Agency Theory & Corporate Governance
Corporate governance is a broad term used to refer to the processes, policies, regulations, and customs by which a corporation is directed, administered, and controlled. Corporate governance specifies the responsibilities and rights of the various stakeholders in the organization. In a narrow sense, corporate governance articulates the relationship of the company to its immediate stakeholders (e.g., employees, stockholders). In a broader sense, it articulates the relationship of the organization to society. The concept of corporate governance is one of the core areas of economic sociology. The sociological study of corporate governance is often concerned with the relationship not only between principals and agents in a corporation, but also the relationship between all stakeholders and the mediating processes, among these the result in an effective organization.
Most corporations are set up to accomplish something. In some cases, it is to earn enough income so that they can do some good in the world. In other cases, the main motive is profit, particularly in terms of dividends paid out to shareholders who invest in the corporation. In general, shareholders do not invest in corporations for altruistic motives; they want a return on their investment. If the risk is too great to the shareholders, they pull out their investment. To help ensure that the interests of the shareholders are being guarded, corporations put into place various mechanisms to see that their goals are being met. Corporate governance is a broad term used to refer to the processes, policies, regulations, and customs by which a corporation is directed, administered, and controlled. Corporate governance specifies the responsibilities and rights of the various stakeholders in the organization. In a narrow sense, corporate governance articulates the relationship of the company to its immediate stakeholders (e.g., employees, stockholders). In a broader sense, it articulates the relationship of the organization to society. The concept of corporate governance is one of the core areas of economic sociology. This subspecialty of sociology examines economic phenomena from a sociological perspective. Studies of corporate governance are often interdisciplinary in nature, including perspectives from sociology, economics, law, and political science.
The study of corporate governance originally arose out of agency theory. This is a perspective that attempts to explain the relationship between the principals (e.g., shareholders) and agents (e.g., executives) of an organization. According to agency theory, the principal hires or delegates an agent to perform work. In this kind of relationship, one party acts on behalf of the other party. According to classical agency theory, however, a dilemma arises due to the fact that the interests of the principal and of the agent are not necessarily aligned. For example, a business owner may act as a principal and hire employees to perform various tasks (e.g., make widgets). The interest of the business owner is to expend as little for producing the widgets as possible while selling them to customers for as much money as possible. The interest of the employees, however, is to make as much money as possible for making the widgets.
If the business owner sets up an arrangement with the employees in which they are paid but it is not articulated how much they have to do in order to get paid, the situation in theory becomes one of the business owner expending a great deal of money without getting a great deal of widgets in return. To help make this relationship more tenable (at least from the point of view of the business owner), various mechanisms may be put in place to help ensure that the employees produce value (i.e., working widgets) for their paychecks. This can be done through such incentives as piece rates (i.e., paying based on the number of widgets produced) or commissions, profit sharing (which gives the employees an incentive to make many widgets for a low price because they will reap the rewards along with the business owner), or the implementation of job standards with the negative incentive of being fired if employees do not meet stated expectations. From the perspective of agency theory, the relationship between the principal and the agent is further complicated by the fact that it exists in an environment of information asymmetry, uncertainty, and risk. For example, when the principal hires the agent, he or she only knows what the agent has said about his or her capabilities on a resume, a notoriously imperfect document. However, the agent also does not have as much information about the job or task to be performed as does the principal.
Principal-agent relationships are also characterized by uncertainty and risk. The principal only has a degree of certainty that the agent will be able to adequately learn or perform the task, and the principal accepts a degree of risk that the job will not be done in a manner that will help meet his or her goals because the agents are unable to do the job, shirking their responsibilities, or pursuing their goals in preference to those of the principal. Scholars of corporate governance attempt to deepen agency theory by better understanding the various stakeholders in an organization and the nature of their relationships as well as the facts underlying the diversity of corporate governance systems around the globe. The classical approach to agency theory has focused in large part on the incentives of managers and owners as was the identification of market mechanisms that will allow principals to minimize the potential cost to the agency. Agency theorists have also devoted significant effort to the study of the board of directors in the agency problem. One of the areas of corporate governance that is of interest within the context of agency theory and economic sociology is the degree to which different characteristics of boards of directors (e.g., composition, structure) affect agency costs.
The Nature of Corporate Governance
From a sociological perspective, there are several reasons why agency theory does not adequately explain the nature of corporate governance. One of these is the fact that the relationship between principals and agents and the assumption that ownership of a corporation is dispersed does not take into account the fact that the stakeholders within an organization are frequently diverse (e.g., families, institutional investors, banks) and that each of these groups act as socially constructed interests. Another difficulty with agency theory from a sociological point of view is that it focuses on bilateral contracts between principals and agents while largely ignoring the importance of interdependencies with other stakeholders in the organization. A third problem with agency theory from the perspective of sociology is that the complexity of an organization can only be understood if it is examined in a wider context than from the narrow perspective of shareholders' rights. To overcome these perceived shortcomings, sociologists also examine social relations and organizational...
(The entire section is 3130 words.)