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Summary Strategy & Organization Design
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STRATEGY & ORGANISATION DESIGNLiterature Summary
Eisenhardt, K. M. (1989). Agency Theory: An assessment and review.
The purposes of the paper are to describe agency theory and to indicate ways in which organisational researchers can use its
insights.
1. What is agency theory?
2. What does agency theory contribute to organisational theory?
3. Is agency theory empirically valid?
4. What topics and contexts are fruitful for organisational researchers who use agency theory?
Agency theory is directed at the ubiquitous agency relationship, in which one party (the principal)
delegates work to another (the agent), who performs that work. This relationship is described with the
metaphor “contract”. It is concerned with resolving two problems:
1. Agency problem: arises when the desires or goals of the principal and agent conflict and it is difficult
or expensive for the principal to verify what the agent is actually doing.
2. Problem of risk sharing: arises when the principal and agent have different attitudes towards risk.
From its roots in information economics, agency theory has developed along two lines:
Positivist agency theory. Positivist researchers have focused on identifying situations in which the
principal and agent are likely to have conflicting goals and then describing the governance
mechanisms that limit the agent’s self-serving behaviour. Positivist research is less mathematical than
principal-agent research. Positivist researchers have focused almost exclusively on the special case of
the principal-agent relationship between owners and managers of large, public corporations. Two
propositions capture the governance mechanisms which are identified in the positive stream:
Proposition 1. When the contract between the principal and agent is outcome based, the agent is
more likely to behave in the interest of the principal.
Proposition 2. When the principal has information to verify agent behaviour, the agent is more
likely to behave in the interest of the principal.
, Principal-agent. Researchers are concerned with a general theory of the principal-agent relationship.
The paradigm involves careful specification of assumptions, which are followed by logical deduction
and mathematical proof. Due to its abstractionism it is less accessible to organisational scholars. They
focus almost exclusively on the owner/CEO relationship in large corporations. The assumption is
that there is goal conflict and an agent who is more risk averse than the principal. When the principal
does not exactly know what the agent has done, the agency problem arises because the principal and
the agent have different goals and the principal cannot determine if the agent has behaved
appropriately. “Moral hazard” refers to lack of effort on the part of the agent. “Adverse selection”
refers to the misrepresentation of ability by the agent. The principal can act upon unobservable
behaviour via discovering the agent’s behaviour by investing in information systems or to contract on
the outcomes of the agent’s behaviour (risk is transferred to the agent).
Proposition 3. Information systems are positively related to behaviour-based contracts and
negatively related to outcome-based contracts.
Proposition 4. Outcome uncertainty is positively related to behaviour-based contract and
negatively related to outcome-based contracts.
The heart of the principal-agent theory is the trade-off between the cost of measuring behaviour and
the cost of measuring outcomes and transferring risk to the agent. However, the risk aversion
assumption can be extended/
Proposition 5. The risk aversion of the agent is positively related to behaviour-based contracts
and negatively related to outcome-based contracts.
Proposition 6. The risk aversion of the principal is negatively related to behaviour-based
contracts and positively related to outcome-based contracts.
In a highly socialised firm, the assumption of goal conflict can be extended.
Proposition 7. The goal conflict between principal and agent is negatively related to behaviour-
based contracts and positively related to outcome-based contracts.
Programmability is defined as the degree to which appropriate behaviour by the agent can be
specified in advance. Behaviour is easier to observe and evaluate in programmed jobs.
Proposition 8. Task programmability is positively related to behaviour-based contracts and
negatively related to outcome-based contracts.
In some circumstances, outcomes are difficult to measure.
Proposition 9. Outcome measurability is negatively related to behaviour-based contracts and
positively related to outcome-based contracts.
The principal learns more about the agent when they’re in a long-term relationship.
Proposition 10. The length of the agency relationship is positively related to behaviour-based
contract and negatively related to outcome-based contracts.
Much of organisational life is based on self-interest. Agency theory makes the following specific
contributions to theory:
1. The treatment of information. Information is regarded as commodity: it has a cost and it can be
purchased. Organisations can invest in information systems to control agent opportunism.
,2. Risk implications. Organisations are assumed to have uncertain futures. Uncertainty is viewed in terms
of risk/reward trade-offs. Outcome uncertainty coupled with differences in willingness to accept risk
should influence contracts between principal and agent.
Empirical results of the Positivist stream
One of the first studies was looking into conglomerate mergers (Amihud & Lev, 1981), which are not in
the interest of stockholders (thus the interests between managers and stockholders are divers). Consistent
with agency theory, manager-controlled firms engaged in more conglomerate acquisitions and were more
diverse. Another study found that managers who have substantial equity positions within their firms
(outcome-based) were less likely to resist takeover bits (they can lose their jobs during takeovers). In yet
another study, it was found that boards of companies that resisted greenmail had a higher proportion of
outside directors and a higher proportion of outside direct executives. Also, executive security holdings
(outcome-based) were related to acquisitions and financing decisions that were more consistent with
stockholder interest. According to Barney, employee stock ownership (outcome-based) would co-align the
interest of employees with stockholders.
Thus, there is support for the existence of agency problems between shareholders and top executives
across situations in which their interest diverge and for the mitigation of agency problems through
outcome-based contracts and through information systems.
Empirical results of the Principal-Agent stream
The common approach in these studies is to use a subset of agency variables such as task
programmability, information systems, and outcome uncertainty to predict whether the contract is
behaviour- or outcome-based. The underlying assumption is that principals and agents will choose the
most efficient contract, although efficiency is not directly tested. One study found that a behaviour-based
contract is used when outcomes are uncertain. Another found that task programmability, information
systems and outcome uncertainty variables predict the salary (behaviour-based) versus commission choice
(outcome-based).
Thus, there is support for the principal-agent hypotheses linking contract form with information
systems, outcome uncertainty and task programmability.
Recommendations for agency theory research:
Focus on information systems, outcome uncertainty and risk.
Key on theory-relevant contexts.
Expand to richer contexts.
Use multiple theories.
Look beyond economics.
Hennart, J. (1993). Explaining the swollen middle: Why most transactions are a mix of “market”
and “hierarchy”.
Two fundamental criticisms against transaction cost theory:
Transaction cost theory is only a theory of market failure; it does not explain why firms succeed.
The categories of market and hierarchy used in transaction costs theory are not useful; observation
shows that most transactions cannot be categorised as either “pure market” or “pure hierarchy”.
The presence of market transaction costs is not a sufficient condition for internalisation. The focus of
TCE is only market transaction costs, but firms also incur organising costs. If organising costs in firms are
so high that they absorb all of the gains from exchange and coordination, then no economic interaction
will take place, either within firms or within markets.
A complete theory of economic institutions should therefore consider simultaneously the costs of
organising transactions in markets (transaction costs) and those of effecting exchange within the firm
(management costs) and should explain how firms can achieve lower organising costs than markets.
TCE does not make this distinction. It also neglects the complexity of institutions by focussing on the
two extremes of markets and hierarchy.
, The argument for the model of the choice between firms and markets consists of six propositions:
1. One must distinguish between methods of organising (the price system and hierarchy) and economic
institutions (markets and firms). A mix of both can be used.
2. The two organising methods (price system and hierarchy) use different techniques to organise
economic activities. Price systems rewards agents on their output, hierarchy on their behaviour.
3. The cost of using price constraints (cheating cost) is the cost of measuring output, plus the losses due
to fraud when measurement is imperfect. Shirking cost (the cost of using hierarchy is that of using
behaviour constraints) is the sum of the cost of constraining behaviour plus the residual amount of
shirking due to imperfect behaviour constraints.
4. Price constraints minimise shirking but encourage cheating an behaviour constraints vice versa.
5. Markets are institutions that predominantly use the price method of organising, whereas firms rely on
hierarchy.
6. The combination of price and behaviour constraints defines a wide variety of institutional forms along
a continuum which goes from pure spot markets to traditional firms.
Prices and hierarchy in the absence of organising costs
Cooperation between individual can be productive, either because tasks are best achieved through pooling
of effort or because individuals have differing abilities and they can exploit these differences through
exchange. However, individuals have bounded rationality; they have only partially overlapping goals and
they are opportunistic (without these assumptions, organising costs would be zero). Opportunism is “self-
interest seeking with guile”. The social network generates powerful pressures that limit opportunism.
There are two ways of reconciling the interest of opportunistic behaviour:
Internal control: consists in electing individuals who have the same goals or in investing resources to
persuade individuals who have different goals to internalise one particular set of goals (clan solution).
Use external control mechanisms: such as hierarchy and price (this paper’s focus).
If individuals are opportunistic, boundedly rational and have different goals, informing parties, rewarding
them for productive behaviour and curbing bargaining will be costly. Prices perform these three tasks of
organising. In the absence of transaction costs (perfectly defined property rights with costless
enforcement, zero information costs and a large number of buyers and sellers), prices convey information
on the consequences of one’s actions so as to allow parties to reach optima decisions on the allocation of
tasks. In the absence of organising costs, hierarchy will also organise economic activity perfectly. While
information is decentralised with prices, it is centralised with hierarchy. Individuals who organise their
interactions through the price system collect their own information and make their own productive
decisions, whereas the boss allocated this resources in the hierarchy. While prices indirectly guide
behaviour by rewarding output, hierarchy directly controls individuals by specifying behaviour and
rewarding compliance.
Prices and hierarchy with positive organising costs
The efficiency of the price system will be reduced by the cost of cheating, while hierarchy will suffer
shirking costs. Prices will not provide the right signals: agents will be incited to use too much of the goods
whose price is below cost and too little of the goods prices below their benefit to the group. When the
number of buyers and sellers falls, prices are no longer exogenous, and it will pay for agents to invest in
bargaining. Because measuring outputs experiences diminishing returns, it will not pay to attempt to
measure outputs perfectly. The organising costs incurred by the price system are referred to as cheating
costs, and they are the sum of the cost of measuring output plus the cost of the residual amount of
cheating due to imperfect measurement. When cheating costs are high, a switch to hierarchy may reduce
organising costs. It reduces the incentives for cheating individuals by breaking the connection between
outputs and rewards. However, while it reduces cheating, it also reduces incentives to work as their reward
is no longer directly proportional to that output measured at market prices. Shirking means that the
behaviour of an employee will differ from what it would be if her were self-employed. Acceptance of
authority comes at the cost of shirking. In this paper’s model, agents and principals are risk-neutral and
hence, outcome uncertainty plays no role.
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