Agency Theory and how it is relevant to P&SCM

In a previous article called Principle Theories in Procurement and Supply Chain Discipline where i tried to address the question regarding the principal theories and conceptual models used to understand, explain and guide procurement and supply chain practice, we concluded that theories that have predominantly been used in the literature to study the two most critical and demanding phases of the procurement process (Vendor Selection & Contracting; Vendor Relationship Management), are: Agency Theory, Transaction Cost Economics, and Relational View. The focus of the present article is the Agency Theory.

• The theory origins and the Agency problem

Agency theory is one of the most notable theoretical perspectives used in business and management research according to Oxford Research Encyclopedia. It has been used by scholars in different disciplines (e.g. accounting, economics, finance, marketing, political science, organizational behaviour, and sociology) (Eisenhardt, 1989).

The theory has its origin in the 1960s and early 1970s, when economists like Arrow (1971, Nobel prize winner 1972) and Wilson (1968, Nobel prize winner 2020) explored risk sharing among individuals or groups. The focus of this literature was on risk-sharing problems arising when cooperating parties have different attitudes toward risk. Agency theory built on this risk-sharing literature and included a new concept which is the agency problem emerging when cooperating parties diverge in their goals and interests. (Eisenhardt, 1989).

• What is it about and how it applies to P&SCM?

The initial focus of the theory was on the manager-stakeholders relationship but expanded to explain inter-organizations relationship. When applied to P&SC perspective, the agency theory aims to explain the relationship between the buyer(principle) and the supplier (agent) (Perunovic and Pedersen, 2007; Vaxevanou & Konstantopoulos, 2014).

• The Agency relationship

Jensen and Meckling (1976, p. 308) defined an agency relationship as: ‘’a contract under which one or more persons (the principal(s)) engage another person (the agent) to perform some service on their behalf which involves delegating some decision-making authority to the agent’’.

• The ''Contract'' as metaphor and the divergent interests of the parties

The theory uses the metaphor of a ‘’contract’’ in describing relationship between the principle and the agent (Jensen & Meckling, 1976 In Eisenhardt, 1989). Since the unit of analysis is the contract governing this relationship, it focuses on identifying the contract that most efficiently govern the relationship considering fundamental assumptions about people, organizations and information (e.g., self-interest, bounded rationality, risk taking preferences and information asymmetry) Eisenhardt (1989).

Jensen and Meckling (1976) suggested that should both agent and principle be utility maximisers, the agent may not always act in the interest of the principle. The principle argument of the theory is that the agent may be driven and motivated by different interests and that information is asymmetric (Oxford Research Encyclopaedia).

• ''Agency costs'' and the best way to minimize them

Jensen and Meckling (1976) claimed that ‘’agency costs’’ are generated from the divergences between the agent and the principle (conflicts of interest and disagreement regarding actions that are taken), and suggested that by establishing incentives to the agent and incurring monitoring (and other control activities) costs, the principle could limit (but probably not eliminate) divergences of the agent from the principle’s interest.

This was emphasized by Barney and Hesterly (1996) who claimed the theory suggest that problems that might arise from the relationship between the principle and its agent, might be addressed through the reinforcement of the principle-agent relationship and the use of continuous monitoring (Perunovic and Pedersen 2007; Vaxevanou & Konstantopoulos 2014), which was supported by Eisenhardt (1989) who suggests that when principals and agents engage in a long-term relationship, the principle is likely to learn more about the agent which will allow him to better assess the agent behaviour. Interchangeably, when the agency relationship is short, the information asymmetry between the parties is likely to be substantial.

On contrast with TCE (Transaction Cost Economics, subject of our next article) which assumes bounded rationality suggesting incomplete contracts and focusing broadly on the use of governance mechanisms, Sanderson (2015) argues that the focus of agency theory is on the contractual mechanism to mitigate hazards arising from the supplier opportunistic behaviour. The theory suggests the possibility ex-ante to draft a complete contract mitigating such risks, assuming full rationality of the parties.

The literature discusses several opportunistic behaviours, among them we find adverse selection, strategic misrepresentation and moral hazard. The agent (supplier) in these behaviours exploit the information asymmetry in its favour to be awarded a contract and deliver it in unfair or misleading manner (Sanderson, 2015).

• A real example from procurement

Scholars argue that in certain purchase categories (providing the professional services as example), the principle (buyer) requirements will be complex and difficult to specify in detailed way in the contract, the agent (supplier) will be well positioned in such circumstances to not deliver the service or deliver it in a way that increases its profit, with the principle (buyer) finding it difficult to detect it (Sanderson, 2015). The theory suggests in such situations to design the hybrid contract ex-ante, partly by specifying desired performance outcome and partly by developing an incentive to mitigate the eventual agent (supplier) opportunistic risk during the contract life cycle.

• Two diverging currents/streams of Agency Theory

Jensen (1983) in Eisenhardt (1989) stresses that the Agency Theory has developed along two lines: Positivist line and Principle-agent line. Eisenhardt (1989) explains that the two streams share the principle-agent contract as the common unit of analysis, as well as common assumptions about people, organizations, and information. The difference comes according to her from their mathematical rigor, dependent variable, and style. She further suggests that that the two streams are complementary, as ‘’Positivist theory identifies various contract alternatives, and principal-agent theory indicates which contract is the most efficient under varying levels of outcome uncertainty, risk aversion, information and other variables(…)’’ (Eisenhardt 1989, p. 60). She further explains that the positivist stream is recognized by the focus of researchers on the situations in which the principle-agent relationship is likely to be conflicting due to divergences in goals and interests and then describing the governance mechanisms that mitigates the risk arising from the agent's opportunistic behaviour. Positivist agency theory can be viewed as enriching economics by a more complex view of organizations that it offers, its critics from the organizational discipline view it as minimalist, whereas microeconomists view it as tautological and lacking rigor. Nevertheless, the theory is very popular and catches considerable interest of researchers (Eisenhardt, 1989).

• Criticism

According to Sanderson et al. (2015) the theory is being criticized through the validity and robustness of its behavioural assumptions as it ignores the complexity of individual motivation and behaviour in an organizational context. Its assumption of the possibility of complete ex-ante contracting based on actor’s rationality is doubtful considering the ubiquitous evidence of contractual incompleteness.

In our next article, we will talk about Transaction Cost Economics, a theory that is also widely used within P&SCM disciplines.

Dr. Taoufik Samaka

Stockholm, 2021-05-20