Agency Theory in Management
| Nicolai Foss |
I believe that agency theory is one of the most informative, useful, and interesting theories coming out of economics ever. It is surely also one of the most influential econ theories in management. Agency theory is, however, fundamentally complicated, and difficult to teach. I find it impossible to teach without making use of at least some math (specifically, simple versions of the linear model). In particular, grasping the role that the risk premium plays in the theory, and, in this connection, what is really the source of the agency loss, is often very difficult for students.
However, not only students but also management academics have difficulties understanding the theory.
Here are some examples of common mistakes in the management literature:
- Conflating moral hazard and opportunism (e.g., Anurag Sharma’s 1997 paper in AMR). This is one of the smaller sins and many economists have sinned here as well, thinking of moral hazard as “ex ante opportunism.” However, opportunism is tied to recontracting which moral hazard isn’t.
- Bounded rationality and asymmetric information. Agency theory emphatically does not make the assumption of bounded rationality. Contracting is not imperfect in this theory because of bounded rationality but because of asymmetric information. Eisenhardt’s heavily cited (1,325 hits on google scholar) 1989 paper makes this mistake.
- The perspective of the theory. Much critique of agency theory, e.g., by Charles Perrow, takes its starting point in the claim that it takes the perspective of the principal. It does not. It is a theory about joint value maximization and what self-interested parties can do to remedy obstacles to such maximization. It takes an agent perspective as much as it takes a principal perspective. What critics may have in mind is the assumption, mainly motivated by analytical convenience, that the principal has all the bargaining power.
- Types of agency theory. Some management writers, such as Nilakant and Rao (1994, Org Studies), claim a distinction between “positivist agency theory” (largely verbal, mainly concerned with corporate governance) and formal agency theory (think Bengt Holmström). The distinction is bogus. While there may be more or less formal contributions to agency theory the analytical core is the same.