Has Agency Theory Run Its Course

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Has Agency Theory Run its Course?:

Making the Theory more Flexible toInform the Management of Reward Systems

Gloria Cuevas-Rodrguez, Luis R. Gomez-Mejia, andRobert M. Wiseman*

ABSTRACTManuscript Type:ConceptualResearch Question/Issue: In this paper we discuss three assumptions of agency theory: (1) conflicts of interest betweeprincipal and agent, (2) nature of risk, and (3) the proposed internal mechanisms to reduce agency costs. We reviecriticisms of agency theorys pessimistic assumptions of human behavior and its simplistic view about individual rispreferences to argue how the context may influence both the interest and mechanisms for aligning interest of principals anagents.Research Findings/Insights: We draw on alternative theoretical perspectives from behavioral and organizational sciencesdescribe circumstances under which honesty, loyalty, and trust in agents behaviors are possible and also the developmenof cooperative rather than contentious relationships.Theoretical/Academic Implications:This study explores the boundary conditions of traditional agency theory in the hopof extending agency theory outside its current contextual boundaries. In doing so, we provide a more robust and exhaustivview of the economic exchange between principals and agents.

Practitioner/Policy Implications: This study offers insights to managers about how intrinsic incentives may provide aalternative mechanism of control over agents behavior to extrinsic incentives prescribed by traditional agency theorIndeed, intrinsic incentives of personal satisfaction and identification with organizational objects, combined with implicsocial obligations and reciprocity may, under certain circumstances, provide stronger restraints on agent opportunism thathe use of traditional extrinsic rewards in the form of incentive alignment.

Keywords: Corporate Governance, Agency Theory, Stewardship, Board Policy Issues, Executive Compensation

INTRODUCTION

Agency theory, as initially conceptualized by Jensen andMeckling (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 hisor her name, so that the wealth of the principal is benefitedby the decisions adopted by the agent. According to thetheory, separating ownership from control can result in costsfor the principal, known as agency costs, thus requiringcostly mechanisms for controlling these costs. Agency costsarise because agents are argued to pursue interests that do

not necessarily coincide with those of the principal. Becausthe use of incentives to create alignment of interests betweeprincipal and agency is a primary mechanism proposed bthe theory to reduce agency costs, the theory is withoudoubt one of the main (if not the main) theoretical framworks in the area of compensation management (particularly at the top management level) (Gomez-Mejia, Berron& Franco-Santos, 2010).

The roots of agency theory are linked to economic utiltarianism (Ross, 1973), which suggests that rational indviduals will favor alternatives that enhance their own utilitThe theory has been used widely in areas as diverse aaccounting (Demski & Feltham, 1978), economics (Spence Zeckhauser, 1971), finance (Fama, 1980), marketing (BasLal, Srinivasan, & Staelin, 1985), political science (Mitnic

*Address for correspondence: Robert M. Wiseman, Eli Broad Graduate School ofManagement, Michigan State University, Management, East Lansing, Michigan, USA.Tel: 517-355-1878; Fax: 517-432-1111; E-mail: [email protected]

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1975), organizational behavior (Eisenhardt, 1985), and soci-ology (White, 1985). Its popularity lies in providing parsi-monious predictions as to how rational individuals wouldbehave in bilateral relations between self-interested indi-viduals, where each individual is faced with informationasymmetry about the other individuals effort and interests.In sum, agency theory focuses on identifying the most effi-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 originallyconceptualized, agency theorys pessimistic assumptions ofhuman behavior as opportunistic would seem to precludetrust and cooperation between the principal and agent (Fehr& Falk, 2002). That is, the theory presupposes that becauseeconomic agents can cover up, cheat, distort, or trick thecontracting party in an economic exchange, opportunismwill prevail in spite of incentives and supervision, resultingin problems of adverse selection and moral hazard.1 Thischaracterization of agents has been challenged as overlynegative and possibly self-fulfilling (Donaldson & Davis,1991, 1994). Instead, these critics suggest that beginning withan assumption of trust and viewing agents as stewards ofthe organization, motivated to act responsibly, may result inmore desirable outcomes for both parties (Davis, Schoor-man, & Donaldson, 1997). Other critics have noted thatagency theory includes simplistic assumptions about indi-vidual risk preferences (Wiseman & Gomez-Mejia, 1998),and does not acknowledge the social context in which theprincipal-agent contract resides, and how that context mayinfluence both the interests and mechanisms for aligninginterests of principals and agents (Wiseman, Cuevas-Rodriguez, & Gomez-Mejia, 2012). In sum, critics charge

that economists formal vision may be too restrictive, andthat it could prove highly useful to widen the agencyconcept by using a behavioral perspective (Tirole, 2002).

In order to overcome the limitations of agency theory, wepropose to incorporate other theoretical perspectives inorder to extend and strengthen agency theorys predictions.Specifically, we contrast agency theorys assumptions aboutconflict of interest, nature of risk, and mechanisms for con-trolling agency costs with alternative views derived frombehavioral and organizational sciences in order to generate amore robust and exhaustive view of the economic exchangebetween principals and agents. As Rabin suggests: Someimportant psychological findings seem tractable and parsi-monious enough that we should begin the process of inte-grating them into economics (1998: 13). Thus, we may beable to benefit from the evidence on human behavior as wellas from organizational theory without necessarily losing thevirtues 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 extendingagency theory outside its current contextual boundaries.

This paper is structured in the following way. It begins bysummarizing three central features of positive agencytheory, conflict of interest, and mechanisms for controllingagency costs. We then compare agency assumptions withnew assumptions derived from behavioral and organiza-

tional perspectives to generate contrasting predictions aboagent behavior. In order to do that, we use content analysas a research methodology. We searched the major academjournals in the ABI/INFORM database, searching for thoarticles that combine agency theory with other theoreticframeworks. Then, we checked the abstracts of the referenclists of articles obtained, and classified them with regard their theoretical or empirical approach (see Table 1). Thu

our survey of alternative theoretical contributions to agenctheory is meant to be illustrative rather than an exhaustivexploration of how agency theory may be extended beyonits present emphasis.

POSITIVE AGENCY THEORY

Positive agency theory is an empirically-oriented examintion of principal-agent relations and has been extensiveused by management scholars as a basis for examining thefficiency of contractual relationships between owners anmanagers of large corporations (Eisenhardt, 1989; GomeMejia, Tosi, & Hinkin, 1987; Tosi & Gomez-Mejia, 1989). Thapproach contrasts with the mathematical non-empiricprincipal-agent theory proposed by Jensen and Mecklin(1976). Though the two views of agency differ epistemologcally, they each provide important insights into the issuearising when one party, a principal, hires another party, aagent, to perform tasks desired by the principal. We focus othe positive agency view because of its roots in scientifirealism, though we acknowledge that the two perspectivare complementary in that principal-agent theory providtheoretical guidance to positive agency research.

A positive agency perspective has been extensively useby management scholars as a basis for examining the efciency of contractual relationships between owners an

managers of large corporations (Eisenhardt, 1989; Jense1983; Tosi & Gomez-Mejia, 1989). Efficiency is measured bthe costs resulting from the separation of control from ownership, which is generally referred to as agency costs. Asuch the theory provides a special case of agency within thnexus of contracts that make up complex organizationAgency costs arise because both parties to the relation arassumed to hold self-serving interests and the contractumechanisms used to align those interests are imperfect ancostly (Alchian & Demsetz, 1972). That is, both owners anagents are rational rent-seekers holding different utilifunctions (Jensen & Meckling, 1976). Thus, positive agenctheory assumes a conflict of interest between principals anagents such that principals desire to maximize personwealth subject to risk constraints, while agents seek to maxmize their personal wealth while minimizing personal effoand risk. In the context of large organizations, an agenteffort toward maximizing the principals utility is positivelinked to the pecuniary rewards promised to the agent in thcontract. Agency costs in the form of moral hazard anadverse selection arise because contracts are by natuincomplete and principals face a problem of informatioasymmetry with regard to agent effort. More specificallagency costs include the pecuniary benefits in the form contingent compensation tied to agent performance, annon-pecuniary benefits such as the physical appointmen

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TABLE1

Summaryo

fthe

Ma

inCharacterist

ics

ofAgency

Theoryan

dComp

lem

en

tary

Theory

Frameworks

Aim

Assumptionsabout

humanbeings

P

roblemanalyzed

Determinan

tvariables

ofthep

roblem

Studiesthatcomb

ineagencytheory

withothertheoret

icalframework(s)

Agency

theory

Maximizationo

f

organizationa

l

efficiency

Individualsare

rationalbeingswith

selfish/opportunist

behaviorandwith

concretepreferences

towardsrisk

(neutralitytorisk

[principal]or

aversion[agent])

Relationshipbetween

p

rincipalandagent,

a

swellas

m

echanisms

(

internal/external)

t

hatallowfor

c

ontrolofagent

p

erformance

Uncertainty

ofresults,

fieldofcontroland

programm

abilityof

tasksperformedby

agent

Trustliterature

Maximizationo

f

sharecapital

in

organization

(developingan

environment

of

constructive

relationships)

Individualdoesnot

alwaysbehavein

selfishor

self-interestedway

butmayshow

attitudeoftrustand

cooperation

Tru

stasthe

d

ispositionofone

individualtobe

v

ulnerableto

a

nother

Contextualfactors

(likeincentiveplans

orsystem

sof

control)

Personalfac

tors

Concep

tua

lstu

dies

BecerraandGupta(1999);Bower,

Garber,andWatson(1997);Ghoshal

andMoran(1996);Granovetter

(1985);Noreen(1988);Perrow(1986);

SealandVincent-Jones(1997);Singh

andSirdeshmukh

(2000)

Emp

irica

lstu

dies

Cruz,Gomez-Mejia,andBecerra(2010);

Davis,

Allen,and

Hayes(2010);

Dimitratos,Liouk

as,

Ibeh,and

Wheeler(1997);G

azley(2008);Gefen,

Wyss,andLichtenstein(2008);Guth,

Klose,

Konigstein,andSchwalbach

(1998);Homburg

andStebel(2009);

HoworthandWesthead(2004);

LiberatoreandWenhong(2010);

Moliner(2009);Rai,

Maruping,and

Venkatesh(2009)

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Stakeholder

theory

Balancinginterests

ofdifferent

interestgroups

(stakeholders

)

Individualsattitudes

arenotalways

selfish,and

relationships

betweenindividuals

areinterdependent

(haverepercussions

andarethemselves

influencedbyother

relationshipsin

turn)

Ho

wexecutive

d

ecisionmaking

c

onsidersthe

interestsofthe

d

ifferent

s

takeholders

involvedinthe

o

rganization

Moral/ethicalreasons

Existenceofan

implicitsocial

contractb

etween

theorgan

ization

andsocie

ty

Concep

tua

lstu

dies

Dixit(1997);HillandJones(1992);

JeffriesandReed

(2000);Shankman

(1999);Wisemanetal.

(2012)

Emp

irica

lstu

dies

Buck,

Bruce,

Main,andUdueni(2003);

Buck,

Filatotchev,

andWright(1998);

Cai,

Jo,andPan(2011);Collier(2008);

Delgado-Garcia,D

eQuevedo-Puente,

andDelaFuente-Sabat(2010);

HarrisonandCoo

mbs(2012);Joand

Harjoto(2012);Le

wellynand

Muller-Kahle(201

2);Prior,Surroca,

andTrib(2008);ScarpelloandFoard

(1996);Woodward

,Pam,andBirkin

(2001)

Stewardship

theory

Maximizationo

f

shareholder

wealthviath

e

maximization

ofthe

administrators

utility

Administrators

behaviorisaltruistic

andcollaborative

(theindividual

identifieswith

organizational

missionand

objectives)

Situationsinwhich

e

xecutives,

like

a

dministrators,are

m

otivatedtoactin

t

hebestinterestof

t

heirprincipals

Psychologic

alfactors

Contextualfactors

(managem

ent

philosoph

y,

organizat

ional

cultureordistance

ofpower)

Concep

tua

lstu

dies

ArthursandBusenitz(2003);Caldwell

&Karri(2005);Davisetal.

(1997);

Eddleston,

Chrism

an,

Steier,and

Chua(2010);Hern

andez(2012);

Sundaramurthya

ndLewis(2003)

Emp

irica

lstu

dies

Anderson,

Melanson,andMaly(2007);

Angwin,

Stern,&

Bradley(2004);

BanalievaandEddleston(2011);Davis

etal.

(2010),

Desai,Kroll,andWright

(2003);FoxandH

amilton(1994);

GhoshandHarjoto(2011);Giovannini

(2010);Kluversan

dTippett(2011);

Lambright(2009);LeeandONeill

(2003);MarvelandMarvel(2009);

Nicholson,

Kiel,a

ndGeoffrey(2007);

Pieper,

Klein,and

Jaskiewicz

(2008);Prencipe,B

ar-Yosef,Mazzola,

andPozza(2011);

Tosi,

Brownlee,

Silva,andKatz(2003);Uhlaner,

Floren,andGeerlings(2007);Vanand

David(2007);Was

serman(2006)




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TABLE1

Continued

A

im

Assumptionsabout

humanbeings

Problemanalyzed

Determinantvariables

ofthep

roblem

Studiesthatcomb

ineagencytheory

withothertheoreticalframework(s)

Institutionaltheory

Legitimationof

theorganization

insocialcontext

Individualadaptsto

thesystemof

norms,valuesand

beliefswithin

institutional

environment

Organizational

practices

Traditiono

fthe

industria

lsector,

socialan

dpolitical

beliefs,legislation,

etc.

Concep

tua

lstu

dies

Eisenhardt(1988);FilatotchevandBoyd

(2009);Strange,Fi

latotchev,

Buck,and

Wright(2009);Wisemanetal.

(2012)

Emp

irica

lstu

dies

BerroneandGomez-Mejia(2009);

Bonini,Alkan,andSalvi(2012);

Bruton,

Filatotchev,Chahine,and

Wright(2010);Capezio,

Shields,and

ODonnell(2011);

ChungandLuo

(2008);Fernandez-Alles,

Cuevas-

Rodriguez,andValle-Cabrera(2006);

FilatotchevandW

right(2011);

Johansonandst

ergren(2011);Kang

andYanadori(201

1);Lawrenceand

Fogarty(1998);LinandChuang

(2011);Nicholson,

Kiel,andKiel-

Chisholm(2011);Nwabuezeand

Mileski(2008);Rendersand

Gaeremynck,

(201

2);Shi,Magnan,

andKim(2012);SinghandGaur

(2009);Young,

Stedham,andBeekun

(2000)

Prospecttheory

Definitio

nofthe

expectedutility

functionof

investorsin

theird

ecision-

makin

gprocess

Individualsbase

decisionson

subjective

perceptionof

changeinwealth

(aimingmoreto

minimizelossthan

maximizegain)

Riskassumedin

decisionmaking

Subjectiveperception

Howconte

xtinwhich

decisionsaretaken

influencesthe

individuals

personal

perception

Concep

tua

lstu

dies

SharpandSalter(19

97);Uecker,

Schepanshi,andS

hin(1985);

WisemanandGomez-Meja(1998)

Emp

irica

lstu

dies

Devers,McNamara,

Wiseman,and

Arrfelt(2008);MattaandBeamish

(2008);Willman,F

enton-OCreevy,

Nicholson,andSo

ane(2002);

WisemanandCatanach(1997);

Zhang,

Bartol,Sm

ith,

Pfarrer,and

Khanin(2008)




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of the office, the attractiveness of the secretarial staff [sic],the level of employee discipline . . . and so forth (Jensen& Meckling, 1976:486). In addition, agents may exhibitskiving, which reflects a failure to responsibly carry outthe duties of the job (Jensen & Meckling, 1976). This canoccur in reduced effort, or the rejection of value-maximizinginvestments in favor of investments that produce privatebenefits 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 theoryseeks to reduce these agency costs through the design of thecontract between the principal and agent. However, thisfocus ignores a variety of factors that characterize actualprincipal-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 coreassumptions of agency theory and allowing for alternativeperspectives, we can reconsider how the mechanisms pre-scribed for controlling agent behavior may impact thatbehavior. In the next sections we explore these extensionsto agency theory as a way to extend the external validity ofthe theory beyond its narrowly defined assumptions.

Introducing Trust into Principal-Agent Relations

By focusing on contractual mechanisms to overcome theconflict of interest that can arise between rational self-interested parties, agency theorists largely ignore alternativescenarios for controlling agency costs. For example, someagents may find emotional or social utility in fulfilling thedesires of the principal. As Fehr and Falk (2002:719) suggest,there are powerful non-pecuniary motives that shapehuman behavior [such as] the desire to reciprocate, the

desire to gain social approval, and the intrinsic enjoymentarising from working on interesting tasks. They go on toargue that by considering these motives, economists maygain a better understanding of how psychological factorsconstitute incentives. Similarly, Hendry (2002) points outthat it is impossible for an organization to function effec-tively without some measure of honesty, cooperation, andtrust, and it is impossible to delegate authority to agentswithout relying to some extent on their loyalty, honesty, andgoodwill. This perspective is compatible with expectationstheory (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 carryingout work responsibly. In other words, agent utility could beenhanced by fulfilling the principals interests. Where agentsfind utility in fulfilling their responsibilities, trust becomesthe most efficient mechanism for maximizing the principalsutility.

Although the concept of trust is not new in an academiccontext (Davis, Schoorman, Mayer, & Hoon Tan, 2000;Mayer, Davis, & Schoorman, 1995; Schoorman, Mayer, &Davis, 1996, 2007), in the last decade numerous studieshave been made of trust and its repercussions in the man-agement of organizations, for example, in the cases ofinter-organizational cooperation (Ring & Van de Ven, 1994),alliances in governing structures (Gulati, 1995), and

compromise/compliance of foreign subsidiary companiwith large multinationals (Kim & Mauborgne, 1993).

The concept of trust has been related to integrity, honestconsistency, and predictability (Butler, 1991; Mayer et a1995). If trust is defined as the extent to which a person confident in, and willing to act on the basis of, the wordactions and decisions of another (McAllister, 1995:25), thetrust entails risk, because the individual who places trust

someone else is vulnerable to opportunistic behavior bothers (Cummings & Bromiley, 1996; Zand, 1972). Thvulnerability is variable, as we do not possess compleinformation regarding individual behavior, competence, oattitudes, which clearly vary across people and perhaps fothe same individual across time. Yet trust is a key element oshare capital and has been directly linked with individuand group performance (within an organization), and withe management of traditional processes like conflict, compromise, and cooperation (for a review, see the works oJeffries & Reed [2000] and Williams [2001]). For Williamso(1993), trust characterized by absence of control exists onin relationships of family, friendship, or love. This is consitent with the type of organization Ouchi (1979) calls a clanthat rely upon a relatively complete socialization procewhich eliminates goal incongruence between individuals. Iother team settings within business relationships (thocalled market or bureaucracies by Ouchi), formal safeguarmechanisms must be designed to obtain cooperation amonindividuals. In this sense, trust is considered noise in thrational decision-making process, something to be avoideHowever, in the absence of objective information, people dmake subjective evaluations of other peoples attitudes, theobligations and their future behavior as criteria for decision(Becerra & Gupta, 2003). So, in situations of uncertain(characteristic of the business world), there is a necessity understand the role played by trust and its repercussions o

the organization.In recognizing the potential for trust, three points

departure from positive agency theory are raised. Firagency theory assumes that the principals and the agentobjectives are established outside the agency relationshand are formalized in their respective utility functionThus, conflict of interest and asymmetry of informationbasic premises in agency theory are not subject to criticisas they are considered exogenous variables to the probleof controlling agency costs. In contrast, the literature otrust recognizes that prior interactions can reduce and eveeliminate conflict of interest between principal and agen(Granovetter, 1985). Drawing on the leadership literaturReicher, Haslam, and Hopkins (2005) compare leadefollower models characterized as zero-sum games, in whicleaders (or followers) benefit at the expense of the otheagainst models built on social identity theory, in whicleaders and followers view themselves as partners activerelying on each other to create conditions where mutuinfluence and mutual benefit is possible.

Second, the basic aim of the literature on trust differs frothat of agency theory (Becerra & Gupta, 1999). Agenctheory focuses on designing efficient contracts that reducagency costs. The trust literature (Zaheer, McEvily, Perrone, 1998) suggests that even when the reduction ogovernance costs is an important objective, the essential an




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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 thatleader trust encourages employee initiative by increasingthe employees sense of security. Harris, Wheeler, andKacmar (2011) also find that the quality of leader-member

exchanges encourages employee psychological and/orsocial commitment to the organization, resulting inimproved 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, theseconstructive relationships built on trust go beyond reduc-ing costs of control because they also enable greater speedin making and implementing decisions by reducing theimpediments to cooperation arising from mistrust anduncertainty. As Becerra and Gupta (1999) show empirically,cooperative relationships built on trust allow more time tobe devoted to other activities, facilitating, for example, thenecessary transfer of knowledge and expertise for innova-tion within the organization. Carmeli, Schaubroeck, andTishler (2011) find that an empowering leadership style cul-tivates trust and increases subordinate collaboration result-ing in increased confidence in pursuing organizationalgoals. Thus, trust releases new possibilities for value creationthat are less accessible to contractual relations built onassumptions of conflict of interest.

Finally, trust presents an alternative to agency theory pre-scriptions for resolving problems arising from conflict ofinterest. Agency theory proposes two contractual mecha-nisms for uniting the interests of principals (owners) andagents (managers). These are monitoring the agents behav-ior directly, and using incentives to align the interests ofagents to those of the principal. Challenging these prescrip-

tions, the literature on trust suggests that the application ofthese mechanisms based on a reward-punishment relation-ship (consistent with an assumption of rational self-interest)could, in the long term, widen differences between theparties (Perrow, 1986). Imposing a contractual relation focus-ing on pecuniary rewards could undermine the climate oftrust and thus increase the possibility of opportunisticbehavior by the agent.

The literature on motivation reinforces this point bynoting that extrinsic rewards can undermine the role ofintrinsic rewards on motivation (Deci & Ryan, 1985; Frey &Jegen, 2001). That is, assuming that intrinsic rewards such assatisfaction with achievement can motivate agents, increas-ing reliance on extrinsic rewards such as compensation maycrowd out the value of intrinsic rewards in the agentscalculation 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 extrinsicrewards and punishments may increase agent opportunisticbehavior, thereby undermining trust.

Though acknowledging a role for trust would seem toundermine 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 foraccurately capturing the empirical reality of economic

exchanges. For example, examinations of trust in personrelationships find that personal characteristics affect an indviduals attitudes and thus bear on the quality of the relationship. Formally recognizing individual differences anhow those differences may impact the nature of a principaagent relation could lead to improved predictions about theffect of different contractual arrangements on agent anprincipal behavior. That is, future examinations of agenc

could explore how individual differences interact with contextual factors to better understand the effect of varioucontrol mechanisms on individual behavior, thus mitigatinthe possibility of managerial interventions inaccurategauging the effects of context on employee perceptions, atttude, and ultimately behaviors (Epitropaki & Martin, 2005

In short, extending agency theory to recognize the potential for trust would necessitate going beyond its pessimistconcept of human nature. As Perrow (1986) highlighagency theory exaggerates the possibility for opportunismshirking of responsibilities, and the laziness/reluctanassociated with the problem of moral hazard. Howeveexaminations of trust have shown that coercion is not alwayrequired; individuals can adopt responsibilities voluntariand perform honest and selfless actions. This leads us toffer contrasting predictions about the potential for confliof interest in a principal-agent relation.

Proposition 1a:According to agency theory, agents are ratinally self-interested and thus weigh the utility of pecuniary annon-pecuniary benefits against the disutility of effort and riin determining how much effort will be expended on behaviorthe principal. This is likely to result in:

(a) agents acting opportunistically to the extent possible undthe terms of the contract defining their relationship to thprincipal;

(b) increased conflict of interests between the agent and tprincipal.

Proposition 1b:According to the literature on trust, creatina climate of trust increases the portion of an individuals utiliassociated with feelings of achievement or self-esteem resultinfrom performing well, and decreases the disutility associatwith the effort required. These conditions are likely to result i

(a) greater trust between the principal and agent;(b) less conflict of interest between agent and principal.

Incorporating a Stakeholder Perspective

A strict application of positive agency theory focuses only othe bilateral relationship between the principal and agenand on designing efficient mechanisms for ensuring that thagent devotes his or her full effort toward fulfilling the inteests of the principal. To the extent that agency theory considers other stakeholders, it views payments to stakeholdeabove the stakeholders reservation wage or opportunicost for securing the stakeholders participation as an agenccost, since this overpayment undermines the efficiency the firm. That is, overpayment to stakeholders increascosts without producing a compensating increase in firvalue, thus reducing the wealth of the principal. Within thrational world of agency theory, overpayments to stakehol




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ers occur because self-serving agents can receive private ben-efits from these investments which cannot be shared by theprincipal. Examples of overpayment include actions thatpromote well-being of other individuals through charitableactions such as donating to charitable organizations, orinvesting in relations beyond what the economic exchangewould justify, such as purchasing from friends rather thanfrom more efficient suppliers (Jensen & Meckling, 1976).

Agency theory, therefore views the agents contractual rela-tionships with stakeholders as potential sources of agencycosts because agents can receive private non-pecuniary ben-efits from these relationships, while the pecuniary costsincurred in supporting these relations are channeled (havenegative repercussions) for the principal.

Challenging this constrained view of agents chasing non-pecuniary benefits at the expense of principals is an equallycompelling view that, by investing in stakeholder relations,agents may create social debt that, based on social norms ofobligation and reciprocity, may enhance firm value and thusthe wealth of principals (Fukuyama, 1995). As Fehr and Falk(2002) suggest, experimental economists have documentedthat agents are motivated by non-pecuniary motives as wellas pecuniary rewards. And these non-pecuniary motives, orsocial preferences, include caring about the materialresources allocated to relevant others, such as relatives, col-leagues, and even trading partners. They go on to concludethat: Reciprocity can be viewed as a contingent social pref-erence because depending on the behavior of the referenceperson . . . 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 andvalue 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, othershave argued that investments in strengthening relations can

create positive spillover effects that benefit the interests ofthe principal. For example, the well-being generated in thecontext of what has come to be called the socially commit-ted company (Granovetter, 1985) could favor an increase inthe future value of the company.

Formally recognizing the agents role in managing abroader set of obligations extends agency theory by showinghow 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 andagents to recognize organizations as a nexus of obligationsthat go beyond investors to include a variety of interestgroups such as employees, suppliers, clients, and society(Donaldson & Preston, 1995).

The term stakeholder has been defined 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 definition, and the one we favor,recognizes that any individual or group that has an interestin the organization or is affected by it would be considereda stakeholder.2 Stakeholder theory argues that the interestsof all the different stakeholders have to be taken into accountin management decision making, without anyone supplant-ing others (Clarkson, 1995; Jones & Wicks, 1999). The agentsrole is therefore to balance the competing interests of thevarious stakeholders in order to assure firm survival. In this

sense, several authors distinguish between control shareamong multiple principals (which is far more common non-Anglo-Saxon countries) and undivided control by single constituency (as exemplified by the shareholder valuconcept predominant in the United States and the UniteKingdom) (La Porta, Lopez-de-Silanes, Shleifer, & Vishn1999, 2000). Dixit (1997) introduces the concept of a stakholder economy, in his analytic development of an agenc

model with heterogeneous principals, arguing that in mancountries managers are supposed to be responsible nmerely to shareholders, but to a more varied collection stakeholders (such as workers, creditors, the local community, and so forth), provoking a politicization of corporagovernance. Tirole (2001) adds that in most non-AnglSaxon countries, the provision of managerial incentives anthe design of a control structure require consideration of thutilities of all stakeholders, not only those who have owneship rights over the firm. In Germany, for example, labunions and bankers have been granted formal authority ovmanagement that rivals the control by shareholders (BrucBuck, & Main, 2005). In many Arab countries, religioufigures often sit on bank boards to ensure compliance wiMuslim law, which proscribes certain lending practic(Abdulrahman, Al-Twaijry, Brierley, & Gwilliam, 2002; Ric2003).

Broadening the perspective of agency theory to recognizthat agents sit at the center of a nexus of stakeholder reltions and that these relations reside within a social conte(e.g., Wiseman et al., 2012) highlights the social nature ocontracts, a perspective obscured in agency theorys calclus. As a social exchange, investment in stakeholder reltions by an agent can create social debt that agents can latleverage on behalf of principals. That is, due to social normof reciprocity, contributions to stakeholders that exceed thstakeholders reservation wage or opportunity cost ma

engender commitment to the relation and a willingness negotiate changes to the performance in response to changing demands and conditions. That is, managing stakeholdrelations, not simply as discrete economic exchanges, but valued relationships that exceed the economic benefits of thexchange, can produce positive benefits for principals thmay not be directly observed, such as the development goodwill and social debt (Jeffries & Reed, 2000; MacNe1977). Creation of goodwill or social debt, regardless of anprivate benefits the agent accrues, can produce a social assthat can be drawn on should changing conditions requicontributions from stakeholders that exceed the econombenefits of the exchange. For example, providing abovmarket benefits may make it easier to secure wage concesions during industry downturns as the Hormel FoodCompany did in the 1960s. Contributions to non-economexchange partners may also benefit. For example, a nationdepartment store chain, Dayton-Hudson, was able to ralcharitable organizations to aid the company in enactinglaw that protected the company from a threat of greenmail.3 In sum, recognizing a stakeholder view of organiztions, acknowledges that stakeholder relations are nsimply economic exchanges, but are also social exchangethat come not only with moral obligations to satisfy thterms of the explicit contract, but also result in implicit socicontracts that impose additional obligations that go beyon




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the economic exchange. These social obligations need not beconsidered inefficient since they can produce indirectreturns that all stakeholders, including the principal, mayshare.

Thus, we agree with Shankman (1999) that agency theoryand stakeholder theory are not irreconcilable, but canapproach convergence by relaxing some of the assumptionsof agency theory. We do this by recognizing that, while

agency theory focuses on the relation of financial investors(principals) to managers (agents), financial investors aresimply one of many groups making investments into thecompany (Hill & Jones, 1992).4 In addition, as Quinn andJones (1995) argue, agents are not simply economic beings,as agency theory would suggest, but are moral beings aswell. Indeed, though agency relationships are built onbinding agreements, the existence of these agreements willnot work without the implicit assumption that individualswill respect the agreements they willingly create. Therefore,agency theory is limited inasmuch as agency relationshipsinvolve a series of underlying moral principles (which arealso accepted by stakeholder theory). Finally, though agencytheory presumes opportunistic behavior, because contractsare incomplete, trust is a necessary condition for a relation-ship to work. As Barney (1990:385) notes, the presence oftrust drastically reduces the number of resources needed tocontrol agency costs: costs of exchanges with honest indi-viduals (firms) will be lower than the costs of exchangeswith individuals (firms) whose honesty cannot be judged apriori. 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 andlogic leads to the adoption of a more flexible perspectivesuch as the stakeholder theory, which supports the idea thatthe attitudes of individuals are not always selfish. As Foss

(1996:519) suggests, some aspects of economic organizationmay be rendered intelligible without appeal to the notion ofopportunism, and . . . socialization, norms, moral communi-ties, etc., play an important role for understanding the coor-dination of economic behavior (and . . . sociological insightsmay therefore be relevant). The divergent situations sus-tained by one or another theory can be seen in the followingpropositions:

Proposition 2a: According to agency theory, exclusivelyfocusing on the bilateral relationship between the principal andagent 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 pecuniarycosts incurred by the agent in the relationship with thirdparties;

(c) agents being rewarded according to their ability toincreases the wealth of the principal.

Proposition 2b: According to stakeholder theory, increasingthe number of different principals will likely result in:

(a) less use of variable pay linked to performance criteria, sincethere is less agreement among principals on which perfor-mance criteria to use;

(b) greater internal monitoring of agents through formbodies representing multiple stakeholders;

(c) agents being rewarded according to their ability to identifand enforce political compromises among principals wiconflicting objectives.

Recognizing a Role for Leadership in

Team ProductionAgency theory presumes that in any exchange relationshthe agent will behave selfishly (maximizing personal utilityso agency costs can arise. Thus as the organization growthe increased number of groups or relationships inside will increase these costs even more (Jensen & Mecklin1976), causing what is known as the team productionproblem. In a team production situation, it is understoothat the end result achieved by a group of workers is greatthan the sum of the products that could be obtained fromeach worker individually, but the input attributable to eacindividual is difficult to measure and observe (Alchian Demsetz, 1972). The larger the team, the greater will be th

possibility of opportunistic behavior on the part of thmembers. The interest of a particular individual in superviing a colleagues performance is diluted, insofar as that indvidual would be responsible for the complete supervisiowith all the effort required, but would receive back onlytiny part of the potential benefit, i.e., the improvement team performance. Therefore, according to agency theorthe increase in the size of the group (organization) carriewith it an increase in agency costs.

By contrast, some research suggests that compensatioschemes can encourage mutual monitoring among teamembers, by tying a portion of the team member pay to thcollective output or performance of the team (Gomez-MejiWelbourne, & Wiseman, 2000). By linking compensation collective output, team members have a vested interest ithe effort and contribution of fellow team members. Asresult, members, who are often in a better position observe the effort of fellow team members, can use socipressure and other tactics to motivate effort on the part of ateam members. Thus, the team production problem need nresult in increased agency costs, if compensation is designeto reward team members for building team effort.

Proposition 3a:According to agency theory, when agent peformance requires a team of agents to cooperate, this is likely result in:

(a) higher costs for monitors in overcoming informationasymmetry about member effort;

(b) larger teams having more opportunity for members shirk;

(c) a larger portion of pay will be contingent on team prodution in order to foster mutual monitoring by teamembers;

(d) an increased used of social pressures by team members oone another to limit shirking behavior.

In addition, management research recognizes that leadecan influence member effort by how they interact with teamembers (Rubin, Bommer, & Bachrach, 2010; Yan & Mos




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holder, 2010). That team members can be encouraged torecognize that their individual fate depends on the collectiveeffort of all members (cf. Fama, 1980). That is, while agencytheory focuses attention on extrinsic motivation, specificallyeconomic incentives (tangible rewards with a quantifiablemarket value), as the main mechanism of control over theagent, behavioral scholars recognize intrinsic incentivessuch as opportunities for growth or self-realization (Davis et

al., 1997). They suggest that leadership style can influencesubordinate behavior by increasing commitment and iden-tification with the organization (Mayer & Schoorman, 1992).

In the context of agency, this perspective has been referredto as stewardship theory (Donaldson & Davis, 1991, 1994).This approach argues that the adoption of organizationalstrategies 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 theadministrators task is to see that the organizations objec-tives are met5 (e.g., greater sales figures or profitability).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 identifies with the organization, there should beconfidence in the execution of delegated tasks because themanagement will use its initiative to promote the success ofthe organization and its principals. By increasing the share-holders wealth, administrators maximize their own utilityat 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 selfish andopportunistic way (Argyris, 1973).

Davis et al. (1997) identify circumstances that would favoragency theory predictions over stewardship predictions (orvice versa) by highlighting the psychological and contextualfactors 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 first factor, Lawler (1992) emphasizes twomain management philosophies, depending on whetherthey are based on control or commitment. Davis et al. (1997)understand that under a management system based oncontrol, 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 amanagement philosophy based on commitment (whichappreciates 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. Somesimilarities could be found among these philosophies andthe 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, leaderstransform subordinates with commitment by motivatingthem to do more than what is initially expected (Podsakoff,Mackenzie, Moorman, & Fetter, 1990; Vigoda-Gadot, 2006).That is why the transformational leadership literaturestresses the cognitive and affective relationships betweenleader and members. Meanwhile, transactional leadershipconsiders the relationship between leader and subordinate

as impersonal and based on an exchange or transaction orewards for services. Transactional leaders motivate followers primarily through conditional reward-based exchangesetting goals, and clarifying the link between performancand rewards (Bass, 1985). Then, transformational leadershre-directs attention from individual leaders behaviors ancharacteristics to the work of leadership, as opposed to thagents through which it is carried out (Foldy, Goldman,

Ospina, 2008). Obviously, beliefs about leadership diffacross cultural contexts, and this may explain some of thdifferences in compensation designs and especially the linbetween incentives and outcomes (Wiseman et al., 2012).

Where there is a belief that leadership matters (whMeindl, Ehrlich, & Dukerich, 1985, dubbed the romance leadership and others have called a heroic view of leadeship), there is an implied assertion that individual executives can provoke large differences in how organizationperform. That is, some cultures strongly believe that toexecutives can and do have a major impact. This is especialtrue of the United States (for examples, see Jacobson House, 2001; Shamir, House, & Arthur, 1993). However, other cultural contexts, agents are not able to, or may not bexpected to, make a significant impact on the organizationbottom line. This latter belief corresponds to a fatalistic vieof life, wherein ones future is less a product of individueffort than of chance or external forces (cf. Esparaza, 200Marin & Van Oss-Marin, 1991). This belief may also be truof more collectivist cultures, where organizational successfailure is attributed to organizational members as a grourather than actions of specific executives (Daft, 2002).

In the second place, Davis et al. (1997) emphasize thcultural differences may influence the choice between aagency and a stewardship relationship. For this they usHofstedes distinction between individualist and collectiviculture. Agency relationships will be favored by an individ

alist culture characterized by a short-term orientation, aemphasis on the reaching of personal goals, consideration conflict as an opportunity to improve communication, anfinally, an idea of business where personal aspects of threlationship are fully ignored (cost/profit analysis). On thother hand, a collectivist culture, in which personal interesare sacrificed in favor of general interests, confrontatiobetween groups is avoided and long-term relationshippermit the people involved in the relationship to understaneach other better, will favor relationships between principand administrator. In an empirical study with mulassessment data of managers and their teams in 80 countrieWendt, Euwema, and Van Emmerik (2009) found that diretive leadership characterized by task-oriented behavior wistrong focus on targets, close supervision, and control osubordinate actions were stronger in individualist societieMeanwhile, supportive leadership style, which includsensitivity to team member needs and focus on harmonworking relations, was prevalent in collectivist societies.

Going further on this distinction between individualiand collectivist culture, Nahum-Shani and Somech (201measure the individual-level orientations that reflect thecultural values. They use the terms idiocentrism and allcentrism to capture within-culture variation in personalitattributes (Triandis, 1995). Individuals high on idiocentrisview the self as being separate from others and give priori




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to the achievement of personal goals over the goals of thecollective. Individuals high on allocentrism view the self asinseparable from their in-group members, and subordinatetheir personal goals to the collective ones (Lam, Chen &Schaubroeck, 2002). Consistent with this notion, Nahum-Shani and Somech (2011) defend that effectiveness of theleadership styles mentioned above (transactional vs. trans-formational) are contingent upon followers idiocentrism

and allocentrism. Transactional leaders are more effectiveamong idiocentric followers, while transformational leadersare more effective among allocentric followers. Then, teammembers personalities seem to be among the most crucialfactors in determining team productivity and performance(Driskell, Hogan, & Salas, 1987). Individualistic membersdo not want to work to benefit the team; they are usuallycompetitive both with the rest of their team membersand with other teams (Chow, Lindquist, & Wu, 2001; Kim,Triandis, Kagitcibasi, Choi, & Yoon, 1994). They do not haveemotional relationships with their teammates, but rathersporadic relationships usually linked with the work or taskthat they must carry out. This attitude can give rise to inter-nal tensions and objective conflicts within the team that canimpair performance (Wagner, 1995). In contrast, teamsformed of people with a collectivist orientation have lessinternal competition, since their members are focused oncooperation and common work to benefit the team (Llies,Wagner, & Morgeson, 2007). They have a strong collectiveinterest, i.e., a team feeling that promotes team targets overindividual interests (Tyler and Blader, 2000), and can expectgreat self-sacrifice when it is necessary to meet the teamgoals (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 themembers of an organization (normally favored by central-ized structures and large differences in privileges and sala-

ries among the different hierarchical levels) favor agencyrelationships because they legitimate the inequality of powerbetween principal and agent. However, the existence ofsmall differences of power leads to stewardship relation-ships that support a greater equality between principal andmanagement. Considering leadership as a process of socialinfluence, Subaic, Reynolds, Turner, Veenstra, and Haslam(2011) discuss how different tools of power affect leaderscapacity to shape the beliefs and attitudes of followers.According to these authors, the utility of rewards/punishments and surveillance depends on whether theleader is considered to be an in-group or out-group member(socially close or distant leaders). Subaic et al. (2011) foundthat while surveillance may be a necessary tool in the reper-toire of out-group leaders (similar to what happens inagency relationships), it is likely to attenuate rather thanenhance leaders capacity of influence when they are per-ceived as in-group (close leader). Also, the objective leadersdistance (not the perceptional leader-follower distance)seems to be important for the effectiveness of leadership. So,Walter and Bruch (2010) argue that the positive relationshipbetween transformational leadership and productive orga-nizational energy is diminished under conditions of highcentralization and size of the organizational structure. Thatis explained because greater (lower) hierarchical differencesin organizations may often manifest both greater (lesser)

physical distance and a lower (higher) frequency of direinteraction between leaders and followers (Chun, Yammarino, Dionne, Sosik, & Moon, 2009).

In short, recognizing a role for vigilant and committeleadership, as stewardship theory does, complemenagency theory. As ONeill (2007) suggests with an empiricstudy of Australian non-executive directors, the reliance oeconomic efficiency arguments alone does not provide

sufficient framework to explain the subjective, judgmentand socially interactive processes involved in determininexecutive pay. While agency theory allows for an undestanding of the conflicts of interests between principal anagent (defining the potential problems and the mechanismto solve them), one can conceive of a different model obehavior in which leadership enhances commitment anultimate team performance. In addition, incorporating a rofor leadership and team dynamics replaces the deterministmodel of agency with a contingent model that allows fthe examination of psychological and social features whiccan lead to improved predictions of principal and agenbehavior.

Proposition 3b:According to stewardship theory, approprialeadership styles characterized by transformational leadercollectivistic teams, and small differences of power amonmembers are likely to result in:

(a) increased team commitment and identification with orgnizational purpose;

(b) a mitigation of the team production problems;(c) less use of pay-for-performance contingent on team produ

tion;(d) greater use of intangible rewards to create incenti

alignment.

CONTROLLING AGENT BEHAVIORIncentive alignment is considered a key mechanism for controlling agents abuse of delegated power (Eisenhardt, 198Gomez-Mejia et al., 1987; Tosi, Katz, & Gomez-Meja, 1997Incentive alignment links salary with the agents perfomance and is often preferred by positive agency theorisbecause of the information problem facing monitors. Withat in mind, the primary focus of attention of agency theorists is on identifying the most efficient contract thbalances the cost of incentives with the benefits deriveby linking incentives to desired outcomes.

Compensation and Incentive PlansGiven the cost of overcoming information asymmetry seprating principals and agents, positive agency theory proposes aligning the interests of agents and principals bmaking a portion of the agents pay contingent on achievinoutcomes important to principals (Fama & Jensen, 1983Compensation that is contingent on the agents ability achieve performance desired by the principal should aligthe interests of the principal and the agent, maximizing thutility function of both. Thus extrinsic rewards tied directto performance outcomes is argued by positive agencscholars to motivate agent effort under conditions whe




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other factors need not be irrational. The adoption of certainstructures or procedures deemed legitimate in the environ-ment may constitute a reasonable and responsible course ofaction, as they may please external institutions of power oravoid claims of negligence (Meyer & Rowan, 1977). Indeed,organizations that cannot defend their results in accordancewith 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 rationalityis 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 alogical-rational pattern that makes agents paycontingent on achieving outcomes important toprincipals;

(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 firm

in the form of larger pay packages is small.

Proposition 4b:Accordingly to institutional theory:

(a) agent compensation packages are designed in searchof social acceptance or legitimacy according to thenorms, values, and beliefs of its institutionalenvironment;

(b) agent monitoring is externally oriented and based on socialacceptance, 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 afirm 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 (aswell as principals) are assumed to be inherently risk averse.Though principals may employ a variety of techniques tohedge against personal risk exposure, such as diversifyingtheir financial investment across firms, agents cannot diver-sify their human capital investments making them overlyinvested in the firm and thus exposed to greater risk (Jensen& Meckling, 1976). This is because they are contractuallybound to a single employer; their primary source of wealthis derived from that employment relation.

The efficient distribution of risk between the principal andagent becomes a critical issue in determining how to com-pensate agents. However, this would give the agent noincentives. Thus agency theory must seek a balance, whatis known as a trade-off, between risk and performancecontingent compensation (Baiman, 1990).

This concept is simplistic because it considers only twotypes 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 situtions. However, the literature seems to suggest thindividuals may change their attitudes towards risk, witindications that there is a lower aversion to risk in thyounger agent (Hambrick & Mason, 1984) and with thdecision-making situation faced by the agent (Hambric1981). For example, executives tend to choose riskier decsions in an innovative prospector strategy as a reflection

the ingrained character of this strategy to support the firmcontinuing search for new products and markets (Miles Snow, 1978).

In addition, as prospect theory suggests, agents cachange their attitude towards risk according to particulsituations in which they may find themselves (Kahneman Tversky, 1979). In this way, while agency theory presentsnormative model, in which decision making is part ofrational-cognitive process in which the aim is the maximzation of personal utility, prospect theory maintains thdecision making responds not to a norm model, but rathera behavior model that explains how preferences are forme(Levy & Levy, 2002). In prospect theory, the final attitudshown by the individual toward risk is determined by thcontext in which the decision is taken. This theory is baseon the premise that individuals are psychologically averse loss and thus will adjust attitudes toward risk depending ohow risk may increase or decrease the potential for lo(Mukherji & Wright, 2002).

Thus, while agency theory centers onaversion to risk, propect theory centers onaversion to loss. According to this laconcept, the risk preferences of the decision makers will bdetermined by the context or environment surrounding thproblem. The aim is to minimize losses (and not so much tmaximize gains), even though this may involve assumingreater levels of risk. Similarly, Rabin (1998:11) suggests tha persons preferences are often determined by changes i

outcomes relative to her reference level, and not merely babsolute levels of outcomes. In particular, relative to thestatus quo (or other reference points), people dislike losssignificantly more than they like gains (see, e.g., VillenGomez-Mejia, & Revilla, 2009; Wiseman & Gomez-Meji1998).

Another problem with agency theory is that it positslinear and positive link between risk and performancunderstanding that greater risk means greater income anvice versa (Jensen & Meckling, 1976). Despite the existincontroversy, agency theory admits that the larger the managements contingent remuneration, the more risk-takindecisions on the part of the agent will be encouragebecause ultimately the managements wealth is dependeon the performance of the company, aligning the interests omanagement and principals. However, this is verified onup to certain risk levels, after which uncertainty suffered bthe management is not compensated by the contingent compensation and, accordingly, risk-averse behavior begins appear. For example, within the behavioral agency modproposed by Wiseman and Gomez-Mejia (1998), managerperceptions of risk derive from threats to their fixed salarThe explanation rests on the observation that managers generally devote fixed compensation to paying for costs relateto their standard of living (house, car, etc.), and devote contingent compensation to savings and purchasing no




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essential items such as luxury goods and services. So areduction in their fixed salary entails a threat not only totheir total wealth but to their daily standard of living. Lossassociated with this type of risk is much greater than thatderived from a threat to variable compensation. While inagency theory risk is associated with uncertainty, and aver-sion to risk will be greater as the proportion of contingentcompensation gets higher, in the behavioral agency model

or BAM, an increase in contingent compensation does notpresuppose an increase in managers perception of risk if thefixed salary is not threatened (assuming that managers areassured of not losing their jobs). In subsequent elaborationsof BAM, Martin, Wiseman & Gomez-Mejia (2012a,b) arguedthat decision makers make risky choices in response to whatthey perceive as mixed gambles that involve weighing thepotential for greater future wealth versus the protection ofcurrent wealth.

Other extensions of BAM propose that the framing oflosses need not necessarily be financial. For example, in aseries of papers, Gomez-Mejia and colleagues have shownthat for family controlled firms (representing the predomi-nant ownership form around the world), a key driver whenmaking risky business decisions is to avoid losses in socioe-motional wealth or the endowment of affect related valuethat the family has accumulated in the firm. In these papers,Gomez-Mejia and colleagues used the behavioral agencymodel to argue that family controlled firms, despite theirconcentrated financial wealth in a single firm, may prefer totake high business risks if this is needed to reduce potentiallosses 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 caninfluence the individuals risk preferences (Chattopadhyay,Glick, & Huber, 2001). Agents who are not averse to risk maybe attracted to turbulent or dynamic atmospheres. In thesesituations, aversion to risk may be considered inadequate toidentify opportunities or threats. Following Wiseman et al.(2012), the analysis of the institutional context, such as thecountry risk, is needed for a better understanding of thespecific manifestations of agency problems in differentcross-national settings. Country risk represents uncertaintyabout future events at a national level that arises from,among other things, lack of confidence in the legal system,arbitrary government decisions, and high political instabil-ity (Miller, 1992). As the principals vulnerability rises withcountry 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 therelationship between CEO stock ownership or options withthe amount of equity capital raised by a foreign firm in USstock markets. For agents, country risk aggravates personalrisk by making performance outcomes more unpredictableand less dependent on their own effort or abilities (Gomez-

Mejia & Palich, 1997; Gregorio, 2005; Shrader, Oviatt, McDougall, 2000). In such situations, agents are likely demand a premium in order to accept this risk. Even so, themay adopt conservative strategies that may lower the principals returns. In high-risk environments, we therefowould expect that post-hoc settling up forms of monitorinwould substitute for ex ante incentive alignment contractsince the former provide a more accurate measure of how

much the agents actions contributed to firm performan(Conyon & Sadler, 2001).

Ghosh and Ray (1997) suggest that what explains attitudtoward risk is not only environmental uncertainty, but hothis is interpreted by the agent and his or her tolerance oambiguity. Using prospect theory and the reference framwork that stresses relative gains or losses, Fornali (2002) alssuggests that risk preferences are not constant over time anacross situations because of the influence of two moderatinvariables: (1) the aims established by the decider (mere suvival aims as opposed to ambitious aims) and (2) the level ocontrol over results perceived by the decider.

Previous studies show that we cannot consider as univesally valid the assumption that all agents are consistentaverse to risk. Prospect theory may complement agenctheory, as Wiseman and Gomez-Meja (1998) argue in thebehavioral agency model. And there is a further problemboth of these theories consider that the formation of prefeences or attitudes toward risk responds to a cognitivprocess, which involves a deliberation concerning the diffeent options, as well as a ranking and choice of the bealternative. However, from a more critical point of viewthere are now some decision-making models that propothat the formation of preferences also responds to subconscious reasoning (Erb, Bioy, & Hilton, 2002), and not necesarily to a rational process. In any case, the ideas supporteby agency theory and prospect theory, respectively, can b

summed up in the following propositions:

Proposition 5a: According to agency theory, because agenare assumed self-interested and thus seek to maximize theparticular utility function, this results in:

(a) agents minimizing their disutility associated with bocompensation risk and employment risk;

(b) agents will be consistently averse to risk.

Proposition 5b: According to prospect theory, individualrisk preferences are determined by the context in which decsions are taken, which is likely to result in:

(a) agents being risk seeking in situations where they anticpate losing wealth or failing to achieve wealth goals;

(b) agent risk preferences being variable across decisiocontexts.

DISCUSSION AND CONCLUSIONS

In summary, agency theory has been subjected to a numbof important criticisms and stands to benefit from beincomplemented by several other theoretical frameworkFirst, agency theory makes the negative and rather inflexibassumption that agents always exhibit opportunistic beha




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ior that reduces the principals wealth. The trust literaturesuggests an alternative proposition that agents may act hon-estly without any control mechanism. Extrapolation of trustto an organizational level implies that: (1) the considerationof multiple stakeholders does not always entail higheragency costs, because social norms of obligation and reci-procity may cause stakeholders to repay benefits, thusincreasing the future value of the firm and therefore the

principals wealth; and (2) the growth of the organizationdoes not always entail higher agency costs, because agents,aware of the difficulty in separating their well-being fromthat of the other members, may identify themselves with themission/vision of the firm and develop commitment andcooperative behavior. Thus, instead of controlling agencycosts through extrinsic rewards as advocated by agencytheorists, it is possible that, in some situations, agents mayself-regulate in response to socioemotional rewards result-ing from accomplishment and cooperation.

By comparing with the rationally self-interested conceptof human behavior that justifies conflict of interests betweenprincipal and agent, we have considered a growing literatureon trust. While agency theory assumes that both principalsand agents are rational rent-seekers and hold differentutility functions, we describe circumstances under whichhonesty, loyalty, and trust in agents behavior are possible.The interpretation of the principal-agent relationship as oneof cooperation and not conflict of interests has differentimplications in order to extend agency theory.

One implication from our reconsidering the mechanismsused to influence agent behavior is in recognizing a role fortrust. Agency theory focuses on identifying the most effi-cient contract for aligning the interest of an agent with thoseof the principal (Fama & Jensen, 1983), recognizing the keyrole played by extrinsic motivation, specifically economicincentives, to reduce agency costs. In contrast, trust litera-

ture fosters the development of constructive relationshipswhere partners can actively rely on each other to create con-ditions where mutual influence and mutual benefit is pos-sible. It implies that the main mechanism of control overagents behavior moves from extrinsic to intrinsic incentivessuch as opportunities for growth or self-realization as stew-ardship theory suggests when management identifies withthe organization; or the implicit social contracts of obliga-tions and reciprocity (beyond the economic exchange) thatexist in stakeholder relations.

In the same way, and regarding incentive alignment, insti-tutional theory suggests that compensation design may notcoincide with the arguments of efficiency and rational self-interest so much as they reflect, but respond to the norms,values, and beliefs of the institutional environment to searchfor social acceptance or legitimacy.

This leads to a second implication from considering therelevance of other theoretical perspectives to agency. This hasto do with acknowledging the social context in which theprincipal-agent contract resides in order to go deeper intheunderstanding of howthatcontext may influence both theinterests and mechanisms for aligning interest of principalsand 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 institutionalfeatures that draft a more realistic view of the economic

exchange between both parts. In fact, we defend the necessito acknowledge, for example, the social context in which thexchanges with stakeholders take place, as well as the roleleadership styles or the organizational culture to understanto what extent individuals will behave opportunistically owill be committed to organizational goals. Similarly, wdiscuss the simplistic assumption of two types of attitudesrisk (aversion and neutrality) to suggest the importance

considering the decision-making situation faced by the agenWhile descriptions of the various contexts that surroundprincipal-agent relation provide us with important cluabout how specific features of the principal-agent relatiomight differ across these contexts, they should not be vieweas deterministic. By formally viewing thebroader social envronment, we can explore the various manifestationsof agenproblems that might arise as well as the mechanisms thmight be used to control them. To conclude, only considerinthe social nature of contracts, we will be able to extend anstrengthen agency theorys predictions.

Our examination here has focused on just a few contextuelements to show how agency problems and their solutionreflect the social environment in which they are embeddeClearly, other dimensions of context may provide additioninsight into the potential for opportunism or stewardship principal-agent relations. Then, apart from the theories dicussed in this research, the possible combinations of agenctheory with other theoretical frameworks are not limiteModeling bilateral relations between principals and agenthrough a lens of rational self-interest has been useful tunderstanding the conditions under which conflict of inteests may result in agent opportunism, undermining firvalue. However, this view is limited and provides a narropicture of how principals and agents may interact. Thus it time to expand our theoretical horizons to build models oagency that reflect the more complex interactions that occu

when principals hire agents.

NOTES

1. Adverse selection is used to define the problem of precontratual informational asymmetry that is produced when the owne(or principals) do not make a right selection of the agenthrough not knowing, at the moment of contracting, his or htrue qualities as a professional. The problem of moral hazardin contrast, happens after the contractual agreement, when pricipals are faced with the impossibility of knowing what theffective effort made by agents is, who abuse the discretioand power they have been given so that they can attain certa

objectives.2. Caroll (1989) differentiates betweenprimary stakeholdersandse

ondary stakeholders, identifying the first with those who haveformal, official or contractual relationship with the organizatioClarkson (1995) differentiates betweenvoluntaryandinvoluntastakeholderson the basis of the exposure to or acceptance of thrisk of the activities performed by the company.

3. Green-mail is the purchase of a companys stock and threateing takeover unless the company purchases the stock back at ainflated price.

4. This interpretation could be similar to Pfeffer and Salancik(1978) theory of resource dependence, with the difference thagency theory would explain the relationship between t




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company stakeholders in search of the optimum contractbetween selfish parties.

5. Stewardship theory has been related to the theory of interestgroups (or stakeholder groups) because, as the administratortries to increase the global organizations performance, it gener-ally satisfies most of the groups involved (who benefit from thatgreater organizational wealth).

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Has Agency Theory Run Its Course

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