Printer Friendly

Putting agency and integrity to the test.

1. Introduction

The agency-theoretic approach to corporate governance emphasizes the incongruence between shareholders and management stemming from the separation of ownership and control. Within a principal-agent framework, this dichotomy is addressed through the proper design of compensation incentives. However, during the past decade, misaligned managerial incentive programs have been credited by the popular press with being at the root of failures in corporate governance ranging from the management of returns to backdating options. Moreover, there is an emerging academic literature on the incentive problems created by the operationalization of the agency-theoretic approach. (l) For example, Jensen (2007) discusses the case of an agent who realizes that the firm is currently overvalued but whose incentive pay will be adversely affected by market reactions if this fact becomes public. For opportunistic agents who operate under a bonus structure, this can result in gaming (e.g., income smoothing and earnings management) that destroys long-term value. According to Jensen, one solution is to recognize and address the role that managerial integrity plays in value creation. He asserts that integrity is something that financial economists tend to avoid or neglect because of the association of integrity with normative considerations. We add that integrity is particularly important in management training at the graduate level, which is overwhelmingly causal. For example, Ghoshal (2005) and Khurana (2007) assert that the emphasis on agency theory within the Master's in Business Administration (MBA) curriculum creates an expectation among future managers that their behavior must be properly incentivized and that the nexus of incentive contracts is the point of reference for making managerial decisions. (2)

The predominant assumption underlying the agency-theoretic approach to corporate governance is that agents are opportunistic to the extent that they may also be characterized as acting with guile. A more measured assessment would state that not all agents are opportunistic, but contracts that operationalize this assumption protect principals from those agents who do act opportunistically. However, pro-management advocates observe that incentive-aligning contracts often come with a tradeoff that reduces agents' latitude for integrity. For example, Osterloh and Frey (2004) and Donaldson (2008) argue for an emphasis on the fixed portion of a contract as compared to the incentive contract offered to opportunistic agents. In particular, Osterloh and Frey (2004, pp. 205-6) contend that in situations characterized by ambiguity or discretion--such as those involving moral hazard--managerial decision-making judgments requiring integrity conflate with that which is beneficial for oneself.

A larger fixed portion of a contract lowers the incentives to take care of one's own interests because it lowers the opportunity cost of integrity (in terms of lost incentive pay). Donaldson (2008, p. 308) classifies stewardship-motivated agents as those who gain satisfaction from performing interesting, challenging work well. Stewardship theory emphasizes the salary/fixed component because financial incentives can make a manager become more like an agent and less like a steward. Indeed, Arce (2007) finds that increased financial incentives make the agency problem self-fulfilling because there are conditions under which a theory of self-interest becomes in the agent's self-interest.

A common factor to both the integrity and pro-management approaches to agent remuneration is that bonuses are less incentivized in terms of their dependence upon targets (e.g., performance or budgetary measures). The issue of a fixed component can therefore be treated from a positive perspective, where the fixed component takes the role of restoring the remunerative value of integrity-based contracts as compared with more incentivized bonuses designed with opportunistic agents in mind. Specifically, it is well known that when the agency problem is present (because the agent faces a binding limited-liability constraint or exhibits risk aversion), then the principal's optimal contract provides rent to opportunistic agents. By comparison, agents that exhibit integrity will accept a contract with a lower incentive portion. Holding all other variables constant, the rent received by agents exhibiting integrity is therefore lower than that for opportunistic agents. Consequently, a lower "slope" (incentive) requires a higher intercept (fixed portion): otherwise, agents with integrity would not survive in competition with their counterparts.

Of course, an agent who accepts such a contract must have preferences that differ from those typically associated with effort-averse opportunistic agents. To this end, we analyze integrity-based preferences consistent with Buchanan (1966), who posits a thought exercise in which economists can be differentiated from the rest of the world through their opinion of the adage, "anything worth doing is worth doing well." Such preferences augment effort-aversion with a nonpecuniary component for doing a job well. Consequently, integrity engenders a contract that is less incentivized. In a similar vein, Sen (1977, pp. 333-4) remarks that it is certainly costly and may be impossible to devise a system such that everyone has the incentive to exert themselves. Every economic system has, therefore, tended to rely on the existence of attitudes toward work that supersede the calculation of net gain from each unit of exertion. Hofstede (1984) provides supporting evidence in which cultural variations in the virtue of hard work differentiate corporate governance practices across nations. Finally, the theory of specialization within large organizations is based on the comparative advantage of employees and the ability of the organization to coordinate these activities (Koch 2007). Comparative advantage suggests that every job worth doing is worth doing well, but not every job worth doing well is worth doing. When agents have integrity, every job that they do is done well.

A novel contribution of our study is that we go beyond the investigation of the contractual implications of integrity to examine whether agents with such preferences can survive in a competitive environment. This is what we mean by putting "to the test" Jensen's (2007) assertion of the necessity of integrity within an agency context. Specifically, we employ an evolutionary model to compare opportunistic agents and the incentive contract they engender with agents with integrity and their associated contract. We put these alternative contract forms and agent types to an evolutionary test via a process that recognizes both biological considerations, in terms of fitness, and (corporate) culture, in terms of selection with assortative matching.

Ours is a "hard test" in which we contrast principals who operate under the assumption of agent opportunism, which underlies agency theory, versus principals who operate under assumptions consistent with pro-management theory and integrity. The issue is distinct from whether principals can screen for agent types because screening effectively takes the distribution of types as a datum without acknowledging that this distribution itself requires an evolutionary foundation for the underlying preferences. In our analysis, both opportunistic agents and agents with integrity are payoff-maximizers. The difference lies in an agent's preference for a job well done or lack thereof. Note that agents with integrity are concerned with their own behavior, rather than social preferences that may exhibit inequity aversion or a concern for the principal's welfare. We examine whether agents with integrity can persist, a necessary condition for any analysis that presumes a distribution of multiple agent types, some of whom exhibit integrity. In so doing, our article is a contribution to the literature that Jensen (2008) labels as the "positive analysis of normative values," which is increasingly being used to understand how the values reflected in moral, ethical, and legal standards of behavior affect human interaction in organizations.

The article proceeds as follows. In section 2, we introduce a principal-agent model where agents are either opportunistic or display integrity. Principals operate either under the assumption that agents are opportunistic or an integrity/pro-management theory where agent actions are less incentivized. Both principals and agents are assumed to be risk neutral, with agents facing a limited-liability constraint. The contracts we consider take the form of an incentive portion involving bonuses and (potentially) a fixed portion. In section 3, the fixed portion of the pro-management contract is derived in an evolutionary context. Here, fitness is measured in material terms only. Selection occurs via a process that summarizes social learning/ cultural evolution. In particular, we allow for the possibility of assortativity in pairwise matchings between agent and principal types by extending the method of Bergstrom (2002, 2003) to asymmetric (two-population) games. This facilitates a characterization of the conditions in which agents with integrity can persist, which is stated in terms of the agent's preferences for a job well done (embodied in the incentive portion of the contract) and the degree of assortativity (reflected in the endogenous constraints on the fixed portion of the contract). In addition, we establish a link between integrity and value creation. In section 4, we discuss our results in the context of integrity/pro-management theory.

2. The Underlying Model

Consider the canonical approach to corporate governance where a principal contracts with an agent under conditions of moral hazard. There are two agent types, i [member of] 1, 2, and two principal types, j = 1, 2. Agents are assumed to be risk neutral. The degree and form of risk aversion are themselves an evolutionary issue, and we do not want to confound the issue of integrity with that of risk aversion. The agency problem is induced by the assumption that agents are subject to a limited-liability constraint. Agent i exerts effort [e.sub.ij] [member of] [0, 1] when contracting with firm j. The probability that surplus S is generated is [e.sub.ij], and the probability that surplus s is generated is 1 - [e.sub.ij], where 1 [greater than or equal to] S > s = 0. The principal offers a bonus contract; in this way, we avoid the potential for unbounded risk taking by risk-neutral agents under a linear contract. Bonus [B.sub.j] is paid when good state S occurs. The fixed portion of the contract is denoted as [f.sub.j]. Principals have sufficient assets to pay [f.sub.j] in state s. The agent's effort therefore does not reflect any effect of effort on the likelihood that the firm may liquidate, because the firm has sufficient assets to cover this risk.

By indexing the contract only according to the principal's type, the implicit assumption is that contract offers are not contingent on an agent's type. This allows us to starkly contrast the agency-theoretic perspective, which states that contracts should be designed on the assumption of agent opportunism, versus pro-management theories, which suggest that contracts should provide the proper latitude for integrity. Agency-theoretic approaches emphasize the alignment of incentives to overcome problems associated with the separation of ownership and control, whereas pro-management theories endorse a higher fixed component of pay so as to avoid incentives that penalize actions associated with integrity. We place the two management theories in direct competition with each other. Specifically, type 1 principals offer a contract that is designed under the assumption of opportunistic agents. This assumption is called the "official story" by Bebchuk and Fried (2004) due to its prevalence in MBA programs and academic studies of corporate governance. By contrast, type 2 principals offer a contract that is consistent with the pro-management assumption that agents have a preference for a job well done and appreciate contractual latitude for acting with integrity. Once the persistence of both types of agents has been established, then issues pertaining to the use of contracts to screen for agents' types or the potential for agent signaling can be addressed. In this study, we establish the conditions that are necessary for such analyses in that the evolutionary process establishes that a distribution of types is possible.

Agent i's preferences are represented by the payoff function:

[U.sub.i]([e.sub.ij], [B.sub.j],[f.sub.j])= [f.sub.j] + ([B.sub.j] + [[theta].sub.ij]) [e.sub.ij] - 1/2 [e.sup.2.sub.ij],



Here, type 2 agents exhibit a preference for a job well done when matched with type 2 principals. Under such circumstances, the utility from the good state is augmented by [theta], representing the satisfaction from a job well done. Besley and Ghatak (2005) label such agents as motivated, but we instead call them agents with integrity because in such a match, type 2 agents recognize the difference between a contract that is purely incentivized versus an integrity contract and act accordingly. In other words, type 2 agents have a preference over their work environment and will act opportunistically under an incentives-based contract. This reflects the idea that, due to their widespread operationalization, management theories that are based on opportunistic behavior have become so widely socialized that they produce the behavior they assume (e.g., Donaldson 2002; Gentile 2004; Ghoshal 2005; Gintis and Khurana 2008). For example, Jensen (2007) has observed that (perfectly honest and upstanding) people in their roles as board members condone manipulation of financial reports because it never occurs to them that this is lying it is just part of what it means to manage. Within the human resources literature, the notion that strong incentives may bring about a change in values is known as the "carrot effect" (Bento and White 1998). Theoretical models that are consistent with this assumption include Frey's (1993, 1997) crowding out of work effort (work morale) in agency models via monetary incentives and supervision, and Arce's (2007) finding that incentivized contracts may select (in an evolutionary sense) against agents whose preferences reflect selfmotivation. By contrast, when a contract is consistent with a process of social/cultural learning, latitude for integrity exists, and type 2 agents prefer this environment. Sen (1984, 1987) similarly contends that agents have preferences not only for the material consequences of their actions but for the way in which they are expected to act. This does not imply that an agent with integrity will be at a fitness advantage under a pro-management contract; opportunism continues to generate higher fitness at the individual level in this context, as will be shown later herein.

By comparison, agents exhibit motivated preferences in the sense of Besley and Ghatak (2005) when a coinciding match occurs between an agent's preferences and a principal's mission, where the mission is characterized by the type of surplus generated (e.g., S versus some [??] [not equal to] S when i = j, with [??] + [theta] > S). Hence, the efficacy of a (motivated agent, mission-oriented principal) match is potentially influenced by the variability in surplus. In our analysis, the surplus in the good state is constant across both principal types. An agent with integrity's interest in the good state is not mission-specific, thereby satisfying Buchanan's (1966) characterization.

From Equation 1, an agent's optimal level of effort is

[e.sup.*.sub.ij] = [B.sub.j] + [[theta].sub.ij]. (IC)

This corresponds to the agent's incentive compatibility (IC) constraint. It follows that [e.sup.*.sub.22] = [B.sub.2] + [theta] and [e.sup.*.sub.ij] = [B.sub.j] for all other i, j combinations. We assume that

S, [theta], S + [theta] [member of] [0, 1] and [theta] < S (2)

in order to ensure that the agent's effort is an interior solution. These conditions also ensure that expected profit is positive when a type j = 1, 2 principal employs a type i = 1, 2 agent.

Because the level of effort directly translates into the probability that the good state occurs, an additional interpretation of the [theta] term in (IC) is one of uncertainty avoidance. In this sense, agents with integrity work harder in order to reduce the uncertainty that the good state occurs. In his survey of employees in large multinational corporations across 40 countries (over 116,000 questionnaires), Hofstede (1984, p. 256) finds significant international differences in the cultural value of working harder to avoid the uncertainty that is associated with success. Nations where preferences for working harder/uncertainty avoidance predominate include Japan, Switzerland, and German-speaking countries. An ability to better accept the uncertainties associated with success is found in the United States, Canada, and Great Britain and many of its former colonies. For Hofstede, individuals with high uncertainty avoidance possess an inner urge to work hard. Those with low uncertainty avoidance do not see hard work as a virtue per se.

We now turn to the fitness of a type i agent, which is given by

[[PI].sub.i] (e.sub.ij], [B.sub.j] [f.sub.j]) = [f.sub.j] + [B.sub.j][e.sub.ij] - 1/2 [e.sup.2.sub.ij], (3)

because [theta] is an intrinsic but nonpecuniary benefit for doing a job well. This embodies the idea that preferences may affect behavior directly, but they only affect fitness to the extent that they alter the material consequences of an effort-contract pairing. It is one way to operationalize Gi.ith's (1995) indirect evolutionary approach to preferences, where the result that evolves only "indirectly" affects behavior. In our analysis, the consequences of behavior are measured in terms of fitness, with matching being assortative, as is common in labor markets. We define selection as a function of an assortative process in section 3. By contrast, it is usually the case that both the measurement of fitness and the selection dynamics are expressed with respect to a biological time horizon (e.g., Arce 2007). In essence, we are assuming that fitness reflects longterm evolutionary considerations, but selection dynamics reflect assortativity, which can be shorter-term.

To clarify, our study differs from the standard approach to the evolution of preferences in several respects. First, general results on the evolution of preferences exist for the case of pairwise matchings within a symmetric set of potential preferences. By contrast, our analysis is necessarily asymmetric. Second, we relax the assumption that the probability of a match is purely a function of the share of each type in the population to allow for (imperfectly) assortative matching. Assortative matching is consistent with a process of (corporate) cultural transmission. Intuitively, genetic mutation is undeniably random, whereas cultural mutation often reflects an underlying purpose/rationale, and the potentially biased nature of cultural transmission is captured by assortative matching. Third, general results on the evolution of preferences are sensitive to assumptions regarding whether differing types are recognizable. By contrast, in Bergstrom's (2002, 2003) evolutionary theory of assortative matching, a trait that is costly at the individual level (e.g., altruism or integrity) is compensated by a higher probability of meeting a partner with a similar trait, rather than a random probability of matching with a perfectly identifiable trait. In this case, assortativity replaces a presumed high cost of mimicking the observable trait.

The principal maximizes their expected residual surplus subject to the incentive compatibility (IC), participation (PC), and limited-liability (LL) constraints for the agent. Recall that principals do not tailor contracts to an agent's type. This is in keeping with type 1 principals who operate under the assumption of opportunistic (type 1) agents and pro-management principals (type 2) who operate under the assumption of agents with integrity (type 2 agents). Again, agents do not self select into contracts--this is a hard test to establish the persistence of agents with integrity. The issue of screening contracts is relevant only after the persistence of the types of agents to be screened has been established. We are examining the preconditions for screening: Specifically, is it possible for pro-management principals and agents with integrity to survive? Only then can distributions of principals/agents that include the types hypothesized exist because the types in question have been shown to persist.

In this way, type j principals design their contracts under the assumption that they are facing type j agents. There is no difference between payoffs and fitness for principals; principals maximize their expected residual surplus [(S - B.sub.j])[e.subjj] - [f.sub.f]). Substituting in the IC constraint from before, principal j's problem is:


subject to:

[f.sub.j] + ([B.sub.j] + [[theta].sub.jj])[e.sub.jj] - 1/2 [e.sup.2.sub.jj] [greater than or equal to] 0, and (PC)

[[B.sub.j] + [f.sub.j] [greater than or equal to] and [f.sub.j] [greater than or equal to] 0. (LL)

Here, both the agent's reservation utility and level of wealth have been normalized to zero.

Result 1

The optimal bonuses are [B.sub.1] = S/2 and [B.sub.2] = (S - [theta])/2. From IC, the corresponding levels of efforts are [e.sub.11] = [e.sub.21] = S/2 and [e.sub.22] = (S + [theta])/2, [e.sub.12] = (S - [theta])/2. Under these conditions, [f.sub.1] = 0. In addition, [e.sub.if] < S + [[theta].sub.ij] < S + [[theta].sub.ij], where S + [[theta].sub.ij] is the first-best level of effort that maximizes the joint payoff of principal j and agent i. The moral hazard problem remains.

Agents with integrity exert the same amount of effort as opportunistic agents under [B.sub.1] and strictly more effort under [B.sub.2]. The opportunistic contract, ([B.sub.1], [f.sub.1]) = (S/2, 0), satisfies the participation constraint with strict inequality for [e.sub.11] and [e.sub.21], even though it is designed with only type 1 agents in mind. Similarly, under ([B.sub.2], [f.sub.2]) = ([S - [theta]]/2, 0), the participation constraint strictly holds for [e.sub.22] and [e.sub.12]. A difficulty arises, however, because even though contract ([B.sub.2], [f.sub.2]) is optimal for principals facing type 2 agents, it places type 2 agents at a strict disadvantage in terms of their ability to persist, as measured by fitness. That is, [[PI].sub.2]([e.sub.22], [B.sub.2], [f.sub.2]) < [[PI].sub.i]([e.sub.ij], [B.sub.2], [f.sub.j] for all other i, j combinations. In other words,([B.sub.2], [f.sub.2]) satisfies the PC for an agent with integrity's preferences, but it violates the PC for the agent's fitness. Setting [f.sub.2] = 0 corresponds to straightforward fitness maximization for the principal, but this form of decision making is not always optimal for social behavior. In the next section, we address this issue.

3. Putting Agency and Integrity to the Test

Jensen (2007) sees the emphasis on integrity as a matter of cultural change within the boardroom and the classroom. The suggestion that corporate culture is an evolutionary phenomenon dates at least as far back as Noreen (1988) and Casson (1991). The evolutionary approach is a positive theory with normative implications because it examines and characterizes behavior at the population level, thereby identifying norms. For example, Jensen contends that integrity is a necessary condition for maximizing firm value. By contrast, agency-theoretic examinations of corporate governance typically assume opportunistic preferences. In this section, we examine the way in which each assumption about preferences fares in an evolutionary competition with the other. We do so by exploring a form of assortative matching to characterize the fixed payment for contract ([B.sub.2], J).

In examining the persistence of nonopportunistic agent preferences, we use fitness as the evolutionary measure of survival and examine a process of selection that allows for assortative

matching. In this way, the outcomes of pairwise matchings between the principal and agent types identified in the preceding section are given in Table 1. (3) Agent types are defined as A i and [A.sub.2], where type [A.sub.1] agents have opportunistic preferences and [A.sub.2] agents have preferences consistent with valuing a job well done (type 2). Type 1 principals offer opportunistic contract ([B.sub.1, [f.sub.1]) = (S/2, 0) and are denoted as [P.sub.1] agents in Table 1. Type 2 principals offer contract ([B.sub.2], [??]) = ([S - [theta]]/2, f) and are denoted as [P.sub.2] agents in Table 1. Type 1 principals are operating under the assumption of opportunistic agents, whereas type 2 principals recognize the need for agent integrity; hence, fixed component f is determined by social criteria.

Assortative matching is a natural phenomenon in labor markets. For this reason, Arce (2006), Besley and Ghatak (2005), and Dam and Perez-Castrillo (2006) consider the effects of assortative matching between agent and principal types; Besley/Ghatak and Dam/PerezCastrillo also require that matching be stable in the sense that it is immune to a deviation in which any principal and agent can negotiate a contract that makes both of them better off. We relax this stability assumption because our approach to assortative matching is from an evolutionary perspective in order to test for the robustness of the alternative agent and principal types defined herein. Given that matching is assortative, we cannot apply the concept of evolutionary stability, which is based on random matching according to the population shares of each type. This means that our results will not be purely population dependent because assortative matching implies that the probability that a given strategy/type is matched with another type is not strictly a function of the proportion of each type within its population. Intuitively, because evolutionary stability is based on random matching, results associated with evolutionary stability are population dependent because the matching process is defined by each type's population share. Because our analysis is based on assortative matching, the results will depend on the index of assortativity (defined below), which, by definition, is not reducible to the respective population frequencies.

The analogy for evolutionary stability in this context is monotonicity. That is, type [A.sub.i] ([P.sub.j]) grows faster than [A.sub.k] ([P.sub.k]) when [A.sub.i] ([P.sub.j]) has a higher expected payoff. Evolutionary stability satisfies monotonicity, as do many other economic, biological, and game-theoretic dynamics. Under monotonicity, our results are not specific to the particulars of the underlying dynamic.

Matching is assortative when pairwise matches are not independent of one's type. For example, consider a symmetric Prisoner's Dilemma with types C (cooperator) and D (defector) and payoffs T > R > P > S, as given in Table 2. Let p(C | C) be the conditional probability that a C type is matched with a C type, p(C | D) be the probability that a D type is matched with a C type, etc. The expected fitness for a C type is [E.sub.C] = p(C | C)R + [1 - 9(C | C)]S = p(C | C)(R - S) + S. Similarly, the expected fitness for a D type is [E.sub.D] = p(C | D)(T - P) + P. Monotonicity ([E.sub.C] > [E.sub.D]) holds when [p(C | C) - p(C | D)](T - P) > P - S + 9(C | C)[(T - P) - (R - S)]. The term a(x) = [p(C | C) - p(C | D)] = [p(D | D) - p(D | C)] is Bergstrom's (2002, 2003) index of assortativity; it measures the degree to which matching is determined by type when x [member of] [0, 1] is the proportion of C types within the population. Assortative matching implies that the associated conditional probabilities are no longer strictly a function of the population shares; hence, the shorthand notation, a, is used for a(x). The preceding inequality therefore reduces to a > (P - S)/(T - P) + p(C | C)[(T - P) - (R - S)]/(T - P). Finally, if the Prisoner's Dilemma is additive, implying T + S = R + P, this condition can be further reduced to a > (T - R)/(T - P). When assortativity surpasses this threshold, then cooperators can persist in a Prisoner's Dilemma even though defector is the dominant type.

When the index of assortativity is a positive constant, it corresponds to Cavalli-Sforza and Feldman's (1981) mechanism of cultural transmission (Bergstrom 2002). Cultural transmission implies that a trait can be transmitted via nonhereditary means. Hence, Bebchuck and Fried's (2004) and Khurana's (2007) concern regarding the effect of agency theory in its role as the predominant paradigm for framing managerial, organizational, and social issues within business education can be investigated within this context, as teaching is a well-recognized form of cultural transmission. In addition, assortative matching summarizes equilibrium outcomes where the overall population is temporarily subdivided into finitely lived groups prior to the process of pairwise matching (Cooper and Wallace 2004). In the context of the present article, finitely lived groups correspond to principals and agents associated with a particular industry, where the movement of principals and agents between industries occurs less frequently.

Our extension of Bergstrom's (2002, 2003) assortative matching framework to an asymmetric (two-population) game is defined as follows. Let p([P.sub.j] | [A.sub.i]) be the conditional probability that a type i agent is matched with type j principal and p([A.sub.i] | [P.sub.j]) be the conditional probability that a type j principal is matched with a type i agent. Further, we assume symmetry in assortativity (but not necessarily in pairwise matching), which leads to the following definition of the index of assortativity:

a = a(x,y)= p([P.sub.2] | [A.sub.2]) - p([P.sub.2] | [A.sub.1]) = p([A.sub.2] | [P.sub.2]) - p([A.sub.2] | [P.sub.1]) > 0. (4)

Once again, the index of assortativity is a function of the population shares of [A.sub.2] and [P.sub.2] types, x, and y [member of] [0, 1], respectively. Because assortative matching implies that the associated conditional probabilities are not strictly a function of the respective population shares, the shorthand notation, a, is again used.

Under assortative matching, the expected fitness for each agent type in Table 1 is:




Once again, our selection criterion is monotonicity, which precludes the necessity for expressing explicit selection dynamics. Monotonicity holds for [A.sub.2] types [MATHEMATICAL EXPRESSION NOT REPRODUCIBLE IN ASCII] when f > [theta]S/4 - [[theta].sup.2]/8 + p([P.sub.2] | [A.sub.2])[[theta].sup.2]/2a. The expected fitness for principal type [P.sub.1] is [MATHEMATICAL EXPRESSION NOT REPRODUCIBLE IN ASCII], and for [P.sub.2], it is [MATHEMATICAL EXPRESSION NOT REPRODUCIBLE IN ASCII]. Simplifying, [MATHEMATICAL EXPRESSION NOT REPRODUCIBLE IN ASCII]. Monotonicity [MATHEMATICAL EXPRESSION NOT REPRODUCIBLE IN ASCII], holds when (l/2)p([A.sub.2] | [P.sub.2])([theta]S + [[theta].sup.2]) - [[theta].sup.2]/4 > f. Together, [MATHEMATICAL EXPRESSION NOT REPRODUCIBLE IN ASCII] require:

1/2 p([A.sub.2] | [P.sub.2])([theta]S + [[theta].sup.2]) - [[theta].sup.2]/4 > f > [theta]S/4 - [[theta].sup.2]/8 + p([P.sub.2] | [A.sub.2]) [[theta].sup.2]/2a(x,y) (5)

Result 2

Agents with integrity and principals offering pro-management contracts can survive when Equation 5 holds.

The right-hand side of Equation 5 is positive for S > [theta] > 0 and 0 < a(x, y) [less than or equal to] 1, implying that f is bounded above zero. This is consistent with pro-management theories that endorse lower incentive pay (recall [B.sub.2] < [B.sub.1]) and a higher fixed component (f > [f.sub.1] = 0). Moreover, this implies that agent preferences involving [theta] > 0 cannot survive if the fixed component of their corresponding incentive contract is zero. A positive fixed component is a necessary attribute of a pro-management integrity contract. Under these conditions, integrity types produce the good state with a higher probability than opportunistic types.

Indeed, the left-hand side of Equation 5 establishes that the principal does better under the pro-management contract than it does under the opportunistic contract. This characterization of profitability provides a rationale for integrity-based contracts. Furthermore, it casts doubt on the idea that principals should make agent opportunism their default assumption in order to protect themselves because the resulting contracts do not provide sufficient latitude for agents with integrity (and the greater expected profitability that integrity garners for the principal). Finally, when Equation 5 is satisfied, the joint surplus under an ([A.sub.2], [P.sub.2]) pairing is higher than that for an (A1, P1) pairing. Our result is consistent with Jensen's (2007) claim that there is value to commitments to nonopportunistic behavior. He calls such commitments integrity, and we find that integrity, leads to value creation. The intuition is that assortative matching capitalizes on the larger joint surplus in groups that increasingly produce ([A.sub.2], [P.sub.2]) pairings.

4. Conclusion

Incentive-based executive compensation is currently under attack on many fronts. The popular press has been quick to point out that many of the public corporations that are most closely associated with the mortgage-backed security crisis had compensation practices in which the underlying rationale was steeped in agency theory. Pro-management advocates in academia assert that because postgraduate (particularly, MBA) business education emphasizes agent opportunism over alternative modes of managerial behavior, the agency-theoretic approach is self activating in that it produces an expectation of opportunism and incentive-laden compensation among newly indoctrinated graduates. Another critique is that agency-theoretic solutions to the separation of ownership and control may create new agency-theoretic problems that are more difficult to correct than the original problems they were designed to solve. An example is that the compensation of a corporation's board is often determined by the chief executive officer (CEO) and vice versa. Finally, the statistical relationship between CEO pay and firm performance is weak (Tosi, Katz, and Gomez-Mejia 2000).

Within this context, one of the founding fathers of the agency-theoretic approach to corporate governance, Jensen (2007), asserts that the role of integrity in agency theory has been overlooked by both proponents and detractors alike. In particular, financial economists have neglected integrity because of its normative connotations. This study begins by positing a form of integrity in management that is consistent with the adage, "anything worth doing is worth doing well." We then derive an optimal contract form for agents with integrity that is less incentivized than the contract for opportunistic agents. This is consistent with many of the critiques mentioned previously, particularly the weak incentives documented in the empirical literature on agency and firm performance and the cross-cultural differences between those societies where hard work is intrinsically valued and those where it is relatively less valued.

A novel contribution of our analysis is that we go beyond the contractual implications of integrity to verify whether agents with integrity can persist alongside opportunistic agents. Hence, while there may be no accounting for taste when it comes to making assumptions about agents' preferences and deriving the associated optimal contract, it is possible to account for taste by requiring that preferences be robust with respect to an evolutionary selection criterion. In particular, we have shown that agents who exhibit integrity in the sense of Jensen (2007) can have an evolutionary advantage over the opportunistic agents assumed in agency-theoretic approaches to corporate governance. Such agents engender contracts that are less incentivized than those associated with opportunistic agents. These contracts place relatively more weight on the fixed portion of pay and can be regarded as consistent with both Jensen's emphasis on integrity in corporate governance and Hofstede's (1984) finding that governance practices vary (across nations) according to cultural differences in the virtue of hard work.

Furthermore, the evolutionary approach characterizes behavior at the population level, thereby providing a positive analysis of organizational norms. Consequently, integrity is consistent with a corporate culture that also creates value as measured in economic terms. Moreover, assortativity in matching allows for nonhereditary transmission of corporate culture, thereby allowing for the consideration of management education in cultural transmission. In this way, the results derived here are complementary to concerns raised about placing agency theory in its proper context when educating potential managers. The end result is a theory of corporate governance where integrity is linked with value creation because incentive alignment is no longer centered on opportunism but also includes latitude for integrity.

Appendix: Deriving the Payoffs in Table 1 from the Contracts Characterized in Result 1

Recall that evolutionary payoffs do not reflect intrinsic preferences. Hence, in a pairwise match between agent type [A.sub.i] and principal type [P.sub.j]:

[[PI].sub.A] ([A.sub.i], [P.sub.j]) = [f.sub.j] + [B.sub.j][e.sub.ij] - 1/2 [e.sup.2.sub.ij]; (A1)


[[PI].sub.P] ([A.sub.i], [P.sub.j]) = (S - [B.sub.j]) [e.sub.ij] - [f.sub.j]; (A2)

Note that the only case in which the agent's payoff [[PI].sub.A] ([A.sub.i], [P.sub.j]) differs from the agent's preferences represented by utility function [U.sub.A] ([A.sub.i], [P.sub.j]) = [f.sub.j] + ([B.sub.j] + [[theta].sub.ij])[e.sup.2.sub.ij] - (1/2) [e.sup.2.sub.ij] is in a ([A.sub.2], [P.sub.2]) match. In this case, by definition, [U.sub.A]([A.sub.2], [P.sub.2]) satisfies the participation constraint, but it is unlikely that [[PI].sub.A]([A.sub.2], [P.sub.2]) satisfies the participation constraint. Hence, intrinsic preferences put an agent with integrity at a potential (evolutionary) disadvantage in a competitive environment because intrinsic preferences, by assumption, do not directly translate into fitness but do so only indirectly through the effect of intrinsic preferences on behavior. Indeed, this is likely to be the case lbr any form of social p references in agency. Result 2 identifies the specific conditions under which integrity is not -competed away," even though it is not directly rewarded in terms of fitness.

Case 1: By result 1. in a ([A.sub.2], [P.sub.2]) match (the northwest cell in Table 1), [e.sub.22] = (S + [theta])/2: [B.sub.2] = (S - [theta])/2: and [f.sub.2] = f. Substituting these values into Equations A1 and A2, respectively, we find:

[[PI].sub.A] ([A.sub.2], [P.sub.2]) = f + (S - [theta])(S + [theta])/4 - [(S + [theta]).sup.2]/8 = f + [S.sup.2]/8 - 2S[theta]/8 - [30.sup.2]/8;


[[PI].sub.P] ([A.sub.2], [P.sub.2]) = (S - (S - [theta])/2) S + [theta])/2 - f = [S.sup.2]/4 + 2S[theta]/4 + [[theta].sup.2]/4 - f.

Case 2: In a ([A.sub.1], [P.sub.2]) match (the southwest cell), [e.sub.12] = (S - [theta])/2: [B.sub.2] = (S - [theta])/2; and [f.sub.2] = f Substituting these values into Equations A1 and A2, respectively, we find

[[PI].sub.A] ([A.sub.1], [P.sub.2]) = f + (S - [theta]).sup.2]/4 - (S - [theta]).sup.2]/8 = f + [S.sup.2]/8 - 2S[theta]/8 + [[theta].sup.2]/8;


[[PI].sub.P] ([A.sub.1], [P.sub.2]) = (S - (S - [theta])/2) S - [theta])/2 - f = [S.sup.2]/4 - [[theta].sup.2]/4 - f.

Case 3: For ([A.sub.1], [P.sub.1]) and ([A.sub.1], [P.sub.1]) matches (the northeast and southeast cells), [e.sub.21] = [e.sub.11] = S/2; [B.sub.1] = S/2; and [f.sub.1] = 0.

Through Equations AI and A2, this implies

[[PI].sub.A] ([A.sub.i], [P.sub.1]) = [S.sup.2]/4 - [S.sup.2]/8 = [S.sup.2]/8;


[[PI].sub.P] ([A.sub.i], [P.sub.2]) = (S - S/2) S/2 = [S.sup.2]/4


Arce, Daniel G. 2006. Taking corporate culture seriously: Group effects in the trust game. Southern Economic Journal 73:27 36.

Arce, Daniel G. 2007. Is agency theory self-activating? Economic Inquiry 45:708-20

Bebchuck. L., and J. Fried. 2004. Pay without performance. Cambridge, MA: Harvard University Press.

Bento, Regina F., and Lourdes F. White. 1998. Participant's values and incentive plans. Human Resources Management 37:47-59.

Bergstrom, Theodore C. 2002. Evolution of social behavior: Individual and group selection. Journal of Economic Perspectives 16:67-87.

Bergstrom, Theodore C. 2003. The algebra of assortative encounters and the evolution of cooperation. International Game Theory Review 5:211-28. Besley, Timothy, and Maitreesh Ghatak. 2005. Competition and incentives with motivated agents. American Economic Review 95:616-36.

Buchanan, James M. 1966. Economics and its scientific neighbors. In The structure of economic science: Essays on methodology, edited by S. R. Krupp. Englewood Cliffs, NJ: Prentice Hall, 166-83.

Casson, Mark. 1991. The economics of business culture. Oxford: Clarendon Press.

Cavalli-Sforza, L. L., and M. W. Feldman. 1981. Cultural transmission and evolution: A quantitative approach. Princeton, N J: Princeton University Press.

Cooper, B., and C. Wallace. 2004. Group selection and the evolution of altruism. Oxford Economic Papers 56:307-30.

Dam, Kaniska, and David Perez-Castrillo. 2006. The principal-agent matching market. Frontiers of Theoretical Economics 2:article 1.

Donaldson, Lex. 2002. Damned by our own theories: Contradictions between theories and management education. Academy of Management Learning and Education 1:96-106.

Donaldson, Lex. 2008. Ethics problems and problems with ethics: Toward a pro-management theory. Journal of Business Ethics 78:299-311.

Frey, Bruno S. 1993. Does monitoring increase work effort'? The rivalry with trust and loyalty. Economic Inquiry 31:663-70.

Frey, Bruno S. 1997. On the relationship between intrinsic and extrinsic work motivation. International Journal of Industrial Organization 15:427-39.

Gentile, Mary C. 2004. "Corporate governance and accountability: What do we know and what do we teach future business leaders?" Accessed January 25, 2011. Available

Ghoshal, S. 2005. Bad management theories are destroying good management practices. Academy of Management Learning & Education 4:73-91.

Gintis, Herbert, and Rakesh Khurana. 2008. Corporate honesty and business education: A behavioral model. In Moral markets: The critical role of values in the economy, edited by P. Zak. Princeton, N J: Princeton University Press, pp. 300-27.

Guth, Werner. 1995. An evolutionary approach to explaining cooperative behavior by reciprocal incentives. International Journal of Game Theory, 24:323-44.

Harris, Jared D., and Philip Bromiley. 2007. Incentives to cheat: The influence of executive compensation and firm performance on financial misrepresentation. Organization Science 18:350-67.

Hofstede, Geert H. 1984. Culture's consequences: International differences in work-related values. Beverly Hills, CA: Sage Publications.

Jensen, Michael. 2007. Putting integrity into finance theory and practice: A positive approach (PDF of keynote slides), revised version. Harvard NOM Working Paper No. 06-06.

Jensen, Michael. 2008. Forward to Moral markets. The critical role of values in the economy, edited by P. Zak. Princeton, N J: Princeton University Press, pp. ix-x.

Khurana, Rakesh. 2007. From higher aims to hired hands." The social transformation of American business schools and unfulfilled promise of management as a profession. Princeton, NJ: Princeton University Press.

Koch, Charles G. 2007. The science of success. Hoboken, NJ: Wiley.

Noreen, Eric. 1988. The economics of ethics: A new perspective on agency theory. Accounting, Organizations and Society 13:9-69.

Osterloh, Margit, and Bruno S. Frey. 2004. Corporate governance for crooks? The case for corporate virtue. In Corporate governance and firm organization, edited by A. Grandori. Oxford: Oxford University Press, pp. 191-211.

Sen, Amaryta. 1977. Rational tools: A critique of the behavioral foundations of economic theory. Philosophy and Public Affairs 6:317-34.

Sen, Amartya. 1984. Well-being, agency and freedom. The Dewey lectures 1984. Journal of Philosophy 82:169-221.

Sen, Amartya. 1987. On ethics and economics. New Delhi, India: Oxford University Press.

Tosi, H. L., S. P. Katz, and L. R. Gomez-Mejia. 2000. How much does performance matter? A meta-analysis of CEO pay studies. Journal of Management 26:301-39.

(1) See Bebchuck and Fried (2004), Osterloh and Frey (2004), and Harris and Bromiley (2007).

(2) "According to Jensen and his colleagues, students exposed to agency theory increasingly used this approach as their primary way of framing managerial, organizational, and social issues" (Khurana 2007, p. 322). See also Gentile (2004) and Donaldson (2008).

(3) The derivation of the payoffs in Table 1 stemming from the optimal contracts derived in Result I is given in the Appendix.

Daniel G. Arce, Economics Program (GR 31), University of Texas at Dallas, 800 W Campbell Road, Richardson, TX 75080, USA; E-mail

Received May 2009; accepted May 2010.
Table 1. Outcomes of Pairwise Matchings of Agent and Principal Types

                                Principal Types

Agent Types   [P.sub.2]

[A.sub.2]     f + [S.sup.2]/8 - 2[theta]S/8   [S.sup.2]/8, [S.sup.2]/4
              - 3[[theta].sup.2]/8,
              [S.sup.2]/4 + 2[theta]S/4 +
              [theta]/4 - f

[A.sub.1]     f + [S.sup.2]/8 - 2[theta]S/8   [S.sup.2]/8, [S.sup.2]/4
              + [[theta].sup.2]/8,
              [S.sup.2]/4 - [theta]S/4 -
              [theta]/4 - f

[A.sub.1], is the opportunistic agent type: [A.sub2] is the agent
with integrity type: [P.sub.1] principals offer contracts consistent
with the assumption of opportunistic agents; and [P.sub.2] principals
offer a pro-management integrity contract that is socially determined.

Table 2. The Prisoner's Dilemma in Canonical Form (T > R > P > S)

                Cooperate (C)   Defect (D)

Cooperate (C)       R, R           S, T
Defect (D)          T, S           P, P
COPYRIGHT 2011 Southern Economic Association
No portion of this article can be reproduced without the express written permission from the copyright holder.
Copyright 2011 Gale, Cengage Learning. All rights reserved.

Article Details
Printer friendly Cite/link Email Feedback
Comment:Putting agency and integrity to the test.
Author:Arce, Daniel G.
Publication:Southern Economic Journal
Geographic Code:1USA
Date:Apr 1, 2011
Previous Article:Social network and weight misperception among adolescents.
Next Article:The dynamics of knowledge diversity and economic growth.

Terms of use | Privacy policy | Copyright © 2020 Farlex, Inc. | Feedback | For webmasters