AGENCY THEORY

Agency Theory

Agency Theory

The term agency theory is often used to refer to a particular body of work that has developed in economics, accounting, and financial economics. This work is actually a subset of the wider range of work using the concepts of agency (Eisenhardt, 1989). Its assumptions about human motivation, especially its assumption of self-interest in the actors, and its focus on decisions as the key modeling contexts constitute significant simplifications that enable theoretical development to be formalized. But this approach, sometimes labeled the economic theory of agency , is also limited by these assumptions and has been the target of criticism from scholars working in other traditions.

As it has spread through the social sciences, research in agency theory has incorporated normative, institutional, cognitive, social, and systemic factors, going beyond the assumptions of the economicsbased model (Mitnick, 1997). Thus, the best-known application of the approach, to the theory of the firm, is only one application of it.

Agency theory grew out of several rich theoretical streams in the social sciences. In economics it goes back at least to Ronald Coase's work on the firm in the late 1930s, in management to Chester Barnard's classic work on the functions of the executive about the same time, and in accounting and control to William Cooper's work in 1940 and 1951 (Eisenhardt, 1989). In sociology, there is even earlier work of relevance in some of the classic works of George Herbert Mead and Georg Simmel.

In economics, the stream carried a series of studies on the divergence of owner and manager interests and behavior and on the objective function of the managed firm (notably from such scholars as Adolf Berle and Gardiner Means through Andreas Papandreou, Edith Penrose, Robin Marris, and William Baumol to Oliver Williamson's 1964 theory of managerial discretion; see also work on agency and the firm by Harvey Leibenstein). Jacob Marschak and Roy Radner's 1972 work on the theory of teams and Michael Spence and Richard Zeckhauser's 1971 work on risk and insurance highlighted the effects of differing information states and risk preferences (Mitnick, 1997).

Oliver Williamson's 1975 transaction costs approach examined how institutional choices could be understood as economizing on costs in exchange (Mitnick, 1997). In contrast, agency theory uses the costs of specification, monitoring, and policing to understand the choice of institutions in its modeling of control. In 1972, Armen Alchian and Harold Demsetz explained the emergence of ...