Agency Theory and Organization Development 1

Organizational Development, Agency Theory, and Efficient Contracts: A Research Agenda

Mesut Akdere
University of Wisconsin-Milwaukee

Ross E. Azevedo
University of Minnesota

Abstract

This paper presents an analysis of the Organization Development (OD) function in

organizations in light of the precepts and utility of agency theory. It examines how the
roles of "principals' and "agents" complicate the change and improvement processes and
experience and challenge the role of OD professionals. This paper contributes to our
understanding of why, even with what appear to be the best of intentions on all sides, the
principals and agents in organizations may interact to cause failure and the implications
of this dynamic existing within the organization.

Keywords: Agency Theory; Organization Development; Human Resources; Change

Introduction and Setting

As organizations strive to improve their performance through a number of developmental

strategies available to them, all must recognize that there is the possibility of a variety of internal

and external elements which may intervene in the process of change and improvement. While

different approaches have been taken to the investigation of those influences which may limit

successful organizational development efforts, we will argue that the principles of agency theory

offer significant tools to analyze those elements which may impede the progress desired and

interfere with the attaining what is in the organization’s best interest.

Agency theory, which has broad roots and application, ranging from economics through

finance, strategic management, insurance, organizational psychology and accounting through to

governmental operations also can be applied to organizational development processes, problems,

Agency Theory and Organization Development 2

and questions. We first turn to agency theory in general and then apply it to issues of

organization development.

Agency Theory and Organizational Development

Agency Theory

First introduced in the literature of information economics to provide a theoretical

model for the relationship between one party (principal) who delegates work to another party

(agent), agency theory received attention in the organizational control literature (Ouchi, 1979;

Pennings & Woiceshyn, 1986; Thompson, 1967), presenting implications for compensation, risk,

and information systems (Eisenhardt, 1985, 1989). Agency theory seeks to explain

organizational behavior by focusing on the relationship between managers as agents of the firms

and the stockholders as principals. Scholars from economics (Coase, 1984; Williamson, 1985),

finance (Jensen & Meckling, 1976), accounting (Baiman, 1990, 1982), and law (Gilson & Roe,

1992), as well as organizational psychology (Abrahamson & Park, 1994; Eisenhardt, 1989;

Nilakant & Rao, 1994) and strategic management (Gomez-Mejia, Tosi, & Hinkin, 1987; Hill &

Snell, 1989; Hoskisson, Johnson, & Moesel, 1984) have increasingly utilized this theoretical

perspective in analyzing executive management behavior in large private and public firms.

As is true of so many questions about organizations, agency theory focuses on the people

within them and how they behave. Given its basis in economics, agency theory posits that the

actors in an organization are utility maximizers, striving to obtain that which is in their individual

best interest and which may not be in the best interest of the organization (Eisenhardt, 1989).

With an intellectual heritage linking back to Barnard’s (1938) work on cooperation in

Agency Theory and Organization Development 3

organizations, agency theory is focused on the conflict among goals which may become evident

as various individuals perform their jobs within said organizations while acting to get the most

for themselves. This approach, however, adds certain new complexities to the picture within the

organization.

Organization Development

Organizations as “recursive” systems comprise complex inter-relationships between the

elements which make up the system (Coghlan, 1995). As an emerging field of practice,

Organization Development (OD) has been practiced in organization across industries to bring

change and attain improvement within the organization. The existing literature on OD dates back

as far as 1969 when a number of scholars provided various definitions of the field (Egan, 2002).

Early theories and practices of OD focus on increasing organizational effectiveness and

achieving change. According to Beckhard, OD is a planned, organization-wide, and managed

from the top, effort to increase organizational effectiveness and health through well-designed

interventions in the organization’s “processes” based on behavioral-science knowledge (1969).

Beckhard’s colleague, Bennis, defined OD in the same year: a response to change, a complex

educational strategy intended to change the beliefs, attitudes, values, and structure of

organizations so that they can better adapt to new technologies, markets, and challenges and the

dizzying rate of change itself (1969). Golembiewski, on the other hand, suggested that OD

implies a normative, re-education strategy intended to affect systems of beliefs, values and

attitudes within the organization so that it can adapt better to the accelerated rate of change in

technology, in an industrial environment and society in general, including formal organizational

restructuring which is frequently initiated, facilitated and reinforced by the normative and
Agency Theory and Organization Development 4

behavioral changes (1969). Another renowned scholar of the field, French, termed OD a long-

range effort to improve an organization’s problem-solving capabilities and its ability to cope

with changes in its external environment with the help of external or internal behavioral-

scientists consultants, or change agents, as they are sometimes called (1969). According to Blake

and Mouton, OD means development of the entire organization or self-sustaining parts of an

organization from top to bottom and throughout which must include individual, team, and other

organization units integrating the management sciences, business logic, and behavioral systems

of an organization into an organic, interdependent whole (1969). A final definition of OD in the

same year was provided by Lippit, where OD was specified as the strengthening of those human

processes in organizations which improve the functioning of the organic system so as to achieve

its objectives through the process of initiating, creating, and confronting needed changes in order

to make it possible for organizations to become or remain viable, to adapt to new conditions, to

solve problems, to learn from experiences, and to move toward greater organizational maturity

(1969).

Over the past three decades, however, the practice and underlying theories of the field of

OD have evolved as a result of rapid and dramatic changes in both organizations and in the

workforce as well as the globalization of the world economies. As a result, there have been

significant differences in the definitions and interpretations of the field to reflect these changes.

According to Dyer, OD is a process whereby actions are taken to release the creative and

productive efforts of human beings at the same time achieving certain legitimate organizational

goals such as being profitable, competitive, and sustainable (1997). French and Bell, define OD

as a long-term effort, led and supported by top management, to improve an organization’s

visioning, empowerment, learning, and problem-solving processes, through an ongoing,

Agency Theory and Organization Development 5

collaborative management of organization culture—with special emphasis on the culture of

intact work teams and other team configurations—using the consultant-facilitator role and the

theory and technology of applied behavioral science, including action research (1999). Another

definition of OD is provided by Cummings and Worley, where they defined OD as a system

wide application of behavioral science knowledge to the planned development and reinforcement

of organizational strategies, structures, and processes that lead to organization effectiveness

(2001). The most current definition of OD is based on a survey study. According to Warrick, OD

is a planned, systems, collaborative, and primarily behavioral science based process for

understanding and changing organizations and improving their present and future health and

effectiveness (2002).

As a process that utilizes behavioral sciences to achieve planned and systematic change

to organizational culture over a sustainable period of time for attaining organizational

effectiveness and efficiency, OD has been regarded as a relative field or a sub-field of Human

Resources (HR) (Sammut, 2001; Ulrich, 1998; Smith, 1996; McKee, 1997). Furthermore, there

is a continuous effort calling OD to be more comprehensive, better integrated, and capable of

incorporating dimensions that have been previously excluded or defined out of the mainstream of

theory and practice (Katz & Marshak, 1996).

Principal-Agent Relationship

All employment relationships have some form of principal-agent relationship. It is

sometimes described as the unending effort of the employer—the principal—to get the agent—

the employee—to work. Thus, the idea is there are two actors in the employment relationship:

principals and agents. First, the individuals within the organization are divided into two groups;

the principals and the agents. These are characterized, within an organizational hierarchy in
Agency Theory and Organization Development 6

Figure I. From the OD perspective, ranging from the stock-holders at the top of the organization

to the OD practitioner at the bottom, the principals direct the agents in delegated/assigned tasks

on their behalf. We note that many play both roles in the organization; thus the CEO is a

principal with respect to the Vice President for HR and an agent in relation to the Board of

Directors. Agency theory assumes that employer-employee contracting occurs atomistically in

which the amount and nature of incentives to perform consistently with organizational objectives

are largely determined by job characteristics and the amount of risk each employee takes in a

given position. Hence, agency theory emphasizes the importance of the ability to monitor

employees’ work efforts. Consequently, from this perspective agency theory considers the

organization as an agent negotiating contracts containing disparate elements with every

individual employee (assumedly with equal bargaining power)

Contracts

In an OD employment setting there exist official (legal) and unofficial (psychological)

job contracts. Unofficial contracting occurs when both parties—the employer and the employee

—verbally agree on the job and its requirements and compensation. In a way, they establish a

psychological contract accepting that the employee will begin to work at an agreed upon time

under stated terms and conditions of employment. The legal contracting occurs when both parties

sign an official employment document that specifies the details of the position such as the pay,

deliverables, and other work arrangements. The contract also may spell out future change

activities, the resources that will be committed to the process, and how OD practitioners and

organization members will be involved (Cummings & Worley, 1997).

Agency Theory and Organization Development 7

Agency theory thus defines the employment relationship as a contract in which employee

—agent—supplies labor to the employer—principal—in exchange for income and other rewards

with a focus on the structure of that relationship. Simply put, the question is whether the contract

is formed in a way which drives the agent to behave in the best interest of the organization. The

questions of economic rationality, information asymmetries, and differences in the risk attitudes

of workers and the firm are among the factors of this theory which need to be recognized in the

contract. These values and principles, derived from economics, are among the basic concerns of

the organizations in drawing up the contract and OD professionals need to deal with them as part

of their responsibility. In any OD intervention, there is always the presence of both psychological

and legal contracting in which both parties—the organization and the OD professional—agree on

the process that will be implemented to achieve and sustain change. Therefore, agency theory

presents significant tools and utility for OD interventions. Nevertheless, contracting process

itself is not sufficient to prevent any potential problems. From the principal-agent perspective,

there are two potential major problems here: communication and conflict of interest.

Asymmetry of Information

Considering the principal-agent relationship illustrated in Figure I, there are information

asymmetries to consider. Communication may not always be effective. For a variety of reasons,

the charge given to agents by the principals may not be clear and understood. It may be because

of bad transmission from the principal, it may be because of poor reception by the agent, or it

may be deliberate concealment. Asymmetry of information occurs when the principal’s ability to

monitor the agent’s behaviors and work is limited, restrained, or interrupted by other factors

known only to the agent. In such situations, agency theory argues that the agents may decrease
Agency Theory and Organization Development 8

their performance or may even shirk because of their ability to conceal such performance

“deficiencies” from the principals.

Information asymmetries may thus be classified as differences in motivation and

differences in knowledge. From the perspective of difference in motivation, one only has to

consider Malcolm Gladwell's The Talent Myth (2002) in which he argues most convincingly that

much of the downfall of Enron was because of the company's emphasis on each employee

maximizing his/her self-interests with the ultimate result that the interests of the organization

were at best ignored or at worst subverted. On the other hand, from the perspective of differences

in knowledge, the practice of General Electric in which employees that perform at the bottom 10

percent are laid off is exemplary (Grote, 2000). In this case, the perspective of the VP for HR (an

agent) may differ from that of the CEO (principal) because of the knowledge that the bottom 10

percent are performing well on an absolute scale. In some cases, information asymmetries occur

as a result of both differences in motivation and knowledge as is the case for the Post-it® Note

concept of 3M Company. Nevertheless, in a situation of information asymmetry, the principal

will not have full access to information; thus, creating a potential opportunity for the agent to

gain by keeping certain information inaccessible to the principal.

When an OD intervention is conducted by external consultants, the possibility of

information asymmetries increases. OD consultants are ethically liable to ensure the flow of the

information at any point to prevent any potential principal-agent problems. In another case, if an

OD consultant creates information asymmetries by not revealing the details of the intervention

accurately, then the reliability of the intervention is at stake. External OD consultants, due to the

nature of their contract with the organization have the capability to create such asymmetries of
Agency Theory and Organization Development 9

information. From the CEO to the OD consultant, the existence of asymmetric information and

its potential impact on organizational change efforts needs to be managed and controlled in the

best interest of the organization. This leads to the message of agency theory to OD: it is the

responsibility of the principals (e.g., HR Managers) to structure the OD intervention contract in a

way which induces the agents to act in the best interest of the organization.

Conflict of Interest

The second problem is that there may be conflicts of interest between the principal and

the agent. Each group, because of its own self-interest, may work to improve its own position

without working to improve the position of the organization. It is potentially possible to have

some type of conflict of interest as both agents and principals may have different and even

conflicting motivation about the work, the organization, and what they expect from them. The

agency theory assumption with respect to the behaviors of the actors—be they principal, agent,

or both—in the system is that they are economically rational, self-interested, and utility

maximizers (Fama, 1980; Hausken, 1996a), implying that in practice each actor will attempt to

do the most to further his or her own interests with varying degrees of interest in the success or

welfare of the organization.

For example, the top management of a firm may try to influence an external OD

consultant by offering him/her some additional incentives to ensure organizational change takes

places within their respective frameworks (Rothwell, Sullivan, & McLean, 1995; French & Bell,

1999). In this situation, the top management may not necessarily be interested in working toward

organizational goals, but rather toward their own personal interests.

Agency Theory and Organization Development 10

To this point we have reviewed the nature of the application of agency theory to the

process of organizational development. The objective has been to show the linkages between the

mechanisms described and operated by principal-agent relationships and the practices of OD.

The generality of this approach needs additional focus and we will now turn to some guidelines

for the specifics which are in need of inquiry.

Summary and a New Direction

The identified inter-connection between OD and agency theory has not been the subject

of substantial academic inquiry to date. It seems appropriate, given the lack of inquiry in this

subject, to propose that such inquiry be instigated and that a set of propositions or guidelines for

that research be offered. One of the objectives of this paper is to open doors of investigation and

to suggest guidance as to what steps to follow after having walked through them. A similar

debate on agency theory and Human Resource Development is already under way (Akdere &

Azevedo, 2004).

As we approach an inquiry into OD and agency theory, we ask what guidance we may

gain from the principles of philosophy of science. That is, what can an inquiry into

organizational development be guided by as we attempt to refine this scientific inquiry? The

nature of our investigation must yield results which are consistent with the precepts of the

science. What we offer below is a set of propositions which should serve as guides to those who

wish to further the inquiry. Are they all which will be offered ultimately? We think not yet we

offer them as providing a set of first steps to which many will contribute along the way.

Proposition 1: When the contractual relationship between the OD professional and the
Agency Theory and Organization Development 11

organization is performance/outcome based; the more likely the OD professional

is to act in the best interests of the organization.

Proposition 2: If the change needs assessment effort is strictly related to the organization's needs,

the more likely the outcome will be consistent with the interests of the

organization.

Proposition 3: The nature of the information processing practices/ machinery of the organization,

from the CEO down through to the OD specialist, will relate negatively to

outcome based contracts and relate positively to behavior based contracts.

Proposition 4: The agent OD consultant who is risk averse will prefer a behavior-based contract

over an outcome-based contract.

Proposition 5: The risk aversion of the principal—organization—mitigates against behavior-

based contracts and in favor of outcome-based contracts.

Proposition 6: The nature of the resulting goal conflict between the principal and agent OD

consultant is positively related to outcome-based contract and negatively related

to a behavior-based contract.

Proposition 7: The level/magnitude of goal conflict between the principal and the agent OD

consultant will be positively related to outcome-based contracts and negatively

related to behavior-based contracts.

Proposition 8: The level of task programming associated with an OD intervention program will

be positively related to behavior-based contracts and negatively related to

outcome-based contracts.

Proposition 9: The longer in duration of the organization and OD consultant relationship, the
Agency Theory and Organization Development 12

closer the outcome will be to a behavior-based contract and the less likely to be an

outcome-based contract.

Proposition 10: The more internal OD specialists in an organization the greater the likelihood

those contracts will be behavior-based.

Proposition 11: The more complex and complicated the OD intervention in the organization the

greater the likelihood that contracts will be outcome-based.

Proposition 12: The newer the organization the more likely agent OD specialist contracts will be

behavior-based than outcome-based.

Proposition 13: The larger the organization the greater the likelihood information asymmetries

will exist between the organization (the principal) and OD consultant (the agent).

These propositions are based on the very nature of the OD interventions and the

relationships between the principals (organizations) and the agents (OD consultants) and the

principles of scientific inquiry. From the perspective of the management, these propositions

provide a unique opportunity for the top-management to reframe their understanding and

philosophy of engaging OD practices within the organization. From an OD consultant stand

point, these propositions serve as professional and ethical guidelines contributing to prevent any

potential failures of any OD interventions. From the scientist’s perspective, any investigation

must combine the management concern for OD practices and the professional and ethical

guidelines of the professional along with the effort to shed illumination on the theoretical and

empirical aspects of the process.

Agency Theory and Organization Development 13

Like any other behavioral science theory, agency theory examines certain aspects of

organizational issues and presents adequate tools for the management in the attainment and

sustaining of organizational change efforts. What we propose will establish one foundational

framework to assess the application of this theory to the field of Organizational Development.

We realize that we are offering more questions than answers but at this point in the path of this

inquiry, this is appropriate. When more is known, when a variety of issues have been

investigated and answers nailed down, the story will be different and the questions more refined.

What is offered herein in intended solely to move in that direction.

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Agency Theory and Organization Development 17

Figure I

Principals and Agents in the Context of Organization Development

Stock-Holders
Principals

Agents
Board of Directors
Principals

Agent
CEO
Principal

Agent
V.P. HR
Principal

Agent
HR Manager
Principal

Agent
OD Consultant