Background and objective

Agency theory can be classified to be one of the most influential frameworks in the context of compensation management. The analysis of economic exchanges when an individual (the principal) delegates some authority in order to act in her name to another individual (the agent) lies in its core. The relation between the principal and the agent is specified in a contract that basically defines what the agent has to do and how the outcome is divided between the principal and the agent. Within agency relationships, costs for monitoring and bonding agents arise for the delegating party, which stem from individual utility maximization.

In a nutshell, in the context of incomplete information and environmental uncertainty, agency theory focuses on finding the most efficient contract (typically from the principal’s viewpoint) between the principal and the agent which aligns the two parties’ interests but also maximizes the principal’s utility.

Agency theory makes specific assumptions about, e.g., how the principal and the agent would behave in such a contractual relation and which information are available for the two parties. These assumptions might be regarded as a virtue of agency theory since they allow for deriving optimal contracts in rigorous closed-form modelling. However, at the same time, these specific assumptions might also be regarded as weakness as they might limit the theory’s predictive validity. Due to restrictive assumptions, much of the agency literature is suspected to fail in explaining empirical phenomena and to focus on problems of little substantive interest, which is potentially dangerous if problems in organizational settings are to be solved.

SARAH aims at providing a systematic analysis of (simplifying) assumptions incorporated in standard agency models with respect to the extent to which these assumptions limit the derived contracts’ applicability in situations where these assumptions do not hold. The focus will be put on problems investigated within the hidden-action framework. In particular, the project aims at quantifying the “costs” of these assumptions in terms of lost utility for the principal.