P

Principal-Agent Theory programs and goals. Agency theory has had con-
of Organizations siderable influence on the theory and practice of
public administration and policy since its emer-
Robin Gauld gence in the 1970s. It was particularly instrumen-
Department of Preventive and Social Medicine, tal in many high-income developed countries
Dunedin School of Medicine, University of through the 1980s and 1990s, with often radical
Otago, Dunedin, New Zealand public sector reforms resulting. Its legacy has
endured, with many public sector organizational
and policy designs continuing to be underpinned
Synonyms by concepts derived from the theory. Based on
institutional economics, agency theory has, there-
Agency theory; Institutional economics; Public fore, provided a powerful and all-encompassing
choice theory; Theory of contracts; Theory of framework for public sector organization. As
incentives such, there has been much written about agency
theory itself, and about public sector contracting,
which is a central tenet (see for instance Ashton
Definition et al. 2004; Klingner et al. 2002; Lane 2001;
Pallesen 2004; Pinch and Patterson 2000). There
Theory of interaction between an agent and the is less literature that discusses the longer-term
principal for whom they act, the point being to policy outcomes when agency theory has been
structure incentives so that the agent will act to an overarching influence on public sector organi-
benefit the principal. zation (Gauld 2007).
This chapter provides an overview of agency
theory, including the key ideas behind it and the
Introduction organizational and policy arrangements that are
derived from it. The chapter outlines the benefits
The principal-agent theory of organizations that might be expected to result when the theory is
(“agency theory” from here on) encapsulates the applied to public sector organization. It also high-
idea that public sector performance can be lights agency theory’s shortcomings. Finally, it
improved if incentive-based contracts between notes areas where theoretical extension is
different actors are implemented. Principals will demanded.
be more likely to achieve their desired outcomes,
while agents will have clarity around work
# Springer International Publishing Switzerland 2016
A. Farazmand (ed.), Global Encyclopedia of Public Administration, Public Policy, and Governance,
DOI 10.1007/978-3-319-31816-5_72-1
2 Principal-Agent Theory of Organizations

What Is Agency Theory? purposes such as setting expectations and objec-

tives of contract partners and for establishing per-
Agency theory has its foundations in two ideas formance assessment and accountability
which were developed through the study of the expectations.
economics of organizational and institutional Advocates of agency theory and related orga-
behavior. nizational arrangements presume that contracting
First was the notion proposed by public choice will align the interests of principals (those wanting
theorists that self-interest is the primary motiva- something done, such as politicians, funding
tion behind the activities and behavior of individ- agencies, or chief executives) and their agents
uals and the organizations that they work for (e.g., government officials and organizations or
(Mitchell and Simmons 1994; Mueller 1989). non-government and private service providers of
Through this lens, people in public employment public services). The result, in theory, is that the
and public organizations are viewed as “rational achievement of principals’ objectives will be
utility maximizers,” meaning that each seeks to maximized, resulting in a more efficient and effec-
advance their own interests as would a private tive policy and service delivery outcomes. Along-
business or private sector employee in pursuit of side of this, the self-interested behavior of agents
profit or an increased salary. In this way, govern- will be stemmed and focused on principals’ goals
ment officials and organizations are presumed to via various incentives and sanctions. These might
be in pursuit of only budgetary expansion; politi- include anything from withholding of service
cians, for their part, are motivated by the prospect delivery payments through to organizational or
of an expanded share of votes; interest groups, individual employee performance bonuses
who represent specific sector groups or services (detailed discussion of agency and related theory
users, are only concerned with furthering their can be found in Dixit 2002; Laffont and
own ends and those of their members. Public Mortimort 2002; Mueller 1989; Self 1993;
choice theory suggests that the result of such Stretton and Orchard 1994; Wallis and Dollery
behaviors is a state which is larger than it should 1999; Walsh 1995).
be, along with policies which are designed pri-
marily to serve voter preferences and boost voter
support for politicians and political parties, and an Factors that Complicate Application
economy which is skewed through meeting the of Agency Theory
demands of selected interests over and above
those of the broader public interest. To counter Complicating agency theory is a series of behav-
this, public choice theorists advocate limits on the ioral factors encapsulated by the terms “adverse
power of politicians, interest groups, and public selection” and “moral hazard,” as well as the very
officials, as well as the implementation of finan- nature of the public sector and government.
cial incentives and sanctions to ensure appropriate Adverse selection results from the existence in
performances. any relationship of what are called “information
The second idea, again based on a presumption asymmetries.” This refers to the simple fact that
that self-interest and rational utility maximization one party (for instance, an experienced and skilled
drive behavior, is the view that all of life, includ- public servant) may be likely to have more knowl-
ing public work, private lives, and organizational edge, and therefore be at an advantage, than
activities, can be viewed as a set of relationships another party (such as a politician). Adverse selec-
between different parties (Moe 1984; Perrow tion can occur when, for example, a principal
1986). The details of these relationships, once (a politician) is not able to gain sufficient knowl-
defined, and the requirements of the various edge about an agent’s (a public servant’s) back-
parties in any particular venture or activity can ground, motivations, or capabilities prior to
be itemized and then written into a formal con- entering into a contractual relationship (Perrow
tract. The contract can, in turn, be deployed for 1986). It can pose particular problems in any
Principal-Agent Theory of Organizations 3

contracting situation and require considerable research into whether long-term public sector per-
investigation to ensure that the potential for formance has improved as a result, and it could be
adverse selection related-difficulties is reduced. difficult to determine direct causality, it may be
The risk of “moral hazard” arises once a con- fair to suggest that performances have continued
tract has been agreed to. It stems from the fact that, to be questionable. Indeed, politicians in most
on a day-to-day basis, principals are not able to high-income countries, along with international
observe most agent activity (Moe 1984). Princi- agencies, continue to demand improvement in a
pals are, therefore, reliant on agents carrying out context where policy challenges are increasingly
tasks and performing at a level as specified in a complex (e.g., issues ranging from how to deal
contract. The ever-present prospect of moral haz- with population aging and chronic disease
ard means an ongoing requirement for monitor- through to inequality and climate change which
ing. This can result in considerable costs to both require considerable cross-government coordina-
contracting parties, as well as goal-displacement tion and long-range planning). This is despite
behavior on behalf of agents where they place a agency theory having an ongoing and influential
disproportionate emphasis on work that is specif- role as a framework for establishing the roles of
ically subject to monitoring. By goal displace- principals and agents and, in turn, for managing
ment, this means that agents focus on monitored policy development and implementation.
goals, to the detriment of other organizational and The above discussion brings to the fore ques-
individual goals that may not be directly tions over the applicability of agency theory to
monitored. complex and changing policy and management
A further factor complicating agency theory is issues and points to several agency theory defi-
a range of circumstances particular to government ciencies. Most of these have been alluded to else-
and public sector work. These include that policy where but not incorporated explicitly into the
refinement is frequently left to the implementation theory (see, e.g., Dixit 2002; Laffont and
process and is routinely the responsibility of Mortimort 2002; Le Grand 2003). In other
agents, being public officials and not principals words, they do not feature prominently in discus-
(Hill and Hupe 2002); most government agencies sions by agency theorists about the implications
have several and often conflicting tasks and objec- of, and prospects for, arrangements derived from
tives which can be difficult to define and itemize the theory. There are four key shortcomings.
(Wilson 1989); multiple principals and agents These include:
characterize the public sector as do situations in
which principals often double as agents; the pub- 1. Principals (in this case, political leaders and
lic sector tends to lack competition, at least in public officials at different levels of govern-
terms of core government non-trading functions ment and the health system) often may not
(Allison 1979); and the public workforce and have sufficiently detailed knowledge of what
agencies are motivated by a complex array of they want when setting parameters and build-
factors, only one of which might be financial ing incentives and goals for agents. If they do,
incentives (Dixit 2002; Le Grand 2003; Thaler and decide upon a certain policy path, then this
2015; Wilson 1989). has implications if political and policy prefer-
ences are subsequently altered. To counter
such problems, principals may need a longer-
Improving Agency Theory term view, as discussed below.
2. Principals may not recognize in advance the
There is now considerable international experi- ramifications of the directions they set. In
ence with application of agency theory to public response, it might be suggested that principals
sector organization. It has provided the founda- clearly need to model in detail the possible
tions for public sector reforms in a range of high- outcomes of various policy options. Such an
income countries. While there is an absence of approach, however, would be subject to the
4 Principal-Agent Theory of Organizations

widely noted limits of “rational” policymaking demanding, raising questions over transaction
(Lindblom 1959). costs.
3. Agency theory fails to adequately account for If so, then alternatives may need to be consid-
situations when principals regularly change. ered. One possibility is for increasing the level of
Such changes, for instance in political leader- centralized policy control and sector oversight, in
ship, can be a harbinger for change in policy short, the growth of a more comprehensive itera-
directions and the organization of the public tion of agency theory that incorporates the coor-
sector. Agency theory may simply need to be dination of principals and agents. If contracting is
amended to include reference to the fact that to remain a fundamental principle of public sector
arrangements inspired by it cannot be relied organization, then longer-term contracts, com-
upon to produce continuity in transitions bined with standardized objectives and funding
between principals. levels (inherent to comprehensive policy), may
4. Following the previous point, when the admin- promote more commitment among agents to cen-
istrative systems within which agents work are trally driven directions. This points to the need for
regularly restructured by principals, with the development of a consensus-based variant, bring-
potential to induce confusion and chaos, this ing together principals and agents, with an aim of
undermines the assumption inherent to agency stewardship over a subset of contractual agree-
theory that principals are in control and capable ments between interested parties. In practice, this
of providing consistent direction over time; it may mean lengthy consultation processes that
also disrupts administrative processes and con- involve policymakers, key interests, industry,
tinuity, creating obstacles to effective individ- and provider groups with a primary aim of forging
ual and aggregate agent activity. long-term goals. Such an approach might be
A consequence is that agents may develop underpinned by a focus on outcome-oriented pol-
their own methods and systems for working icies being increasingly pursued by various
and fail to coordinate with one another. If national governments (Baehler 2003; Christensen
incentives are to be relied upon for complex and Laegreid 2013; Hoque 2008). Forging a long-
organization and in scenarios of transition, term, cross-government view may carry with it a
then their design needs to be sophisticated. risk of committing to particular directions that,
A simple vertical contract between principals following any future political change, could be
and agents may not be enough; horizontal con- rejected. Consensus may, also, over time lead to
tracts between agents may also be required, policy embeddedness and establishment of a set of
and these may need to be coordinated by prin- institutions that would be resistant to future
cipals. By implication, this means that princi- reform (see Blank and Burau 2004; Putnam
pals need the detailed knowledge and foresight 1993: 179; Wilsford 1994). This may be appro-
discussed in points 1 and 2 above, along with priate when effective responses are demanded to
commitment to stability implied in point 3. complex policy problems such as those listed
earlier in this chapter.
Thus, for agency theory to be an effective
organizing principle now and into the future,
more intricacy in its development may be required Conclusion
(Deacon 2004). Yet even if an approach that
accounted for the four points above were applied, Short of the developments described in the previ-
this may be too constrained for the exigencies of ous section, which might be seen by agency the-
politics, the multitudinous motivations of individ- ory proponents as undermining competitive
uals and public organizations, the ever-changing incentive systems, the rudimentary method of
and increasingly complex nature of administration simple contracts between principals and agents
and society, and the challenges for the foreseeable may fail to provide an effective developmental
future. It may also prove to be administratively foundation for multifarious administrative issues.
Principal-Agent Theory of Organizations 5

Cross-References Laffont J-J, Mortimort D (2002) The theory of incentives:

the principal-agent model. Princeton University Press,
Princeton
▶ Agency Theory in Organizations Lane JE (2001) From long-term to short-term contracting.
▶ Goal-Setting Theory Public Adm 79(1):29–47
▶ Market Theory of Organizations Le Grand J (2003) Motivation, agency and public policy:
▶ Organizational Efficiency of knights, knaves, pawns and queens. Oxford Univer-
sity Press, Oxford
▶ Organizational Performance Lindblom C (1959) The science of muddling through.
▶ Organizational Theory and Ideology Public Adm Rev 19(2):79–88
▶ Public Choice Theory of Organizations Mitchell W, Simmons R (1994) Beyond politics: markets,
welfare, and the failure of bureaucracy. Westview
Press, Boulder
Moe T (1984) The new economics of organization. Am
References J Polit Sci 28:739–775
Mueller D (1989) Public choice II. Cambridge University
Allison G (1979) Public and private management: are they Press, Cambridge
fundamentally alike in all unimportant respects? In: Pallesen T (2004) A political perspective on contracting
Shafritz J, Hyde A (eds) Classics of public administra- out: the politics of good times. Experiences from Dan-
tion. Brooks/Cole Publishing Company, Pacific Grove ish local governments. Governance 17(4):573–587
Ashton T, Cumming J, McLean J (2004) Contracting for Perrow C (1986) Complex organizations: a critical essay.
health services in a public health system: the New Random House, New York
Zealand experience. Health Policy 69(1):21–31 Pinch PL, Patterson A (2000) Public sector restructuring
Baehler K (2003) “Managing for outcomes”: accountabil- and regional development: the impact of compulsory
ity and thrust. Aust J Public Adm 62(4):23–34 competitive tendering in the UK. Reg Stud
Blank RH, Burau V (2004) Comparative health policy. 34(3):265–275
Palgrave Macmillan, Houndmills Putnam R (1993) Making democracy work: civic traditions
Christensen T, Laegreid P (eds) (2013) Transcending new in modern Italy. Princeton University Press, Princeton
public management: the transformation of public sector Self P (1993) Government by the market? The politics of
reforms. Ashgate, Surrey public choice. Westview Press, Boulder
Deacon A (2004) Book review: Julian Le Grand, “motiva- Stretton H, Orchard L (1994) Public goods, public enter-
tion, agency and public policy: of knights, knaves, prise, public choice: theoretical foundations of the con-
pawns and queens”. J Soc Policy 33(3):503–506 temporary attack on government. Macmillan Press,
Dixit A (2002) Incentives and organizations in the public Houndmills
sector: an interpretive review. J Hum Resour Thaler RH (2015) Misbehaving: the making of behavioural
32(4):696–727 economics. Allen Lane, London
Gauld R (2007) Principal-agent theory and organisational Wallis J, Dollery B (1999) Market failure, government
change: lessons from New Zealand health information failure, leadership and public policy. Macmillan,
management. Policy Stud 28(1):17–34 London
Hill M, Hupe P (2002) Implementing public policy. Sage, Walsh K (1995) Public services and market mechanisms:
London competition, contracting and the new public manage-
Hoque Z (2008) Measuring and reporting public sector ment. Macmillan, London
outputs/outcomes: exploratory evidence from Austra- Wilsford D (1994) Path dependency, or why history makes
lia. Int J Public Sect Manag 21(5):468–493. it difficult but not impossible to reform health systems
doi:10.1108/09513550810885787 in a big way. J Public Policy 14(3):251–283
Klingner DE, Nalbandian J, Romzek BS (2002) Politics, Wilson JQ (1989) Bureaucracy: what government agencies
administration, and markets – conflicting expectations do and why they do it. Basic Books, New York
and accountability. Am Rev Public Adm
32(2):117–144