Agency Theory (organizational economics)
Agency Theory, also known as the principal-agent problem, addresses situations where one party (the agent) makes decisions on behalf of another (the principal), often in contexts of asymmetric information. This theory, developed in the mid-20th century by economists Stephen Ross and Barry Mitnick, highlights the challenges that arise when the principal lacks the same level of information as the agent, leading to potential conflicts of interest and inefficiencies. Agency Theory finds applications across various fields including political science, business, and economics, helping to analyze relationships where externalities and incentive structures are at play.
For instance, in a healthcare scenario, a provider may make decisions that impact a patient who does not have all the relevant information, resulting in costs or benefits that the patient must bear. The theory also explores how negotiation dynamics, such as wage determination in employment, can be influenced by the desire for performance-based incentives, as seen in tipping practices within the restaurant industry. While Agency Theory offers valuable insights into optimizing relationships and contractual agreements, it operates under the assumption that all parties are rational actors seeking to maximize their benefits. However, it may fall short in scenarios where values diverge significantly or when individuals do not prioritize wealth maximization. Overall, Agency Theory provides a framework for understanding the complexities of decision-making in situations of incomplete information.
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Agency Theory (organizational economics)
Agency theory, also known as the principal-agent problem, agency dilemma, or theory of agency, is a game theory–based solution to the distribution of choice based on asymmetric information and externalities. In the case of agency theory, information is asymmetric because one position, whether it is principal or agent, has more information than the other. Externalities come into play because one of the parties will be made to pay or live with the choices made by the other. The agent is the individual who makes decisions on behalf of the principal. Agency theory was developed in the middle of the twentieth century and has come to have applications in political science, business, game theory, and everyday life.
Brief History
Agency theory was developed by Stephen Ross and Barry Mitnick in the mid-1970s. Some have contended that the theory was developed by Michael Jensen and William Meckling. The initial use of agency theory was to uncover solutions that had been posed in economics problems. Eventually, the theory was used to address problems in political science, business, game theory, and economics, as well as everyday life.
Ross and Mitnick independently and concurrently developed agency theory, working through different perspectives. Ross’s theory was grounded in economics, while Mitnick’s work was in institutional management and organization. The most commonly cited work on agency theory, however, is from Jensen and Meckling. The initial development of the problem was to uncover a solution for equitable distribution of incentives in an asymmetric environment.
Later theories and scientists studying agency theory have tailored their work to specific environments, such as horse racing, real estate, salaries of top executives, and contract design. These specific studies are designed to improve the effectiveness of those specific fields, while generalizable results can be culled and related to other enterprises.
Agency Theory Today
Agency theory has many applications and is connected with many other economic and game theory concepts and models. Agency theory has an impact on externalities, negotiations, incentive structure, contract design, law, and price structures.
Externalities are external costs or benefits to the person who did not make a choice. In the framework of agency theory, imagine the relationship between a health-care provider and a patient. The health-care provider may make choices for the patient when the patient does not have all pertinent information. There are benefits and costs that the patient must bear, even though the patient did not make the choice to engage in the activities. The economics approach to externalities is to make the most efficient bearer endure the cost. The economics approach differs from the agency theory approach in that the agency theory approach permits externalities to be distributed to either party, regardless of the ability to bear the cost.
Negotiations occur at various points while an employee is being hired and after the individual is hired. Negotiations range from hours worked to salary to more detail-oriented points, such as whether an employee may have a coffee maker at their desk. The primary interaction of agency theory with negotiations comes with wage determination. By law, in some states, a restaurant is permitted to pay a server a reduced salary, as the majority of earnings comes through tips. The agent in this case is the server, while the principal is the restaurant. The agent must perform the job well to receive tips. The principal wants the agent to perform well so that the restaurant receives repeat business. However, the restaurant does not pay more, instead passing the duty of payment off to the customer. The agent therefore provides the principal a service that is not compensated. Agency theory explains how incentive structures function. Performance-oriented pay, as in the case of the tipping example, demonstrates how agency theory contributes to incentive structure.
Contracts are designed and written in such a manner that the employer provides for the employee, while the employer ultimately gains. There are altruistic employers, but the standard model accounts for profits, not personality. Agency theory entails that randomness and arbitrary factors be removed from consideration when hiring, promoting, or firing an individual. This produces the optimal benefit for the employer and employee.
The law and economics movement in the American legal realm uses agency theory. The law and economics movement advocates the use of economic reasoning to determine fault and award liability to the most efficient bearer. Agency theory, as well as the law and economics movement, both provide solutions for how to deal with incomplete information.
Agency theory is not a perfect system to explain behavior, nor is it perfect in producing behavior. The actions of individuals do not necessarily correlate with a given theory. Further, an individual’s actions may not be rational. In the case of rational actors, agency theory may not apply if there is shared information. In the event of asymmetric information and rational actors, agency theory works except in the case of an individual who does not seek to maximize wealth, or if the values of the parties radically differ. If a person does not seek to maximize wealth, their actions will not be done with the furtherance of this goal, in contradiction of agency theory. In the event that both parties have radically different values, then agency theory will be helpless to provide a solution, as the end state for both parties is not mutual. Agency theory does not produce perfect behavior either. In the tipping example, a server may give a patron free food, or free upgrades, such as an extra shot of liquor or a larger slice of cake, to improve their tips. In addition, this creates competition between employees, wherein each one seeks to outdo, outperform, or give more away to secure the largest tip or bonus.
Bibliography
Eisenhardt, K. "Agency Theory: An Assessment and Review." Academy of Management Review, vol. 14, no. 1, 1989, pp. 57–74.
Laffont, Jean-Jacques, and David Martimort. The Theory of Incentives: The Principal-Agent Model. Princeton UP, 2002.
Pepper, Alexander, et al. "Fairness, Envy, Guilt and Greed: Building Equity Considerations into Agency Theory." Human Relations, vol. 68, no. 8, 2015, pp. 1291–314.
Rutherford, R., et al. "Conflicts Between Principals and Agents: Evidence from Residential Brokerage." Journal of Financial Economics, vol. 76, 2005, pp. 627–665.
Saltaji, Issam M. F. "Corporate Governance and Agency Theory How to Control Agency Costs." Internal Auditing & Risk Management, vol. 8, no. 4, 2013, pp. 47–60.
Syafriadi, Eko, et al. "The Impact of Agency Theory on Organizational Behavior: A Systematic Literature Review of the Latest Research Findings." Brazilian Journal of Development, vol. 9, no. 12, 2023, doi:10.34117/bjdv9n12-090. Accessed 5 Nov. 2024.
Tan, Jon Chiew Kwee, and Richard Lee. "An Agency Theory Scale for Financial Services." Journal of Services Marketing, vol. 29, no. 5, 2015, pp. 393–405.
Zellweger, Thomas, and Nadine Kammerlander. "Family, Wealth, and Governance: An Agency Account." Entrepreneurship: Theory & Practice, vol. 39, no. 6, 2015, pp. 1281–303.