Is agency theory self‐activating?

TLDR: This paper examined the conditions under which the principal-agent model is self-activating/socially causal and examined the extent to which the agency model is robust when autonomy-preferring agents are introduced into the population.

Abstract: This article examines the conditions under which the principal-agent model is self-activating/socially causal. We do so by exploring a principal-agent framework that allows for the possibility that rational agents may hold intrinsic preferences for autonomy in decision making and experience disutility from being monitored. Using a dynamic model of preference formation, we identify conditions under which the principal-agent model is self-activating in that, over time, the introduction of the model in an otherwise efficient monitor-worker relationship leads to the inefficient adoption of the agency model. We also examine the extent to which the agency model is robust when autonomy-preferring agents are introduced into the population. (JEL G30, L20, C72) I. INTRODUCTION As a social science, economics seeks to both explain and influence behavior. This in turn fosters a constructive process of self-assessment of the economic approach to decision making. For example, in examining the effect of exposure to economics and differences in cooperativeness in the Prisoner's Dilemma, Frank, Gilovich, and Regan (1993) report that economics students were statistically more likely to frame the objective of the game in self-interested terms and to refer exclusively to the features of the game itself in explaining their strategy choices, rather than considering issues such as fairness, trust, or social norms. Frey and Meier (2003) offer a more distilled view; they use a nonlaboratory experiment (voluntary student contributions to two university funds), with an eye toward examining whether self-interested students self-select into economics (selection bias) or self-interested behavior is a consequence of indoctrination. Surprisingly, their most significant variable was the study of business economics, which obviated both the self-selection and indoctrination effects. By contrast, those with primary training in political economy exhibited neither effect. In examining a dilemma in which subjects were forced to weigh their commitment to profit maximization against concern for workers who would be fired as a consequence of profit maximization during a time of high unemployment, Rubinstein (2006) found that economics students were statistically more likely to adhere to the profit-maximization criterion. Similarly, Israeli readers of a business daily who had a BA in economics or an MBA laid off more workers in the same survey. One area where economic theory has played a significant role in both framing the issues and training the affected parties is executive compensation, particularly the principal-agent model. Beginning with Berle and Means (1932), agency theorists have recognized the need to overcome problems stemming from the separation of ownership and control in public corporations, for example, Jensen and Meckling (1976). Further, not only are the lessons from the principal-agent model widely taught but its operationalization is also recognized within the popular press as the intellectual foundation for the shareholder value movement within Corporate America, as well as the doubling of the number of chief executives who were offered stock option plans from 1980 to 1994.1 Whether seen as the embodiment of "best practice" or as the impetus for corporate avarice, it cannot be denied that the operationalization of agency theory has revolutionized the culture of Corporate America. Further, Bebchuck and Fried's (2004) finding that the design of compensation schemes creates its own agency problems reinforces the core assumption of opportunistic behavior in agency theory. The principal-agent model is an example of a widely disseminated theory in which those who are exposed to it are expected both to put it into practice and have it practiced on them. Consequently, the model raises expectations about the usefulness and occurrence of incentive-based compensation schemes through its underlying assumptions about agents' opportunism. …