Has Agency Theory Run Its Course

Has Agency Theory Run its Course?
:
Making the Theory more Flexible to
Inform the Management of Reward Systems
Gloria Cuevas-Rodrguez, Luis R. Gomez-Mejia, and
Robert M. Wiseman*
ABSTRACT
Manuscript Type: Conceptual
Research Question/Issue: In this paper we discuss three assumptions of agency theory: (1) conicts of interest between
principal and agent, (2) nature of risk, and (3) the proposed internal mechanisms to reduce agency costs. We review
criticisms of agency theorys pessimistic assumptions of human behavior and its simplistic view about individual risk
preferences to argue how the context may inuence both the interest and mechanisms for aligning interest of principals and
agents.
Research Findings/Insights: We drawon alternative theoretical perspectives frombehavioral and organizational sciences to
describe circumstances under which honesty, loyalty, and trust in agents behaviors are possible and also the development
of cooperative rather than contentious relationships.
Theoretical/Academic Implications: This study explores the boundary conditions of traditional agency theory in the hope
of extending agency theory outside its current contextual boundaries. In doing so, we provide a more robust and exhaustive
view of the economic exchange between principals and agents.
Practitioner/Policy Implications: This study offers insights to managers about how intrinsic incentives may provide an
alternative mechanism of control over agents behavior to extrinsic incentives prescribed by traditional agency theory.
Indeed, intrinsic incentives of personal satisfaction and identication with organizational objects, combined with implicit
social obligations and reciprocity may, under certain circumstances, provide stronger restraints on agent opportunism than
the use of traditional extrinsic rewards in the form of incentive alignment.
Keywords: Corporate Governance, Agency Theory, Stewardship, Board Policy Issues, Executive Compensation
INTRODUCTION
A
gency theory, as initially conceptualized by Jensen and
Meckling (1976) analyzes the relationship that devel-
ops in an economic exchange when an individual (the prin-
cipal) concedes authority to another (the agent) to act in his
or her name, so that the wealth of the principal is beneted
by the decisions adopted by the agent. According to the
theory, separating ownership from control can result in costs
for the principal, known as agency costs, thus requiring
costly mechanisms for controlling these costs. Agency costs
arise because agents are argued to pursue interests that do
not necessarily coincide with those of the principal. Because
the use of incentives to create alignment of interests between
principal and agency is a primary mechanism proposed by
the theory to reduce agency costs, the theory is without
doubt one of the main (if not the main) theoretical frame-
works in the area of compensation management (particu-
larly at the top management level) (Gomez-Mejia, Berrone,
& Franco-Santos, 2010).
The roots of agency theory are linked to economic utili-
tarianism (Ross, 1973), which suggests that rational indi-
viduals will favor alternatives that enhance their own utility.
The theory has been used widely in areas as diverse as
accounting (Demski & Feltham, 1978), economics (Spence &
Zeckhauser, 1971), nance (Fama, 1980), marketing (Basu,
Lal, Srinivasan, & Staelin, 1985), political science (Mitnick,
*Address for correspondence: Robert M. Wiseman, Eli Broad Graduate School of
Management, Michigan State University, Management, East Lansing, Michigan, USA.
Tel: 517-355-1878; Fax: 517-432-1111; E-mail: wiseman@bus.msu.edu
526
Corporate Governance: An International Review, 2012, 20(6): 526546
2012 Blackwell Publishing Ltd
doi:10.1111/corg.12004
1975), organizational behavior (Eisenhardt, 1985), and soci-
ology (White, 1985). Its popularity lies in providing parsi-
monious predictions as to how rational individuals would
behave in bilateral relations between self-interested indi-
viduals, where each individual is faced with information
asymmetry about the other individuals effort and interests.
In sum, agency theory focuses on identifying the most ef-
cient contract for aligning the interests of an agent with
those of the principal (Fama & Jensen, 1983).
By contrast, critics charge that the theorys parsimony is
also its Achilles heel in that the theorys simplistic assump-
tions and narrow focus limit its predictive validity (cf. Eisen-
hardt, 1989; Perrow, 1986). For example, as originally
conceptualized, agency theorys pessimistic assumptions of
human behavior as opportunistic would seem to preclude
trust and cooperation between the principal and agent (Fehr
& Falk, 2002). That is, the theory presupposes that because
economic agents can cover up, cheat, distort, or trick the
contracting party in an economic exchange, opportunism
will prevail in spite of incentives and supervision, resulting
in problems of adverse selection and moral hazard.
1
This
characterization of agents has been challenged as overly
negative and possibly self-fullling (Donaldson & Davis,
1991, 1994). Instead, these critics suggest that beginning with
an assumption of trust and viewing agents as stewards of
the organization, motivated to act responsibly, may result in
more desirable outcomes for both parties (Davis, Schoor-
man, & Donaldson, 1997). Other critics have noted that
agency theory includes simplistic assumptions about indi-
vidual risk preferences (Wiseman & Gomez-Mejia, 1998),
and does not acknowledge the social context in which the
principal-agent contract resides, and how that context may
inuence both the interests and mechanisms for aligning
interests of principals and agents (Wiseman, Cuevas-
Rodriguez, & Gomez-Mejia, 2012). In sum, critics charge
that economists formal vision may be too restrictive, and
that it could prove highly useful to widen the agency
concept by using a behavioral perspective (Tirole, 2002).
In order to overcome the limitations of agency theory, we
propose to incorporate other theoretical perspectives in
order to extend and strengthen agency theorys predictions.
Specically, we contrast agency theorys assumptions about
conict of interest, nature of risk, and mechanisms for con-
trolling agency costs with alternative views derived from
behavioral and organizational sciences in order to generate a
more robust and exhaustive view of the economic exchange
between principals and agents. As Rabin suggests: Some
important psychological ndings seem tractable and parsi-
monious enough that we should begin the process of inte-
grating them into economics (1998: 13). Thus, we may be
able to benet from the evidence on human behavior as well
as from organizational theory without necessarily losing the
virtues of economic analysis. In essence we draw on alterna-
tive theoretical perspectives to explore the boundary condi-
tions of traditional agency theory in the hope of extending
agency theory outside its current contextual boundaries.
This paper is structured in the following way. It begins by
summarizing three central features of positive agency
theory, conict of interest, and mechanisms for controlling
agency costs. We then compare agency assumptions with
new assumptions derived from behavioral and organiza-
tional perspectives to generate contrasting predictions about
agent behavior. In order to do that, we use content analysis
as a research methodology. We searched the major academic
journals in the ABI/INFORM database, searching for those
articles that combine agency theory with other theoretical
frameworks. Then, we checked the abstracts of the reference
lists of articles obtained, and classied them with regard to
their theoretical or empirical approach (see Table 1). Thus,
our survey of alternative theoretical contributions to agency
theory is meant to be illustrative rather than an exhaustive
exploration of how agency theory may be extended beyond
its present emphasis.
POSITIVE AGENCY THEORY
Positive agency theory is an empirically-oriented examina-
tion of principal-agent relations and has been extensively
used by management scholars as a basis for examining the
efciency of contractual relationships between owners and
managers of large corporations (Eisenhardt, 1989; Gomez-
Mejia, Tosi, & Hinkin, 1987; Tosi & Gomez-Mejia, 1989). This
approach contrasts with the mathematical non-empirical
principal-agent theory proposed by Jensen and Meckling
(1976). Though the two views of agency differ epistemologi-
cally, they each provide important insights into the issues
arising when one party, a principal, hires another party, an
agent, to perform tasks desired by the principal. We focus on
the positive agency view because of its roots in scientic
realism, though we acknowledge that the two perspectives
are complementary in that principal-agent theory provides
theoretical guidance to positive agency research.
A positive agency perspective has been extensively used
by management scholars as a basis for examining the ef-
ciency of contractual relationships between owners and
managers of large corporations (Eisenhardt, 1989; Jensen,
1983; Tosi & Gomez-Mejia, 1989). Efciency is measured by
the costs resulting from the separation of control from own-
ership, which is generally referred to as agency costs. As
such the theory provides a special case of agency within the
nexus of contracts that make up complex organizations.
Agency costs arise because both parties to the relation are
assumed to hold self-serving interests and the contractual
mechanisms used to align those interests are imperfect and
costly (Alchian & Demsetz, 1972). That is, both owners and
agents are rational rent-seekers holding different utility
functions (Jensen & Meckling, 1976). Thus, positive agency
theory assumes a conict of interest between principals and
agents such that principals desire to maximize personal
wealth subject to risk constraints, while agents seek to maxi-
mize their personal wealth while minimizing personal effort
and risk. In the context of large organizations, an agents
effort toward maximizing the principals utility is positively
linked to the pecuniary rewards promised to the agent in the
contract. Agency costs in the form of moral hazard and
adverse selection arise because contracts are by nature
incomplete and principals face a problem of information
asymmetry with regard to agent effort. More specically,
agency costs include the pecuniary benets in the form of
contingent compensation tied to agent performance, and
non-pecuniary benets such as the physical appointments
HAS AGENCY THEORY RUNS ITS COURSE? 527
Volume 20 Number 6 November 2012 2012 Blackwell Publishing Ltd
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of the ofce, the attractiveness of the secretarial staff [sic],
the level of employee discipline . . . and so forth (Jensen
& Meckling, 1976:486). In addition, agents may exhibit
skiving, which reects a failure to responsibly carry out
the duties of the job (Jensen & Meckling, 1976). This can
occur in reduced effort, or the rejection of value-maximizing
investments in favor of investments that produce private
benets for the agent such as lower personal risk or higher
compensation (Kolev, Wiseman, & Gomez-Mejia, 2012).
Because of the costs faced by principals in overcoming the
problem of information asymmetry, positive agency theory
seeks to reduce these agency costs through the design of the
contract between the principal and agent. However, this
focus ignores a variety of factors that characterize actual
principal-agent relations such as the role of trust, the impor-
tance of other interest groups, and the possibility of enlight-
ened self-interest on the part of the agent. By relaxing core
assumptions of agency theory and allowing for alternative
perspectives, we can reconsider how the mechanisms pre-
scribed for controlling agent behavior may impact that
behavior. In the next sections we explore these extensions
to agency theory as a way to extend the external validity of
the theory beyond its narrowly dened assumptions.
Introducing Trust into Principal-Agent Relations
By focusing on contractual mechanisms to overcome the
conict of interest that can arise between rational self-
interested parties, agency theorists largely ignore alternative
scenarios for controlling agency costs. For example, some
agents may nd emotional or social utility in fullling the
desires of the principal. As Fehr and Falk (2002:719) suggest,
there are powerful non-pecuniary motives that shape
human behavior [such as] the desire to reciprocate, the
desire to gain social approval, and the intrinsic enjoyment
arising from working on interesting tasks. They go on to
argue that by considering these motives, economists may
gain a better understanding of how psychological factors
constitute incentives. Similarly, Hendry (2002) points out
that it is impossible for an organization to function effec-
tively without some measure of honesty, cooperation, and
trust, and it is impossible to delegate authority to agents
without relying to some extent on their loyalty, honesty, and
goodwill. This perspective is compatible with expectations
theory (De Dreu, Giebels, & Van de Vliert, 1998; Lant, 1992),
which accepts the individuals need for self-esteem and rec-
ognition from others, which in turn could justify carrying
out work responsibly. In other words, agent utility could be
enhanced by fullling the principals interests. Where agents
nd utility in fullling their responsibilities, trust becomes
the most efcient mechanism for maximizing the principals
utility.
Although the concept of trust is not new in an academic
context (Davis, Schoorman, Mayer, & Hoon Tan, 2000;
Mayer, Davis, & Schoorman, 1995; Schoorman, Mayer, &
Davis, 1996, 2007), in the last decade numerous studies
have been made of trust and its repercussions in the man-
agement of organizations, for example, in the cases of
inter-organizational cooperation (Ring & Van de Ven, 1994),
alliances in governing structures (Gulati, 1995), and
compromise/compliance of foreign subsidiary companies
with large multinationals (Kim & Mauborgne, 1993).
The concept of trust has been related to integrity, honesty,
consistency, and predictability (Butler, 1991; Mayer et al.,
1995). If trust is dened as the extent to which a person is
condent in, and willing to act on the basis of, the words,
actions and decisions of another (McAllister, 1995:25), then
trust entails risk, because the individual who places trust in
someone else is vulnerable to opportunistic behavior by
others (Cummings & Bromiley, 1996; Zand, 1972). This
vulnerability is variable, as we do not possess complete
information regarding individual behavior, competence, or
attitudes, which clearly vary across people and perhaps for
the same individual across time. Yet trust is a key element of
share capital and has been directly linked with individual
and group performance (within an organization), and with
the management of traditional processes like conict, com-
promise, and cooperation (for a review, see the works of
Jeffries & Reed [2000] and Williams [2001]). For Williamson
(1993), trust characterized by absence of control exists only
in relationships of family, friendship, or love. This is consis-
tent with the type of organization Ouchi (1979) calls a clan
that rely upon a relatively complete socialization process
which eliminates goal incongruence between individuals. In
other team settings within business relationships (those
called market or bureaucracies by Ouchi), formal safeguard
mechanisms must be designed to obtain cooperation among
individuals. In this sense, trust is considered noise in the
rational decision-making process, something to be avoided.
However, in the absence of objective information, people do
make subjective evaluations of other peoples attitudes, their
obligations and their future behavior as criteria for decisions
(Becerra & Gupta, 2003). So, in situations of uncertainty
(characteristic of the business world), there is a necessity to
understand the role played by trust and its repercussions on
the organization.
In recognizing the potential for trust, three points of
departure from positive agency theory are raised. First,
agency theory assumes that the principals and the agents
objectives are established outside the agency relationship
and are formalized in their respective utility functions.
Thus, conict of interest and asymmetry of information
basic premises in agency theory are not subject to criticism
as they are considered exogenous variables to the problem
of controlling agency costs. In contrast, the literature on
trust recognizes that prior interactions can reduce and even
eliminate conict of interest between principal and agent
(Granovetter, 1985). Drawing on the leadership literature,
Reicher, Haslam, and Hopkins (2005) compare leader-
follower models characterized as zero-sum games, in which
leaders (or followers) benet at the expense of the other,
against models built on social identity theory, in which
leaders and followers view themselves as partners actively
relying on each other to create conditions where mutual
inuence and mutual benet is possible.
Second, the basic aim of the literature on trust differs from
that of agency theory (Becerra & Gupta, 1999). Agency
theory focuses on designing efcient contracts that reduce
agency costs. The trust literature (Zaheer, McEvily, &
Perrone, 1998) suggests that even when the reduction of
governance costs is an important objective, the essential and
critical goal is to create an adequate environment of con-
structive relationships. This type of relationship, character-
ized by high degrees of trust, reduces the need for control,
resulting in lower agency costs. Again drawing on the lead-
ership literature, Gao, Janssen, and Shi (2011) suggest that
leader trust encourages employee initiative by increasing
the employees sense of security. Harris, Wheeler, and
Kacmar (2011) also nd that the quality of leader-member
exchanges encourages employee psychological and/or
social commitment to the organization, resulting in
improved outcomes. Further, trust is known to increase reci-
procity, thus further increasing commitment to the relation
(Zhu, Chew, & Spangler, 2005). It must be noted that, these
constructive relationships built on trust go beyond reduc-
ing costs of control because they also enable greater speed
in making and implementing decisions by reducing the
impediments to cooperation arising from mistrust and
uncertainty. As Becerra and Gupta (1999) show empirically,
cooperative relationships built on trust allow more time to
be devoted to other activities, facilitating, for example, the
necessary transfer of knowledge and expertise for innova-
tion within the organization. Carmeli, Schaubroeck, and
Tishler (2011) nd that an empowering leadership style cul-
tivates trust and increases subordinate collaboration result-
ing in increased condence in pursuing organizational
goals. Thus, trust releases newpossibilities for value creation
that are less accessible to contractual relations built on
assumptions of conict of interest.
Finally, trust presents an alternative to agency theory pre-
scriptions for resolving problems arising from conict of
interest. Agency theory proposes two contractual mecha-
nisms for uniting the interests of principals (owners) and
agents (managers). These are monitoring the agents behav-
ior directly, and using incentives to align the interests of
agents to those of the principal. Challenging these prescrip-
tions, the literature on trust suggests that the application of
these mechanisms based on a reward-punishment relation-
ship (consistent with an assumption of rational self-interest)
could, in the long term, widen differences between the
parties (Perrow, 1986). Imposing a contractual relation focus-
ing on pecuniary rewards could undermine the climate of
trust and thus increase the possibility of opportunistic
behavior by the agent.
The literature on motivation reinforces this point by
noting that extrinsic rewards can undermine the role of
intrinsic rewards on motivation (Deci & Ryan, 1985; Frey &
Jegen, 2001). That is, assuming that intrinsic rewards such as
satisfaction with achievement can motivate agents, increas-
ing reliance on extrinsic rewards such as compensation may
crowd out the value of intrinsic rewards in the agents
calculation of where and how much to expend effort (cf.
Vroom, 1964). That is, principal-agent relations built prima-
rily around contractual obligations that rely on extrinsic
rewards and punishments may increase agent opportunistic
behavior, thereby undermining trust.
Though acknowledging a role for trust would seem to
undermine agency theorys assumptions of self-interest,
some authors (Ghoshal & Moran, 1996; Perrow, 1986)
suggest that trust is not only compatible with economic theo-
ries such as agency theory, it opens new possibilities for
accurately capturing the empirical reality of economic
exchanges. For example, examinations of trust in personal
relationships nd that personal characteristics affect an indi-
viduals attitudes and thus bear on the quality of the rela-
tionship. Formally recognizing individual differences and
how those differences may impact the nature of a principal-
agent relation could lead to improved predictions about the
effect of different contractual arrangements on agent and
principal behavior. That is, future examinations of agency
could explore how individual differences interact with con-
textual factors to better understand the effect of various
control mechanisms on individual behavior, thus mitigating
the possibility of managerial interventions inaccurately
gauging the effects of context on employee perceptions, atti-
tude, and ultimately behaviors (Epitropaki & Martin, 2005).
In short, extending agency theory to recognize the poten-
tial for trust would necessitate going beyond its pessimistic
concept of human nature. As Perrow (1986) highlights,
agency theory exaggerates the possibility for opportunism,
shirking of responsibilities, and the laziness/reluctance
associated with the problem of moral hazard. However,
examinations of trust have shown that coercion is not always
required; individuals can adopt responsibilities voluntarily
and perform honest and seless actions. This leads us to
offer contrasting predictions about the potential for conict
of interest in a principal-agent relation.
Proposition 1a: According to agency theory, agents are ratio-
nally self-interested and thus weigh the utility of pecuniary and
non-pecuniary benets against the disutility of effort and risk
in determining how much effort will be expended on behavior of
the principal. This is likely to result in:
(a) agents acting opportunistically to the extent possible under
the terms of the contract dening their relationship to the
principal;
(b) increased conict of interests between the agent and the
principal.
Proposition 1b: According to the literature on trust, creating
a climate of trust increases the portion of an individuals utility
associated with feelings of achievement or self-esteem resulting
from performing well, and decreases the disutility associated
with the effort required. These conditions are likely to result in:
(a) greater trust between the principal and agent;
(b) less conict of interest between agent and principal.
Incorporating a Stakeholder Perspective
Astrict application of positive agency theory focuses only on
the bilateral relationship between the principal and agent,
and on designing efcient mechanisms for ensuring that the
agent devotes his or her full effort toward fullling the inter-
ests of the principal. To the extent that agency theory con-
siders other stakeholders, it views payments to stakeholders
above the stakeholders reservation wage or opportunity
cost for securing the stakeholders participation as an agency
cost, since this overpayment undermines the efciency of
the rm. That is, overpayment to stakeholders increases
costs without producing a compensating increase in rm
value, thus reducing the wealth of the principal. Within the
rational world of agency theory, overpayments to stakehold-
ers occur because self-serving agents can receive private ben-
ets from these investments which cannot be shared by the
principal. Examples of overpayment include actions that
promote well-being of other individuals through charitable
actions such as donating to charitable organizations, or
investing in relations beyond what the economic exchange
would justify, such as purchasing from friends rather than
from more efcient suppliers (Jensen & Meckling, 1976).
Agency theory, therefore views the agents contractual rela-
tionships with stakeholders as potential sources of agency
costs because agents can receive private non-pecuniary ben-
ets from these relationships, while the pecuniary costs
incurred in supporting these relations are channeled (have
negative repercussions) for the principal.
Challenging this constrained view of agents chasing non-
pecuniary benets at the expense of principals is an equally
compelling view that, by investing in stakeholder relations,
agents may create social debt that, based on social norms of
obligation and reciprocity, may enhance rm value and thus
the wealth of principals (Fukuyama, 1995). As Fehr and Falk
(2002) suggest, experimental economists have documented
that agents are motivated by non-pecuniary motives as well
as pecuniary rewards. And these non-pecuniary motives, or
social preferences, include caring about the material
resources allocated to relevant others, such as relatives, col-
leagues, and even trading partners. They go on to conclude
that: Reciprocity can be viewed as a contingent social pref-
erence because depending on the behavior of the reference
person . . . a reciprocal agent values [the reference persons]
material payoff positively or negatively (Fehr and Falk,
2002:689). That is, agents are social beings that recognize and
value their relations to others, leading them to enact proto-
cols of justice and fairness in their dealings with other indi-
viduals. Extending the role of reciprocity further, others
have argued that investments in strengthening relations can
create positive spillover effects that benet the interests of
the principal. For example, the well-being generated in the
context of what has come to be called the socially commit-
ted company (Granovetter, 1985) could favor an increase in
the future value of the company.
Formally recognizing the agents role in managing a
broader set of obligations extends agency theory by showing
how the effective management of these obligations contrib-
utes to the welfare of principals. Thus, a stakeholder per-
spective looks beyond the bilateral relation of principals and
agents to recognize organizations as a nexus of obligations
that go beyond investors to include a variety of interest
groups such as employees, suppliers, clients, and society
(Donaldson & Preston, 1995).
The term stakeholder has been dened in various ways,
such as from anyone who assumes some risk (Clarkson,
1995) to only those who are economically affected (Freeman,
1984). The most inclusive denition, and the one we favor,
recognizes that any individual or group that has an interest
in the organization or is affected by it would be considered
a stakeholder.
2
Stakeholder theory argues that the interests
of all the different stakeholders have to be taken into account
in management decision making, without anyone supplant-
ing others (Clarkson, 1995; Jones & Wicks, 1999). The agents
role is therefore to balance the competing interests of the
various stakeholders in order to assure rm survival. In this
sense, several authors distinguish between control shared
among multiple principals (which is far more common in
non-Anglo-Saxon countries) and undivided control by a
single constituency (as exemplied by the shareholder value
concept predominant in the United States and the United
Kingdom) (La Porta, Lopez-de-Silanes, Shleifer, & Vishny,
1999, 2000). Dixit (1997) introduces the concept of a stake-
holder economy, in his analytic development of an agency
model with heterogeneous principals, arguing that in many
countries managers are supposed to be responsible not
merely to shareholders, but to a more varied collection of
stakeholders (such as workers, creditors, the local commu-
nity, and so forth), provoking a politicization of corporate
governance. Tirole (2001) adds that in most non-Anglo-
Saxon countries, the provision of managerial incentives and
the design of a control structure require consideration of the
utilities of all stakeholders, not only those who have owner-
ship rights over the rm. In Germany, for example, labor
unions and bankers have been granted formal authority over
management that rivals the control by shareholders (Bruce,
Buck, & Main, 2005). In many Arab countries, religious
gures often sit on bank boards to ensure compliance with
Muslim law, which proscribes certain lending practices
(Abdulrahman, Al-Twaijry, Brierley, & Gwilliam, 2002; Rice,
2003).
Broadening the perspective of agency theory to recognize
that agents sit at the center of a nexus of stakeholder rela-
tions and that these relations reside within a social context
(e.g., Wiseman et al., 2012) highlights the social nature of
contracts, a perspective obscured in agency theorys calcu-
lus. As a social exchange, investment in stakeholder rela-
tions by an agent can create social debt that agents can later
leverage on behalf of principals. That is, due to social norms
of reciprocity, contributions to stakeholders that exceed the
stakeholders reservation wage or opportunity cost may
engender commitment to the relation and a willingness to
negotiate changes to the performance in response to chang-
ing demands and conditions. That is, managing stakeholder
relations, not simply as discrete economic exchanges, but as
valued relationships that exceed the economic benets of the
exchange, can produce positive benets for principals that
may not be directly observed, such as the development of
goodwill and social debt (Jeffries & Reed, 2000; MacNeil,
1977). Creation of goodwill or social debt, regardless of any
private benets the agent accrues, can produce a social asset
that can be drawn on should changing conditions require
contributions from stakeholders that exceed the economic
benets of the exchange. For example, providing above-
market benets may make it easier to secure wage conces-
sions during industry downturns as the Hormel Foods
Company did in the 1960s. Contributions to non-economic
exchange partners may also benet. For example, a national
department store chain, Dayton-Hudson, was able to rally
charitable organizations to aid the company in enacting a
law that protected the company from a threat of green-
mail.
3
In sum, recognizing a stakeholder view of organiza-
tions, acknowledges that stakeholder relations are not
simply economic exchanges, but are also social exchanges
that come not only with moral obligations to satisfy the
terms of the explicit contract, but also result in implicit social
contracts that impose additional obligations that go beyond
the economic exchange. These social obligations need not be
considered inefcient since they can produce indirect
returns that all stakeholders, including the principal, may
share.
Thus, we agree with Shankman (1999) that agency theory
and stakeholder theory are not irreconcilable, but can
approach convergence by relaxing some of the assumptions
of agency theory. We do this by recognizing that, while
agency theory focuses on the relation of nancial investors
(principals) to managers (agents), nancial investors are
simply one of many groups making investments into the
company (Hill & Jones, 1992).
4
In addition, as Quinn and
Jones (1995) argue, agents are not simply economic beings,
as agency theory would suggest, but are moral beings as
well. Indeed, though agency relationships are built on
binding agreements, the existence of these agreements will
not work without the implicit assumption that individuals
will respect the agreements they willingly create. Therefore,
agency theory is limited inasmuch as agency relationships
involve a series of underlying moral principles (which are
also accepted by stakeholder theory). Finally, though agency
theory presumes opportunistic behavior, because contracts
are incomplete, trust is a necessary condition for a relation-
ship to work. As Barney (1990:385) notes, the presence of
trust drastically reduces the number of resources needed to
control agency costs: costs of exchanges with honest indi-
viduals (rms) will be lower than the costs of exchanges
with individuals (rms) whose honesty cannot be judged a
priori. Therefore, it seems more logical to adopt a perspec-
tive of contingency that may or may not accept the possibil-
ity of egotistical individual behavior.
Thus, it appears that critical analysis of agency theory and
logic leads to the adoption of a more exible perspective
such as the stakeholder theory, which supports the idea that
the attitudes of individuals are not always selsh. As Foss
(1996:519) suggests, some aspects of economic organization
may be rendered intelligible without appeal to the notion of
opportunism, and . . . socialization, norms, moral communi-
ties, etc., play an important role for understanding the coor-
dination of economic behavior (and . . . sociological insights
may therefore be relevant). The divergent situations sus-
tained by one or another theory can be seen in the following
propositions:
Proposition 2a: According to agency theory, exclusively
focusing on the bilateral relationship between the principal and
agent will likely result in:
(a) agents compensation being based primarily on variable
pay linked to performance criteria;
(b) extensive monitoring of agents to reduce the pecuniary
costs incurred by the agent in the relationship with third
parties;
(c) agents being rewarded according to their ability to
increases the wealth of the principal.
Proposition 2b: According to stakeholder theory, increasing
the number of different principals will likely result in:
(a) less use of variable pay linked to performance criteria, since
there is less agreement among principals on which perfor-
mance criteria to use;
(b) greater internal monitoring of agents through formal
bodies representing multiple stakeholders;
(c) agents being rewarded according to their ability to identify
and enforce political compromises among principals with
conicting objectives.
Recognizing a Role for Leadership in
Team Production
Agency theory presumes that in any exchange relationship
the agent will behave selshly (maximizing personal utility),
so agency costs can arise. Thus as the organization grows,
the increased number of groups or relationships inside it
will increase these costs even more (Jensen & Meckling,
1976), causing what is known as the team production
problem. In a team production situation, it is understood
that the end result achieved by a group of workers is greater
than the sum of the products that could be obtained from
each worker individually, but the input attributable to each
individual is difcult to measure and observe (Alchian &
Demsetz, 1972). The larger the team, the greater will be the
possibility of opportunistic behavior on the part of the
members. The interest of a particular individual in supervis-
ing a colleagues performance is diluted, insofar as that indi-
vidual would be responsible for the complete supervision
with all the effort required, but would receive back only a
tiny part of the potential benet, i.e., the improvement in
team performance. Therefore, according to agency theory,
the increase in the size of the group (organization) carries
with it an increase in agency costs.
By contrast, some research suggests that compensation
schemes can encourage mutual monitoring among team
members, by tying a portion of the team member pay to the
collective output or performance of the team (Gomez-Mejia,
Welbourne, & Wiseman, 2000). By linking compensation to
collective output, team members have a vested interest in
the effort and contribution of fellow team members. As a
result, members, who are often in a better position to
observe the effort of fellow team members, can use social
pressure and other tactics to motivate effort on the part of all
teammembers. Thus, the teamproduction problemneed not
result in increased agency costs, if compensation is designed
to reward team members for building team effort.
Proposition 3a: According to agency theory, when agent per-
formance requires a team of agents to cooperate, this is likely to
result in:
(a) higher costs for monitors in overcoming informational
asymmetry about member effort;
(b) larger teams having more opportunity for members to
shirk;
(c) a larger portion of pay will be contingent on team produc-
tion in order to foster mutual monitoring by team
members;
(d) an increased used of social pressures by team members on
one another to limit shirking behavior.
In addition, management research recognizes that leaders
can inuence member effort by how they interact with team
members (Rubin, Bommer, & Bachrach, 2010; Yan & Moss-
holder, 2010). That team members can be encouraged to
recognize that their individual fate depends on the collective
effort of all members (cf. Fama, 1980). That is, while agency
theory focuses attention on extrinsic motivation, specically
economic incentives (tangible rewards with a quantiable
market value), as the main mechanism of control over the
agent, behavioral scholars recognize intrinsic incentives
such as opportunities for growth or self-realization (Davis et
al., 1997). They suggest that leadership style can inuence
subordinate behavior by increasing commitment and iden-
tication with the organization (Mayer & Schoorman, 1992).
In the context of agency, this perspective has been referred
to as stewardship theory (Donaldson & Davis, 1991, 1994).
This approach argues that the adoption of organizational
strategies based on both mutual trust and a spirit of coop-
eration are both feasible and desirable. Thus, the adminis-
trator behaves cooperatively (or collaboratively) because the
administrators task is to see that the organizations objec-
tives are met
5
(e.g., greater sales gures or protability).
Thus, the theory attempts to explain the presence of collabo-
rative, altruistic and non-remunerated behavior in organ-
izations (OReilly & Chatman, 1986). Inasmuch as the man-
agement identies with the organization, there should be
condence in the execution of delegated tasks because the
management will use its initiative to promote the success of
the organization and its principals. By increasing the share-
holders wealth, administrators maximize their own utility
at the same time. That is, according to stewardship theory,
administrators gain greater utility when they develop a col-
laborative approach than when they behave in a selsh and
opportunistic way (Argyris, 1973).
Davis et al. (1997) identify circumstances that would favor
agency theory predictions over stewardship predictions (or
vice versa) by highlighting the psychological and contextual
factors that predispose individuals to be opportunistic or
committed to organizational goals. These factors include:
(1) management philosophy, (2) organizational culture, and
(3) power distance.
Examining the rst factor, Lawler (1992) emphasizes two
main management philosophies, depending on whether
they are based on control or commitment. Davis et al. (1997)
understand that under a management system based on
control, in which the function of work control must be sepa-
rate from its execution, it is more likely that agency relation-
ships will develop. On the other hand, when there is a
management philosophy based on commitment (which
appreciates that there must be no separation between plan-
ning, control, and execution), it is more likely that relation-
ships will occur in the context of stewardship theory. Some
similarities could be found among these philosophies and
the transactional vs. transformational leadership styles.
As long as transformational leaders motivate their subor-
dinates by developing closer relationships with them, inspir-
ing them, and encouraging individual development, leaders
transform subordinates with commitment by motivating
them to do more than what is initially expected (Podsakoff,
Mackenzie, Moorman, & Fetter, 1990; Vigoda-Gadot, 2006).
That is why the transformational leadership literature
stresses the cognitive and affective relationships between
leader and members. Meanwhile, transactional leadership
considers the relationship between leader and subordinate
as impersonal and based on an exchange or transaction of
rewards for services. Transactional leaders motivate follow-
ers primarily through conditional reward-based exchanges,
setting goals, and clarifying the link between performance
and rewards (Bass, 1985). Then, transformational leadership
re-directs attention from individual leaders behaviors and
characteristics to the work of leadership, as opposed to the
agents through which it is carried out (Foldy, Goldman, &
Ospina, 2008). Obviously, beliefs about leadership differ
across cultural contexts, and this may explain some of the
differences in compensation designs and especially the link
between incentives and outcomes (Wiseman et al., 2012).
Where there is a belief that leadership matters (what
Meindl, Ehrlich, & Dukerich, 1985, dubbed the romance of
leadership and others have called a heroic view of leader-
ship), there is an implied assertion that individual execu-
tives can provoke large differences in how organizations
perform. That is, some cultures strongly believe that top
executives can and do have a major impact. This is especially
true of the United States (for examples, see Jacobson &
House, 2001; Shamir, House, & Arthur, 1993). However, in
other cultural contexts, agents are not able to, or may not be
expected to, make a signicant impact on the organizations
bottom line. This latter belief corresponds to a fatalistic view
of life, wherein ones future is less a product of individual
effort than of chance or external forces (cf. Esparaza, 2005;
Marin & Van Oss-Marin, 1991). This belief may also be true
of more collectivist cultures, where organizational success or
failure is attributed to organizational members as a group
rather than actions of specic executives (Daft, 2002).
In the second place, Davis et al. (1997) emphasize that
cultural differences may inuence the choice between an
agency and a stewardship relationship. For this they use
Hofstedes distinction between individualist and collectivist
culture. Agency relationships will be favored by an individu-
alist culture characterized by a short-term orientation, an
emphasis on the reaching of personal goals, consideration of
conict as an opportunity to improve communication, and
nally, an idea of business where personal aspects of the
relationship are fully ignored (cost/prot analysis). On the
other hand, a collectivist culture, in which personal interests
are sacriced in favor of general interests, confrontation
between groups is avoided and long-term relationships
permit the people involved in the relationship to understand
each other better, will favor relationships between principal
and administrator. In an empirical study with multi-
assessment data of managers and their teams in 80 countries,
Wendt, Euwema, and Van Emmerik (2009) found that direc-
tive leadership characterized by task-oriented behavior with
strong focus on targets, close supervision, and control of
subordinate actions were stronger in individualist societies.
Meanwhile, supportive leadership style, which includes
sensitivity to team member needs and focus on harmonic
working relations, was prevalent in collectivist societies.
Going further on this distinction between individualist
and collectivist culture, Nahum-Shani and Somech (2011)
measure the individual-level orientations that reect these
cultural values. They use the terms idiocentrism and allo-
centrism to capture within-culture variation in personality
attributes (Triandis, 1995). Individuals high on idiocentrism
view the self as being separate from others and give priority
to the achievement of personal goals over the goals of the
collective. Individuals high on allocentrism view the self as
inseparable from their in-group members, and subordinate
their personal goals to the collective ones (Lam, Chen &
Schaubroeck, 2002). Consistent with this notion, Nahum-
Shani and Somech (2011) defend that effectiveness of the
leadership styles mentioned above (transactional vs. trans-
formational) are contingent upon followers idiocentrism
and allocentrism. Transactional leaders are more effective
among idiocentric followers, while transformational leaders
are more effective among allocentric followers. Then, team
members personalities seem to be among the most crucial
factors in determining team productivity and performance
(Driskell, Hogan, & Salas, 1987). Individualistic members
do not want to work to benet the team; they are usually
competitive both with the rest of their team members
and with other teams (Chow, Lindquist, & Wu, 2001; Kim,
Triandis, Kagitcibasi, Choi, & Yoon, 1994). They do not have
emotional relationships with their teammates, but rather
sporadic relationships usually linked with the work or task
that they must carry out. This attitude can give rise to inter-
nal tensions and objective conicts within the team that can
impair performance (Wagner, 1995). In contrast, teams
formed of people with a collectivist orientation have less
internal competition, since their members are focused on
cooperation and common work to benet the team (Llies,
Wagner, & Morgeson, 2007). They have a strong collective
interest, i.e., a team feeling that promotes team targets over
individual interests (Tyler and Blader, 2000), and can expect
great self-sacrice when it is necessary to meet the team
goals (Llies et al., 2007; Triandis & Gelfand, 1998).
Finally, Davis et al. (1997) argue that acceptance and toler-
ance of great differences in power and status among the
members of an organization (normally favored by central-
ized structures and large differences in privileges and sala-
ries among the different hierarchical levels) favor agency
relationships because they legitimate the inequality of power
between principal and agent. However, the existence of
small differences of power leads to stewardship relation-
ships that support a greater equality between principal and
management. Considering leadership as a process of social
inuence, Subaic, Reynolds, Turner, Veenstra, and Haslam
(2011) discuss how different tools of power affect leaders
capacity to shape the beliefs and attitudes of followers.
According to these authors, the utility of rewards/
punishments and surveillance depends on whether the
leader is considered to be an in-group or out-group member
(socially close or distant leaders). Subaic et al. (2011) found
that while surveillance may be a necessary tool in the reper-
toire of out-group leaders (similar to what happens in
agency relationships), it is likely to attenuate rather than
enhance leaders capacity of inuence when they are per-
ceived as in-group (close leader). Also, the objective leaders
distance (not the perceptional leader-follower distance)
seems to be important for the effectiveness of leadership. So,
Walter and Bruch (2010) argue that the positive relationship
between transformational leadership and productive orga-
nizational energy is diminished under conditions of high
centralization and size of the organizational structure. That
is explained because greater (lower) hierarchical differences
in organizations may often manifest both greater (lesser)
physical distance and a lower (higher) frequency of direct
interaction between leaders and followers (Chun, Yam-
marino, Dionne, Sosik, & Moon, 2009).
In short, recognizing a role for vigilant and committed
leadership, as stewardship theory does, complements
agency theory. As ONeill (2007) suggests with an empirical
study of Australian non-executive directors, the reliance on
economic efciency arguments alone does not provide a
sufcient framework to explain the subjective, judgmental
and socially interactive processes involved in determining
executive pay. While agency theory allows for an under-
standing of the conicts of interests between principal and
agent (dening the potential problems and the mechanisms
to solve them), one can conceive of a different model of
behavior in which leadership enhances commitment and
ultimate team performance. In addition, incorporating a role
for leadership and team dynamics replaces the deterministic
model of agency with a contingent model that allows for
the examination of psychological and social features which
can lead to improved predictions of principal and agent
behavior.
Proposition 3b: According to stewardship theory, appropriate
leadership styles characterized by transformational leaders,
collectivistic teams, and small differences of power among
members are likely to result in:
(a) increased team commitment and identication with orga-
nizational purpose;
(b) a mitigation of the team production problems;
(c) less use of pay-for-performance contingent on team produc-
tion;
(d) greater use of intangible rewards to create incentive
alignment.
CONTROLLING AGENT BEHAVIOR
Incentive alignment is considered a key mechanism for con-
trolling agents abuse of delegated power (Eisenhardt, 1989;
Gomez-Mejia et al., 1987; Tosi, Katz, & Gomez-Meja, 1997).
Incentive alignment links salary with the agents perfor-
mance and is often preferred by positive agency theorists
because of the information problem facing monitors. With
that in mind, the primary focus of attention of agency theo-
rists is on identifying the most efcient contract that
balances the cost of incentives with the benets derived
by linking incentives to desired outcomes.
Compensation and Incentive Plans
Given the cost of overcoming information asymmetry sepa-
rating principals and agents, positive agency theory pro-
poses aligning the interests of agents and principals by
making a portion of the agents pay contingent on achieving
outcomes important to principals (Fama & Jensen, 1983).
Compensation that is contingent on the agents ability to
achieve performance desired by the principal should align
the interests of the principal and the agent, maximizing the
utility function of both. Thus extrinsic rewards tied directly
to performance outcomes is argued by positive agency
scholars to motivate agent effort under conditions where
effort cannot be directly observed. The challenge for agency
theorists is therefore to derive the most efcient compensa-
tion package for maximizing agent effort, subject to the risk
constraints of rational self-interested agents.
However, it seems that in reality the denition of com-
pensation does not always correspond with a logical pattern
(i.e., one that maximizes organizational efciency), as
agency theory suggests. Instead, it responds to norms
imposed by the sector the company operates in, or to man-
agement trends (Meyer & Rowan, 1977; Zucker, 1987) that
could be explained from an institutional theory perspective.
According to this theory, the behavior and survival of orga-
nizations are decided by social context. Organizations adopt
the structures and processes that best adapt to the norms,
values, and beliefs in the institutional environment. Thus
their behavior is not always the result of a previous choice;
rather, they respond to the search for social acceptance or
legitimacy (Pfeffer, 1982). Suchman (1995:580) states that the
activities of organizations are evaluated and perceived as
legitimate when the organizations use socially accepted
techniques and procedures to demonstrate that they are
making a good-faith effort to achieve valued . . . ends.
In sum, according to institutional theory, it is possible to
predict practices in an organization on the basis of cultural
denitions of legitimate behavior, tradition in the industrial
sector, the history of the company or popular management
practices (Eisenhardt, 1988). For example, Davis (1991)
found that companies were more inclined to adopt poison
pill anti-takeover provisions if their directors served on the
boards of other companies that had adopted such provi-
sions. Brenner and Schwalbach (2009) also pointed out the
inuence that legal institutions can have on CEO pay,
making boards more accountable to shareholders. As a
result, isomorphism arises between organizations that
share the same environment or niche (DiMaggio & Powell,
1983).
There is increasing evidence that institutional theory pro-
vides a strong basis for explaining management practices in
human resources (Paauwe & Boselie, 2003) and particularly
compensation practices. In this way, Shaw, Gupta, and
Delery (2002) explain the power of pay dispersion as an
element that favors the implementation of a strategy com-
bining classic economic perspectives with institutional
theory and organizational justice. St. Onge, Magnan, Thorne,
and Raymond (2001) provide empirical evidence that incen-
tives are managed not exclusively to align interests between
principal and agent (reducing the problem of agency), but
rather as a sign or image of how the company belongs to a
given social context (even when the practices of other com-
panies in the sector do not yield greater efciency for the
imitating company). Hence the increasing literature on what
has come to be called the symbolismof compensation (West-
phal & Zajac, 1994, 1998; Zajac & Westphal, 1995). Staw and
Epstein (2000) also provide evidence that the adoption of
certain popular management practices responds to the
search for legitimacy, in that the adopting companies gain
more admiration from society and are considered more
innovative. These authors also show that the adoption of
these popular practices is associated with greater compen-
sation of their executives (even if they did not contribute to
improving the economic performance of the company).
Clearly, societies are likely to vary in the importance
assigned to various rewards (such as money, recognition,
status, social inuence, respect, and the like) (Gomez-Mejia,
1984). Pecuniary rewards should be more popular in highly
competitive market environments because they allow and
even encourage score keeping. In cultures where pecuniary
rewards are important, CEOs make social comparisons of
their achievements by devoting close attention to how their
pay stacks up against that of other CEOs (Crystal, 1991).
There is substantial evidence in the United States and the
United Kingdom supporting this view (e.g. Eriksson, 1999;;
Ezzamel & Watson, 2002; Henderson & Fredrickson, 2001;
OReilly, Main, & Crystal, 1988). Indeed, the practice of
adjusting agent pay to the compensation of the agents peers
is quite common in these societies, with a large cadre of
specialists and consulting rms dedicated to gathering such
data (Baker, Jensen, & Murphy, 1988). As OReilly et al.
(1988) suggest, these comparisons inevitably pressure remu-
neration committees to be relatively generous in redressing
pay anomalies in order to avoid any possibility that execu-
tive talent may be bid away by competitors. Eriksson (1999)
and Henderson and Fredrickson (2001) also argue that
determining CEO pay by reference to the pay of other CEOs
increases the pay gap between a CEO and his/her subordi-
nates. However, in many Latin and Asian societies, high
executive compensation packages may be seen not as
symbols of personal success but as signs of avarice and
hidden corruption (Ibanez, 2005; Vassolo, Decastro, &
Gomez-Mejia, 2011). In France, high compensation differen-
tials between top and lower organizational levels on the
order often seen in the United States would be regarded as
shameful (Cala, 2005). These social values may explain why
CEO compensation in most other countries (even after con-
trolling for rm size, performance, industry, and per capita
income) is only a fraction of what is paid to CEOs in the
United States and the United Kingdom (Gomez-Mejia &
Wiseman, 1997). Other rewards (such as ofcial titles, wide
media exposure, honorary appointments to prestigious uni-
versities, participation in key national committees on indus-
trial policy, being portrayed as the embodiment of a set of
moral or ethical values, and the like) may provide visible
cues to position that may substitute for money in societies
that acknowledge and respect those cues. As a case in point,
Samsungs top managers in Korea are often portrayed as
national heroes for driving down costs and creating more
value for the customer, even though they are paid little by
US standards (Lewis, 2005). In this sense, Chefns (2003)
discusses how factors such as legal regulation and business
culture can hinder the possibility that US pay-for-
performance emphasis could globalize to other contexts.
So, Chizema (2008) and Conyon (2001) provide empirical
evidence of the institutional inertia and problems that
large German and UK rms, respectively, present to the
disclosure of individual executive compensation.
In short, while agency theory focuses on deriving efcient
incentive structures for motivating agent effort toward spe-
cic performance outcomes, institutional theorists suggest
that other factors such as rm tradition, industry norms,
social, cultural, and political beliefs, legislation, or manage-
ment fads may strongly inuence the design of agent com-
pensation (Eisenhardt, 1988). However, responding to these
other factors need not be irrational. The adoption of certain
structures or procedures deemed legitimate in the environ-
ment may constitute a reasonable and responsible course of
action, as they may please external institutions of power or
avoid claims of negligence (Meyer & Rowan, 1977). Indeed,
organizations that cannot defend their results in accordance
with acceptable legitimized accounts of their activities . . .
[will be] more vulnerable to claims that they are negligent,
irrational, or unnecessary (Meyer & Rowan, 1991:50).
Therefore, rationality is a common feature in both theories,
though they differ in the objective towards which rationality
is used: rational behavior to achieve social legitimacy (insti-
tutional theory) vs. rational behavior to
Proposition 4a: According to agency theory:
(a) agent compensation packages are designed following a
logical-rational pattern that makes agents pay
contingent on achieving outcomes important to
principals;
(b) internal monitoring will be devoted to establishing indi-
vidual accountability by ascertaining the agents personal
contributions to observed outcomes;
(c) the proportion of residuals an agent will extract from a rm
in the form of larger pay packages is small.
Proposition 4b: Accordingly to institutional theory:
(a) agent compensation packages are designed in search
of social acceptance or legitimacy according to the
norms, values, and beliefs of its institutional
environment;
(b) agent monitoring is externally oriented and based on social
acceptance, so that personal contributions without a posi-
tive reputation or legitimacy are unlikely to be acknowl-
edged;
(c) the proportion of residuals an Agent will extract from a
rm in the form of larger pay packages is high.
Role of Risk in Principal-Agent Relations
Building on neo-classical economics, positive agency theo-
rists assume that risk carries disutility and thus agents (as
well as principals) are assumed to be inherently risk averse.
Though principals may employ a variety of techniques to
hedge against personal risk exposure, such as diversifying
their nancial investment across rms, agents cannot diver-
sify their human capital investments making them overly
invested in the rm and thus exposed to greater risk (Jensen
& Meckling, 1976). This is because they are contractually
bound to a single employer; their primary source of wealth
is derived from that employment relation.
The efcient distribution of risk between the principal and
agent becomes a critical issue in determining how to com-
pensate agents. However, this would give the agent no
incentives. Thus agency theory must seek a balance, what
is known as a trade-off, between risk and performance
contingent compensation (Baiman, 1990).
This concept is simplistic because it considers only two
types of risk preferences (aversion and neutrality to risk),
ignoring the existence of behavior prone to risk. Moreover,
this theory assumes that individuals keep their risk prefer-
ences stable over time and across decision-making situa-
tions. However, the literature seems to suggest that
individuals may change their attitudes towards risk, with
indications that there is a lower aversion to risk in the
younger agent (Hambrick & Mason, 1984) and with the
decision-making situation faced by the agent (Hambrick,
1981). For example, executives tend to choose riskier deci-
sions in an innovative prospector strategy as a reection of
the ingrained character of this strategy to support the rms
continuing search for new products and markets (Miles &
Snow, 1978).
In addition, as prospect theory suggests, agents can
change their attitude towards risk according to particular
situations in which they may nd themselves (Kahneman &
Tversky, 1979). In this way, while agency theory presents a
normative model, in which decision making is part of a
rational-cognitive process in which the aim is the maximi-
zation of personal utility, prospect theory maintains that
decision making responds not to a normmodel, but rather to
a behavior model that explains how preferences are formed
(Levy & Levy, 2002). In prospect theory, the nal attitude
shown by the individual toward risk is determined by the
context in which the decision is taken. This theory is based
on the premise that individuals are psychologically averse to
loss and thus will adjust attitudes toward risk depending on
how risk may increase or decrease the potential for loss
(Mukherji & Wright, 2002).
Thus, while agency theory centers on aversion to risk, pros-
pect theory centers on aversion to loss. According to this last
concept, the risk preferences of the decision makers will be
determined by the context or environment surrounding the
problem. The aim is to minimize losses (and not so much to
maximize gains), even though this may involve assuming
greater levels of risk. Similarly, Rabin (1998:11) suggests that
a persons preferences are often determined by changes in
outcomes relative to her reference level, and not merely by
absolute levels of outcomes. In particular, relative to their
status quo (or other reference points), people dislike losses
signicantly more than they like gains (see, e.g., Villena,
Gomez-Mejia, & Revilla, 2009; Wiseman & Gomez-Mejia,
1998).
Another problem with agency theory is that it posits a
linear and positive link between risk and performance,
understanding that greater risk means greater income and
vice versa (Jensen & Meckling, 1976). Despite the existing
controversy, agency theory admits that the larger the man-
agements contingent remuneration, the more risk-taking
decisions on the part of the agent will be encouraged,
because ultimately the managements wealth is dependent
on the performance of the company, aligning the interests of
management and principals. However, this is veried only
up to certain risk levels, after which uncertainty suffered by
the management is not compensated by the contingent com-
pensation and, accordingly, risk-averse behavior begins to
appear. For example, within the behavioral agency model
proposed by Wiseman and Gomez-Mejia (1998), managers
perceptions of risk derive from threats to their xed salary.
The explanation rests on the observation that managers gen-
erally devote xed compensation to paying for costs related
to their standard of living (house, car, etc.), and devote con-
tingent compensation to savings and purchasing non-
essential items such as luxury goods and services. So a
reduction in their xed salary entails a threat not only to
their total wealth but to their daily standard of living. Loss
associated with this type of risk is much greater than that
derived from a threat to variable compensation. While in
agency theory risk is associated with uncertainty, and aver-
sion to risk will be greater as the proportion of contingent
compensation gets higher, in the behavioral agency model
or BAM, an increase in contingent compensation does not
presuppose an increase in managers perception of risk if the
xed salary is not threatened (assuming that managers are
assured of not losing their jobs). In subsequent elaborations
of BAM, Martin, Wiseman & Gomez-Mejia (2012a,b) argued
that decision makers make risky choices in response to what
they perceive as mixed gambles that involve weighing the
potential for greater future wealth versus the protection of
current wealth.
Other extensions of BAM propose that the framing of
losses need not necessarily be nancial. For example, in a
series of papers, Gomez-Mejia and colleagues have shown
that for family controlled rms (representing the predomi-
nant ownership form around the world), a key driver when
making risky business decisions is to avoid losses in socioe-
motional wealth or the endowment of affect related value
that the family has accumulated in the rm. In these papers,
Gomez-Mejia and colleagues used the behavioral agency
model to argue that family controlled rms, despite their
concentrated nancial wealth in a single rm, may prefer to
take high business risks if this is needed to reduce potential
losses in their socioemotional endowment (Berrone, Cruz,
Gomez-Mejia, & Larraza-Kintana, 2010; Gomez-Mejia, Cruz,
Berrone, &DeCastro, 2011; Gomez-Mejia, Hoskisson, Makri,
Sirmon, & Campbell, 2012; Gomez-Mejia, Larraza-Kintana,
& Makri, 2003; Gomez-Mejia, Makri, & Larraza-Kintana,
2010; Gomez-Mejia, Nunez-Nickel, & Gutierrez, 2001;
Gomez-Mejia, Takacs-Haynes, Nuez-Nickel, Jacobson, &
Moyano-Fuentes, 2007).
Finally, the literature also emphasizes that the environ-
ment in which the principal-agent relationship develops can
inuence the individuals risk preferences (Chattopadhyay,
Glick, &Huber, 2001). Agents who are not averse to risk may
be attracted to turbulent or dynamic atmospheres. In these
situations, aversion to risk may be considered inadequate to
identify opportunities or threats. Following Wiseman et al.
(2012), the analysis of the institutional context, such as the
country risk, is needed for a better understanding of the
specic manifestations of agency problems in different
cross-national settings. Country risk represents uncertainty
about future events at a national level that arises from,
among other things, lack of condence in the legal system,
arbitrary government decisions, and high political instabil-
ity (Miller, 1992). As the principals vulnerability rises with
country risk, trust in the agents motives is likely to decline
(Rousseau, Sitkin, Burt & Camerer, 1998), increasing invest-
ment in control systems. Carpenter, Indro, Miller, and Rich-
ards (2010) analyze how home-country risk moderates the
relationship between CEO stock ownership or options with
the amount of equity capital raised by a foreign rm in US
stock markets. For agents, country risk aggravates personal
risk by making performance outcomes more unpredictable
and less dependent on their own effort or abilities (Gomez-
Mejia & Palich, 1997; Gregorio, 2005; Shrader, Oviatt, &
McDougall, 2000). In such situations, agents are likely to
demand a premiumin order to accept this risk. Even so, they
may adopt conservative strategies that may lower the prin-
cipals returns. In high-risk environments, we therefore
would expect that post-hoc settling up forms of monitoring
would substitute for ex ante incentive alignment contracts,
since the former provide a more accurate measure of how
much the agents actions contributed to rm performance
(Conyon & Sadler, 2001).
Ghosh and Ray (1997) suggest that what explains attitude
toward risk is not only environmental uncertainty, but how
this is interpreted by the agent and his or her tolerance of
ambiguity. Using prospect theory and the reference frame-
work that stresses relative gains or losses, Fornali (2002) also
suggests that risk preferences are not constant over time and
across situations because of the inuence of two moderating
variables: (1) the aims established by the decider (mere sur-
vival aims as opposed to ambitious aims) and (2) the level of
control over results perceived by the decider.
Previous studies show that we cannot consider as univer-
sally valid the assumption that all agents are consistently
averse to risk. Prospect theory may complement agency
theory, as Wiseman and Gomez-Meja (1998) argue in their
behavioral agency model. And there is a further problem:
both of these theories consider that the formation of prefer-
ences or attitudes toward risk responds to a cognitive
process, which involves a deliberation concerning the differ-
ent options, as well as a ranking and choice of the best
alternative. However, from a more critical point of view,
there are now some decision-making models that propose
that the formation of preferences also responds to subcon-
scious reasoning (Erb, Bioy, & Hilton, 2002), and not neces-
sarily to a rational process. In any case, the ideas supported
by agency theory and prospect theory, respectively, can be
summed up in the following propositions:
Proposition 5a: According to agency theory, because agents
are assumed self-interested and thus seek to maximize their
particular utility function, this results in:
(a) agents minimizing their disutility associated with both
compensation risk and employment risk;
(b) agents will be consistently averse to risk.
Proposition 5b: According to prospect theory, individuals
risk preferences are determined by the context in which deci-
sions are taken, which is likely to result in:
(a) agents being risk seeking in situations where they antici-
pate losing wealth or failing to achieve wealth goals;
(b) agent risk preferences being variable across decision
contexts.
DISCUSSION AND CONCLUSIONS
In summary, agency theory has been subjected to a number
of important criticisms and stands to benet from being
complemented by several other theoretical frameworks.
First, agency theory makes the negative and rather inexible
assumption that agents always exhibit opportunistic behav-
ior that reduces the principals wealth. The trust literature
suggests an alternative proposition that agents may act hon-
estly without any control mechanism. Extrapolation of trust
to an organizational level implies that: (1) the consideration
of multiple stakeholders does not always entail higher
agency costs, because social norms of obligation and reci-
procity may cause stakeholders to repay benets, thus
increasing the future value of the rm and therefore the
principals wealth; and (2) the growth of the organization
does not always entail higher agency costs, because agents,
aware of the difculty in separating their well-being from
that of the other members, may identify themselves with the
mission/vision of the rm and develop commitment and
cooperative behavior. Thus, instead of controlling agency
costs through extrinsic rewards as advocated by agency
theorists, it is possible that, in some situations, agents may
self-regulate in response to socioemotional rewards result-
ing from accomplishment and cooperation.
By comparing with the rationally self-interested concept
of human behavior that justies conict of interests between
principal and agent, we have considered a growing literature
on trust. While agency theory assumes that both principals
and agents are rational rent-seekers and hold different
utility functions, we describe circumstances under which
honesty, loyalty, and trust in agents behavior are possible.
The interpretation of the principal-agent relationship as one
of cooperation and not conict of interests has different
implications in order to extend agency theory.
One implication from our reconsidering the mechanisms
used to inuence agent behavior is in recognizing a role for
trust. Agency theory focuses on identifying the most ef-
cient contract for aligning the interest of an agent with those
of the principal (Fama & Jensen, 1983), recognizing the key
role played by extrinsic motivation, specically economic
incentives, to reduce agency costs. In contrast, trust litera-
ture fosters the development of constructive relationships
where partners can actively rely on each other to create con-
ditions where mutual inuence and mutual benet is pos-
sible. It implies that the main mechanism of control over
agents behavior moves from extrinsic to intrinsic incentives
such as opportunities for growth or self-realization as stew-
ardship theory suggests when management identies with
the organization; or the implicit social contracts of obliga-
tions and reciprocity (beyond the economic exchange) that
exist in stakeholder relations.
In the same way, and regarding incentive alignment, insti-
tutional theory suggests that compensation design may not
coincide with the arguments of efciency and rational self-
interest so much as they reect, but respond to the norms,
values, and beliefs of the institutional environment to search
for social acceptance or legitimacy.
This leads to a second implication from considering the
relevance of other theoretical perspectives to agency. This has
to do with acknowledging the social context in which the
principal-agent contract resides in order to go deeper in
the understandingof howthat context mayinuence boththe
interests and mechanisms for aligning interest of principals
and agents. It gives us the opportunity to replace the deter-
ministic model of agency with a contingent one that encour-
ages the analysis of psychological, social, and institutional
features that draft a more realistic view of the economic
exchange between both parts. In fact, we defendthe necessity
to acknowledge, for example, the social context in which the
exchanges with stakeholders take place, as well as the role of
leadership styles or the organizational culture to understand
to what extent individuals will behave opportunistically or
will be committed to organizational goals. Similarly, we
discuss the simplistic assumption of two types of attitudes to
risk (aversion and neutrality) to suggest the importance of
considering the decision-making situation facedby the agent.
While descriptions of the various contexts that surround a
principal-agent relation provide us with important clues
about how specic features of the principal-agent relation
might differ across these contexts, they should not be viewed
as deterministic. By formally viewing the broader social envi-
ronment, we canexplore the various manifestations of agency
problems that might arise as well as the mechanisms that
might be used to control them. To conclude, only considering
the social nature of contracts, we will be able to extend and
strengthen agency theorys predictions.
Our examination here has focused on just a fewcontextual
elements to show how agency problems and their solutions
reect the social environment in which they are embedded.
Clearly, other dimensions of context may provide additional
insight into the potential for opportunism or stewardship in
principal-agent relations. Then, apart from the theories dis-
cussed in this research, the possible combinations of agency
theory with other theoretical frameworks are not limited.
Modeling bilateral relations between principals and agents
through a lens of rational self-interest has been useful to
understanding the conditions under which conict of inter-
ests may result in agent opportunism, undermining rm
value. However, this view is limited and provides a narrow
picture of how principals and agents may interact. Thus it is
time to expand our theoretical horizons to build models of
agency that reect the more complex interactions that occur
when principals hire agents.
NOTES
1. Adverse selection is used to dene the problem of precontrac-
tual informational asymmetry that is produced when the owners
(or principals) do not make a right selection of the agent,
through not knowing, at the moment of contracting, his or her
true qualities as a professional. The problem of moral hazard,
in contrast, happens after the contractual agreement, when prin-
cipals are faced with the impossibility of knowing what the
effective effort made by agents is, who abuse the discretion
and power they have been given so that they can attain certain
objectives.
2. Caroll (1989) differentiates between primary stakeholders and sec-
ondary stakeholders, identifying the rst with those who have a
formal, ofcial or contractual relationship with the organization.
Clarkson (1995) differentiates between voluntary and involuntary
stakeholders on the basis of the exposure to or acceptance of the
risk of the activities performed by the company.
3. Green-mail is the purchase of a companys stock and threaten-
ing takeover unless the company purchases the stock back at an
inated price.
4. This interpretation could be similar to Pfeffer and Salanciks
(1978) theory of resource dependence, with the difference that
agency theory would explain the relationship between the
company stakeholders in search of the optimum contract
between selsh parties.
5. Stewardship theory has been related to the theory of interest
groups (or stakeholder groups) because, as the administrator
tries to increase the global organizations performance, it gener-
ally satises most of the groups involved (who benet from that
greater organizational wealth).
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Gloria Cuevas-Rodrguez is Associate Professor at the Busi-
ness Administration Department of Pablo de Olavide Uni-
versity (Seville, Spain). She earned her bachelors and
masters from the University of Cadiz. She teaches Strategic
Management and Managerial Economics. Her research
interests include corporate governance, privatization, com-
pensation, and innovation. Currently, she is a member of the
National Research Project Success Factors in Interorganiza-
tional Networks for Innovation (ECO2010-21859).
Robert M. Wiseman is the chair of the management depart-
ment, and the Eli Broad Legacy Fellowof Management in the
Eli Broad Graduate School of Management at Michigan State
University. He earned an MBA from the University of
Wisconsin-Milwaukee, and a Ph.D. in Strategic Management
from the University of Minnesota. Dr. Wisemans research
interests include modeling strategic decision making under
uncertainty, strategic risk management, the role of risk in
executive compensation, and corporate governance.
Luis R. Gomez-Mejia is the Benton Cocanaougher Chair in
Business at the Mays Business School, Texas A&M Univer-
sity. He earned his bachelors, masters and Ph.D. from
the University of Minnesota. Dr. Gomez-Mejias interests
include strategic risk management, socioemotional wealth in
family rms, compensation and reward systems, and corpo-
rate governance.
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