain information, and those where large numbers of principals have only relatively small individual stakes at risk the incentives for agents faithfully to represent their principals may easily become so weak as to be largely ineffective. Experience demonstrates that these kinds of organizations often come to be run mainly for the benefit of the agents (managers and other employees, service professionals, politicians, officials) rather than their purported principals (stockholders, voters, taxpayers, clients, etc.). Two of the important tasks of the academic disciplines of business administration and public administration are to identify, and then to devise cheaper substitutes or remedies for, organizational arrangements that are characterized by costly agency problems.

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