of Managem Ss 28:2 March 1992 ina=28e0 $3.50, STAKEHOLDER-AGENCY THEORY (Grignuss W. Le, Hau ‘THOMAS M. Joxrs, ‘Schoo of Business Administration, Universi of Washington ansrRACT. agency theory and stakeholder theory as points of departure this article proposes a paradigm that helps explain the following (1) ert aspects ofa firm's strategic behaviour; (2) the structure of management stakeholder contracts; (3) the form taken by the institutional structures that ‘monitor and enforce contracts between managers and other stakeholder; and (4) the evolutionary process that shapes both management-stakeholder Contracts and the institutional structures that police those contract INTRODUCTION (pie ltt Ah, ype eH Gineac othe domi paras App nancial Sconce tcratareGensen tnd Mectling’ 976; aa, 176), PSH ce ta icatirpgee Macey bexa etch ceri team en yor 4s inn eee eb a 9 ‘uors e he angen feld have begin fo e¢plore he plead fat Fey aight aye tee a Sryap acta Boca SaHlOPeleA’ wey, eo HEGc meagan To Blebatdy (908 1968, 1989; Kosnik, 1987). One area that remains relatively fase ay yhgetey Nal Pheer nanre en Ree eeu cee ict Fea warrce « hres saleanuecae ts Gace ceaagos Gat Wee, pelciokien ates enplopbe, Feet piety seliley cctales, cnt the gener Ptlia Ds oy thoy oie Gt at's nen of contract bejeencesburee holders (stakeholders) suggests that this may be a promising avenue for investigation. PORT eet cny ke eBay GRIER te ef iis article ito propose a parsdigm Tat belpy explain, the Following: (1) certain aspects ofa rms suategc bchavour, (2) the structure (of management-stakcholder contracts; (3) the form taken by the institutional eeette ike tien nat OatecetBa tes pees menage See SGkeholderss and (4) the evoliGonary process that “shapes ‘bath finnagerent-atkehilder couch ant Me insutional tue. that les WL, Hil, Departnen of Management and Organization, Schoo! ion, DJ-10, University of Washington, Seate, Washington 98195,132 (C.WL, HILL AND T.M. JONES police those contracts. Like"agency: theory this paradigny suggestthatithe firm can be seen 9s a nexus of contracts between resource holders. ‘Unlike Although similar to agency theory in many respects, stakeholder—agency theory is based! on assumptions concerning market processes that are substan- tially different from those underlying the finance version of agency theory ‘The result is a paradigm whose predictions ate not always consistent with those of agency theory. While agency theory operates on the assumption that ‘markets are efficient and adjust quickly to new circumstances, here the ‘sieecemfanerosn-moniiumenn mati ncirincns nmacimiti” The fesult is the introduction of power difrentials into the stakeholder-agent equation. Although the idea of power differentials is at variance with the traditional agency approach, in our view the approach developed here increases the explanatory power of the paradigm. AGENCY THEORY ‘That is, the agent may incur et-ante boning casts in order to in the right to manage the resources ofthe principal. Despi principal'seinterests=may-remain:®Insofar as this divergence reduces the principals’s welfare, it can be viewed as a residual los ees nan cen erence eee lance structures that economize on agency costs (Fama and Jensen, 1983; enforcement mechanisms (such as the market for corporate control and the | ‘Although applied primarily to the stockholder-manager relationship, Jen-STAKEHOLDER-AGENGY THEORY 133 ‘sen and Meckling (1976) argue that agency theory ‘will lead to a rich theory ‘of organizations which is now lacking in economics and the social sciences ‘generally’ (p. 309). Jensen and Meckling view the implicit contract between Stockholders and managers as just one of the nexus of contracts that form the legal fiction known as the modern corporation. ‘he vatious primary interest groups of the firm or stakeholderse ‘STAKEHOLDERS is legitimacy is estab> | lished through the existence of an exchange relationship. Stakeholders include stockholders, creditors, managers, employees, customers, suppliers, local ‘communities, and the general public. Specie Asset Invesimens magnitude of an individual actor's stake is a funetion of the extent to which that actor’s exchange relationship with the firm is supported by investments in specific assets (Williamson, 1984). Following Williamson (1984, 1985), by specific assets we mean assets that cannot be redeployed to alternative use ‘without a loss of value and knowledge can leave the firm and be replaced without productive loss to” ‘ither the worker othe firm (assuming efficient tabowr markets). In such - employees with skills that Ganiguncsinniequsnianynomereqtonssonasamann leave without bearing substantial exit costs in the form of the lower rent= “stream that their skills can earn in the next best application, The ‘stake’ of ‘such:employeesin thefirmishight This distinction is important: eampated tom134 .W.L. HILL AND T.ML JONES. ators with a low stake in the firm, actors with a high stake will demand more ‘The Unique Role of Management Whatever the magnitude oftheir stake, each stakeholder is a part of the nexus of implicit and explicit contracts that constitutes the firm, However, as a ‘group, managers are unique in this respect because of their position at the Cente ofthe nexus of contracts. Managers are the only group of stakeholders ‘ho enter into a contractual relationship with all other stakeholders. Mana- gers are also the only group of stakeholders with direct control over the decision-making apparatus of the firm (although some stakeholders, and particularly the suppliers of capital, have indirect control). Therefore, itis) res and some customers apart, few stakeholders can be said to hire managers (in the case of employees the reverse is clearly true). Nevertheless, there is a parallel between the general class of stakeholder-agent relationships and the |-agent relationships articulated by agency theory. Both ures: Moreover, many of the concepts and much of the language of agency theory can be applied to stakcholder-agent relationshi L Our main assumptions concern the efficiency of the market mechanism, ie sommnpiony he impo th elms of power dient between the parties to a contract 19625 Pieller, 1981). and Wrong’ (1988) ‘Agency theorists sec the firm as surrounded by efficient markets that adjust quickly to new circumstances (Barney and Ouchi, 1986). They make the rather heroic assumption that markets are in or near an efficient equilibrium :‘STAKEHOLDER-AGENGY THEORY 135 (Fama, 1980; Fama and Jensen, 1983; Jensen, 1983), ee el heishe-canvalways:seekeasbetteralternatives If a shortage of agents (princi- pals) results, the principals (agents) will be compelled by market forces to Seles Tike tein pees we cone Bor iiyes Haantemstihie elas nckcamemene De eae ccc eae es ee ee een reionmnaaia ee ameeteeeeemeampemmnmee a —————oncoiensonn ay eis eect ean eet oten 1986; Putterman, 1984). If the markets that Surround the firm: ane Peon npemcienelinedamnetibigreemntienminie Mess pner acest pram mie ‘taking a substantial loss (because ‘better alternatives’ are not available), or if as the supply of agents exceeds the demand for agents by principals, power shifts ? ® Sree nes ates SIGE Se wily ces tak ect aie sictetaretiaars irene acta ieee Be eersaemepneicies dgenennbcpattctmessoeeeroneyen sar Tear cota nee eee ‘The first concerns the speed wavahiaeqeienedieatarearentemeeeereses eke Srloreernrenceraeernermre sera _adjustinent processes as being characterized by friction (Williamson (1985) ‘makes-a-similar point and argues that this friction results in transaction cosis)-Due to friction, once created disequilibrium conditions may aaa ‘a. prolonged period of time before an ‘equilibrium is re-established! “The resulting disequilibrium conditions imply the existence of power differen eerie ‘Soutes of Friction Barners to entry and exit constitute one source of inichon (Porter, 1980p. ‘Open systems theory suggests a further source of ffiction. Managers and other stakeholders can to a degree shape or enact their spiepenee: (ic en ant 10 c giaeeaiiai slow down the adjustment process by appropriate strategic investmens (eg.v¥ a i 136 CW.L HILL AND TM. JONES investments designed to increase entry barriers, by collusion, by predatory Pricing, etc) disadvamtaged. Correcting the disadvantage may require the innovation of new incentive structures and/or monitoring and enforcement mechanisms. However, the ability of the disadvantaged party to innovate may be hindered by strong inertia forces. ‘routines. and procedures: for monitoring and enforeing-management-> stakeholder contracts so as to-refiect new realities. Pressures such as sunk? Se ‘ircumstances? and exit, attempts by managers to shape the environment to their advantage, and inertia, in the long tun Although the adjustment process can be slowed down, it cannot be halted altogether. fagre that only the most efficient survive, we think its highly probable that Exuiibriam and Market Process Ifchange was a rare event, the above arguments would imply that equili sium situations in which the most inefficient organizational forms have been selected out are commonplace. However, one of the central features of the real world is that the only constant is change. Although market process work towards some kind of equilibrium, change constantly alters the direction in ‘which that equilibrium is tobe found, As argued by Schumpeter (1942), auch Change often occurs due to the process of reative destruction triggered by innovation. Moreover, Schumpeter suggested that innovation is itself & product ofthe competitive process. Thus, ongoing change may be a persistent Endogenous feature of capitalism, Altematively, change may be due to ‘exogenous macro-environmental trends (demographics, socalpoltical fac. tora, macro-economic change, e.). No matter how it arises, ongoing change creates situation of permanent disequilibrium and hence, of persistent power differentials between stakeholders and managers. However, because of the random nature of change, power differentials are themselves unlikely to remain unidirectional. While change atone point in time may favour mana: fers, change ina subsequent period may shit the balance of power towards Other stakeholder groups iri et 1979; Knight, 1921; Littlechild = ]STAKEHOLDER-AGENGY THEORY 137 ‘Owen, 1980; Nelson and Winter, 1982; Schumpeter, 1942), While w drive towards efficiency may characterize the business system, in the sense that the ‘most inefficient producers ultimately get selected out, we view short~ and ‘medium-term inefficiencies arising out of disequilibrium conditions as rte teeta fiecaly lithe dat ‘which characterizes most ofthe agent=principalliterarure. We do not assume ‘equilibrium, although we do. assume that market processes work in such a manner that, in the long run, inefficient incentive structures and monitoring fnd enforcement mechanisms are selected out, while more eiient structures > Be land mechanisms evolve to replace them. Howeversduestasbarrierstorentry> DIVERGENT CLAIMS, UTILITY LOSS, AND CONTRACTING COSTS ‘The interests of principals and agents diverge primarily because these ditfé- ‘ent groups have different utility functions. In turn, this can lead to direct conflict over the use to which resources are put (lor example, see Jensen, 1986), Ageney theory focuses on the divergence af interests between managers and stockholders. 1 Ti turn, it bas been argued that the desire to increase rm sie results in 8 managerial preference for maximizing the growth rate ofthe firm, principally through diversification (Amibud and Lev, 1981; Aoki, 1984; Marrs, 1968)138 (O.WL. HILL AND T.ML JONES. ‘mote stable ordering patterns; and the claims of local communities and the ‘general public tor lower pollution and an entianced quality of li, all involve K) te use’ of resources thar might otherwise be invested by managers in quo replete eves dam cram aig employes ct a higher meet ‘ter working conditions: may improve employee productivity and thus provide manageinent wit greater resources. Stati, devouing resources controlling pollution may result in local communities being more receptive to 7 fur ropa by anager png Opt crs Narre tie ciegtak pion! hid eal a eaten ferences with regard to the way in which a firm allocates its resources will result in a failure of stakeholders to maximize their utility. incentive, monitoring, and enforcement structures that serve to align the interests of managers and stakcholders, utility loss may be substantial. The fiinetion of incentive, monitoring, and enforcement structures is t0 minimize utility loss by correcting for the divergence of interests between management and stakeholders. For example, imagine thatthe maximum amount of wity that stakeholder: can derive froma given ‘eladonshipis 100 unt, but that management preferences resulin stakehol ders only getting 6D units, resting in 0 tt uty Toss of 40 units If Saeholders devote rexouroes equal to 10 units of uty to establishing ceive, monitoring, nd eaforesment mechanism, they may increase tie uly they derive fom the vlatoship co 90 unity, rnulting in amet gi ot + bo-anita ‘The remaining rsidval ult lee “units. INTERESTSTAKEHOLDER-AGENCY THEORY 139 acy 1983) sa np to induce managers and employees to pay more atietion to maximizing stockholder wealth, since that wil Jinultaneously mazimize their own wealth. On a more general level, ofering be ror ea investments in pollution containment equipment is an example ‘of how local communities and the general public (through their legila- tive agents) use incentives to try and align management interests with their Tn adaltion, to gain access to their resources, stakeholders may demand sermenpesicemmctitinneaatn THs species managervent's obtgn Gpertierren dcceor provtlestiabls compeoanion in fe cventofae- Standard quay. Thewananty isa boning mechan hat commana to-coasusiers a cocumementon Wepar Oaranagement toa ceran standard a imi ‘concept has been used to explain certain characteristics of a firm's relationships with its suppliers and consumers (although itis hardly limited to this context). For example, when a supplier hhas to make substanti ized assets in order to enter ‘trade with the firm, itis also exposing itself to the possibility of opportunistic abuse by management (Williamson, 1985). Once the supplier has made the investment, itis effectively 14 cannot exit ‘without reducing the value of thove assets ich Examples include reciprocal trade agreements, ‘most-favoured-buyer clauses, inflexible prices, posted prices, exclusive terri- tories, franchise-specific investments, patent pools, and union shop agree~ ‘ments (Williamson, 1985). In all these cases, the underlying objective is to establish mutual dependency between managers and other stakeholder sroup vo that interes ae more cos aligned, Mpuquneebvabrehesussat "greater the investments in specialized assets required of either stakeholders oF "managers to support a given exchange relationships140 (GWW.L- MILL AND TM JONES © MONITORING AND ENFORCEMENT MECHANISMS AND STRUCTURES, Interest alignment mechanisms apart, the contracts between stakeholders and managers are primarily implicit (Mitroff, 1983), Stakeholders supply the firm with resources on the implicit (tacit) understanding that their elas on the organization will be recognized. To ensure that this occurs, a number of institutional structures have evolved that serve the function of monitoring and enforcing the terms of implicit contracts. Agency theory generally refers to such institutions as governance structures. Our change of terminology reflects «broadening of emphasis. Specifically, we are concerned with more than just 4quasisindependent or third party governance (such as the board of directors, the market for corporate control, or the legal superstructure of society). We are also concerned with institutions that have evolved to represent and further the interests of a given set of stakeholders (such as labour unions and ‘consumer unions) precisely because such institutions have tility. Ioss- ‘minimizing properties. Thus, the term institutional structures subsumes the term governance structures ‘Boog Sc. A css ece3 managers and sakcholder. As insiders, managers are in a position to filter or distort the information that they release to other. stakeholders. Management control over critical informa~ tion complicates the agency problem lt makestitdificultfonstakelolders 6) - identify if management is acting in their interests, The obvious response #8 1oF- ‘This is particularly likely when stakeholders are diffused. Diffusion refers to a situation where a stakeholder group contains many individuals or entities, nno one of which has command over a significant proportion af the group's total resources. In such circumstances, ceteris paribus, no one individual ot entity may be able to finance the extensive information-gathering and analy- sis necessary to reduce significantly the information asymmetry between ‘managers and stakeholders. dturupthigives mranagersigreaterdiseretioniary -contiol over the use to which the firm's resources are put, increasing the "residual loss that stakeholders have 1 bea. “The response to the monitoring problem has been the evolution of a wide! “range of institutional structures that serve to economize upon the costs of ‘Some ofthese structures are enshrined in ‘anngalaesounts). Other institutions have evolved in an attempt to exploit the profit opportunities of gathering, analysing, and then selling information to Stakcholders (egisstockeanalyst services; consumer reports lg). Sul others havearisen azmonpeaticorganizations that exist in pat to monitor the degree to which managers act inthe best interests of certain stakeholder groups (ey |. The common theme fond inal of these structures is their ability to achieve economies of scale in information-STAKEHOLDER-AGENGY THEORY ma ‘gathering and analysis, primarily through the employment of specialists. ‘The fansequence of such devices is @ reduction in utility loss, UBiajercrment Mechanions ond Sipucturs D. Enforcement mechanisms are articulated by stakeholders prior to any resource exchange in an attempt to deter management from maximizing its uility at the expense of stakehol- ‘ders. The success of enforcement mechanisms depends upon their credibility (Schelling, 1960), and those lacking credibility will be ignored by manage- iment. In such circumstances, any attempt to put enforcement mechanisms into effect will involve costs that outweigh the benefits of reducing the utility loss from management opportunism. In short, mechanisms that are not cflective deterrents will fail (as do laws that are commonly ignored by the general population), Late a deere, LaSRRNRESCIMERARIETEN inthe contest of Makcholder-management relationships. requires enforcement. mechanisms that are supported by a broad consensus of stakeholders, and which are effectively communicated to management exan‘e. Certain legal penalties have this character (lays againstinsider trading, antitrust regulations, pollution regulations, .). Indeed, it ean be argued that much of the structure of lave “relating to business activity in society reflects critical points of conflict in. ‘That is, legislators, as representatives of ‘certain stakeholder interests, have enacted into law enforcement mechanisms that, because they are credible deterrents, serve to economize on utility loss Evil ata deer. "The legal approach to resolving principal-agent conflicts ‘constitutes only one way of establishing a eredible threat. Amore general approach involves the establishment ofa credible threat to withhold resources” from the firm if management fails to serve stakeholder interests threaten ext ftom the exchange relationship (Hirschman, 1970). Such threats may be more elective than legal penalties. Only in rare situations are Tegal penalties likely to jeopardize the survival of the firm. Indeed, many fitms view uch penalties as a ‘normal cost of doing busines’. In cont therm access to critical resources, stakeholders can threaten its very survival (Pfeffer and Salancik, 1978). Ina sense, the threat of ‘management relationships isan underlying theme of many stakeholder However, market action suffers feom a number of weaknesses. First, there is a co-ordination problem among diffused stakeholders that in certain cireumst- ances makes collective action problematic. impose demands on management. For example, while employees may be f ‘unhappy about working conditions, individual complaints or threats of exi may do litle to persuade management t iprove conditions, particula42 CW.L HILL AND TM JONES there is a ready supply of replacement labour. Similarlypwhileeonsumensay individuals may disapprove of the pollution implications of a giver product (eg. auto exhaust, plastic containers,.air conditioning fluid) the threat of » even though as individuals they are unhappy about the implications of doing so, and would prefer the firm to devote resources to developing less harmful alternatives, ‘The institutional response to the problem of achieving collective action among diffused stakeh en ‘Examples include labour unions: eeeehicesisienenteei Thar lthjcnipe oe iat a strike if management fils to meet their demands for better working con tions. Similarly, special-interest groups may initiate a consumer boyeot ifthe firm continues to produce products that they consider to be harmfil (6 Infac’sconsumer-led boycott of Neste’s was designed to halt the company's ‘questionable infant forma marketing practies in Third World countries). ABbm Wns apecie ser inventnsner ts hem ae by Solon fang themostinponant of ts nskcheders lr fture row closely » Signa to that of he frm) However, certain bonding mechanisms have the additional character of increasing the credibility of the threat to exit among stakeholders who have invested in firm-specific assets. union labour as a means of safeguarding employees investments’ in firm specifichumanceapitah This bonding mechanism limits management's ability to abrogate any previously agreed labour contract. If they do, they face the possibility of a strike (exit), the threat of which is made credible by the Inability to hire non-union labour. Notwithstanding such examples, however, the threat of exit may be limited in such circumstances, in which case stakeholders may have © resort to voice as an enforcement mechanism (Hirschman, 1970). _ Voice as 0 deterrent In certain circumstances voice may be the most effective ® Seam hn hn only meinem 0 nop reputations and the intrinsic value of a manager's human capital, To be fective, however, voice must be articulated by interest groups that have aSTAKEHOLDER-AGENCY THEORY 43. legitimate claim to represent stakeholder interests. Again, certain insitutio- nal structures such as labour unions, consumer unions, and special-interest STATIC EQUILIBRIUM In our view, due to the pervasive nature of change, much of the business system is ina state of almost permanent disequilibrium. Despite this, igh this is something of an abstract and ‘eological exercise, such a discussion tells us something about the end towards which dynamic processes propel the system. Here we discuss the factors determining the complexity of the institutional structures that we 1m situation; later we focus on disequi TF equilibrium were ever reached, institutional structures would display clic ‘managers still retain some (diminished) discretionary control over the use to ‘which the firm's resources are put. The argument is explained with reference to figure 1. he vertical axis measures units of uty. ‘A positive relationship between the complexity of availabe institutional ‘uructures and the costs of those structures (in terms of the utility that has to bbe sactficed to support them) ean be postulated. If working efficiently, the farket system, because itis a decentralized mechanism, imposes the lowest ‘costs on stakcholders. More-complex structures-impose-additionabcestsi Far” ‘example, ultimately consumers underwrite Consumer Watch through dona 7 . ¢ “egal apparatas: However, due to the benefits Si ae H4 GN.L. HILL AND TAM JONES ’ Bent i ° a Complete of ‘aca Figure 1 {noma dmg renin tospeiaenton are ey tein a "The befits to stakeholders of taintaining indtutional structured can be seasuted in terms of the rein in wily fete that uch structures achieve “he benef function in figure 1 is shown to increase at a decreasing rae, symbolising decreaang returns to increasing complex structures that i increasing management resinance to reductions in ther discretionary contl cover the use to which resources are put. Eventually the function, wil ‘approach the ine where O-b symbolizes the total uly los arising from amt evant divergence of interests ‘equilibrium point involves a reduction in total ut remaining utility loss is equivalent to eb ‘aan dca glo aio Tegice obr cari rgcieia ciate that these resources will be devoted to investments in maximizing the growth rate of the firm, Toss of O-c. ‘The AST 2 juavestordevelopomore:eficientinstitutionalmechanisms. More precisely, the‘STAKEHOLDER-AGENCY THEORY 45, _grss returns to innovation are equivalent to the discounted present-value of 24 ~ bye where the subseript ¢ refers to successive time periods. For Cl to epresent a true equilibrium, the pereeived returns to innovation must be equivalent to the perceived costs of innovation, The costs of innovation refer 10 the costs of overcoming resistance to change (in terms of the utility that ‘must be sacrificed) and imposing new institutional structures upon the implicit or explicit contract. An example of these costs might be the costs in terms of both money and emotion to employees of supporting a strike to get their labour contract with management renegotiated. I the perceived returns 10 innovation are greater than the foreseeable costs it wll pay stakeholders to devote resources to the development of more efficient institutional structures, ‘The implications of this point are developed later. Extensions AA shortcoming of this model is that it glosses over the problems created by the ‘conflicting claims of different stakeholder groups. Obviously, the claims of different groups may conflict (e.g. stockholder demands for greater dividends ‘conflict with, employee demands for higher wages) Siete acre eriniens dite teens saichader groups is ‘on how the firm’s resources should be allocated between investments, and the most desirable time pattern of organizational rent streams, Methe aifferent, {as when employees go on strike or consumers boycott its product). ‘An equilibrium solution t0 this type of problem can be found in the literature on co-operative game theory. Although beyond the scope of this article, it should be noted that itis possible to model what has been referred to ‘otherstakeholders® A rational stakeholder would not disturb such a state by making a demand for greater control over how the firm's resources are invested (for a theoretical proof of this:argument see Aoki, 1984), With reference to institutional structures, the implication of such an organizational equilibrium is that each stakeholder group will adopt increas- {ingly complex structures up to the point that is consistent with the co- ‘operative solution, ‘That is, no one group will attempt to establish additional structures ifdoing so would upset the organizational equilibrium te open conflict between stakeholders, achieve cooperativessaution! Management is hard, passive player, howevel Under the restrictive conditions of neoclassical equilibrium, such an exercise would be fruitless46 (G.WiL. HILL AND TM JONES However, an Austrian perspective of the market process leads to a very ent conclusion POWER DIFFERENTIALS AND MARKET PROCESS 1x was argued earlier that due to the pervasiveness of change, extensive disequilibrium is the norm. Moreover, although we view markets as being ultimately elficent, we theorized that the adjustment process is characterized by considerable fFiction due to inertia, the ability of managers and stakehol- ders to slow down adjustment by their strategic investments, and entry and ‘exit barriers, ‘Of course, power diferentials do not always work to management's advan- tage. For example, labour shortages arising from unanticipated macro- ‘eavironmental change will increase the bargaining power of employees rela- tive to managers, enabling them to impose tighter constraints on managers (2g. to demand higher wages, better working conditions, more extensive {grievance procedures, and employee directors). Often, however, power differ- entials will be in managements favour. Moreover, by virtue of their position at the nexus ofthe implicit and explicit contracts that constitute the firm, ancl because of their control over the decision-making apparatus of the firm ‘managers may be better positioned to exploit power differentials than indi- ‘vidual groups of stakeholders. Thus, imhememainderof thisssection: Weel! | Establishing and Exploiting Power Differentials Starting with the convenient fiction that in the ‘beginning there was an ffcient equilibrium’, disequilibrium can be seen as either the product of a firm's own innovative efforts, or the result of an exogenous shock. However created, involves undertaking strategic actions that reduce the concentration of stake- holder power and/or increase the concentration of management power. The concentration of stakeholder power can be reduced by strategies dlsigned to diffs the control aver critical resources exercised by stakeholder ). In a similar vein, management may diffuse supplier power by developing altemative sources of supply (assuming that alternatives‘STAKEHOLDER-AGENGY THEORY 47 are available). Management may reduce customer power by building a more diverse customer base through product and market diversification, Manage- ‘ment may limit the power of local communities and the general public by both national and multinational diversification. And finally, it has been argued that the way in which management has organized production in the ‘workplace and has exercised control through bureaucratic mechanisms has significantly reduced the power of employees to oppose management pol (Braverman, 1974; Clawson, 1980; Edwards, 1979). ‘The common theme ‘underlying these strategies is that they restriet the choice set of stakeholders, thereby altering the configuration of resource dependencies. For example, ‘horizontal acquisitions increase the buying power of the firm by limiting the ‘number of independent customers to whom suppliers can sel, All ofthese strategies are undertaken to increase management power rather ‘than maximize efficiency. Their ultimate objective isto loosen the constraints ‘imposed by stakeholders and give management greater discretionary control ‘over the firm’s resources. Without a commensurate increase in productive ffciency, the additional bureaucratic costs ofrunning an expanded organiza tion or of achieving intra-organizational co-ordination imply that declining efficiency will be one result of such strategies. Thus, in an efficient market, firms that pursue such strategies will be selected out by the competitive ‘mechanism, However, the view of competitive dynamics advocated. here suggests that disequilibrium gives managers the opportunity to build such power differentials Of course, itis possible that the ability of managers to pursue strategies that inerease management power over one group of stakeholders may be limited by the constraints imposed by other stakeholder groups, Most sign’- ficantly, the board of directors (as the representative of stockholders), is in theory well positioned to limit managerial actions that it perceives as being ‘contrary to stockholder interests (Fama and Jensen, 1983). ‘Thus, for exam- pile, management attempts to reduce customer power by building a more iverse customer base through diversification may be blocked by the board, precisely because the board might regard such diversification as being an ecient use of stockholders funds. Whether the board can impose such constraints in practice is the subject of some debate. Contrary to the argument made by Mace (1971) and others that ‘most boards do little more than rubber-stamp management decisions,48 (CW. HILL AND TM JONES On the other hand, there is also evidence which suggests that board control lover top management is still relatively weak. For example, Jensen and ‘Murphy (1990), after finding only a very weak relationship between CEO pay ind firm performance, concluded that most boards may lack the power t0 impose stockholder objectives on management. Similarly, However, one factor which suggests that tighter control over management actions may become the rule rather than the exception has been the dramatic rise of financial institutions as major providers of capital. On both sides ofthe Atlantic pension funds, insurance companies, mutual funds, and investment hanks have rapidly been replacing individuals as the main stockholders in public corporations. For example, in the United States, Hanson and Hill (1991) present evidence which suggests that among Fortune 500 companies the percentage of common stock held by institutions increased from 24 percent to 50 percent between 1977 and 1986. increasingly able to exert ect influence over management actions, either through (2) the threat tose their holdings: (b) the threat to fight proxy votes: more aggressively: or (c) by using their voting: power to elect their own ‘nominees to the board ot ditectors: For crample, 1987 a group of firancialinstitations with major holdings in General Motors wat able to presse GM management into adopting = tomas pay system for GM exccutves that was based poe” ook price rformance (prior to that time, bonuses had been awarded automatialy, respective of the company's performance). The inaitations did this by introduce a resolution at the next stockholders” meeting that cal of management unless the company changed its bons pay Policies (Nussbaum and Dabraynaki, 1987), More generally, Mints 4nd SChwarts (1985) argue for and present evidence which supports the vew that financial institutions play a key role in the contro of large fms, Simiaey, Scot (1979) conchades that large fms and major bunks "enfont one another as equals, each being constrained by it controling constellation of interests and that ‘banks are able to exercise coneiderable influence over the polices of major indurtsal corporations and 30 can affect what happen Eompanica were they have no dest power (p. 173). Tohould be pointed out, however, hat toa large degree management and major financial invitations share the same agenda Although there wil Andoubtedly be conflict between them, itis ressonsble to suppose that In fang eases management sctione designed to weaken the power of certain Stakeholder groupe (gs employees, supplier, or customers), wil be con- igrocmt with the interests of major financlalinedtutions long’ as they'STAKEHOLDER-AGENCY THEORY 9 inerease the profitability of the Corporation, ‘Thus, while important, the ‘potential for conflict between managers and financial institutions should not, hye overstated The Implications of Power Differentials Power differentials created by the strategies detailed above limit the ability of stakeholders to enforce implicit or explicit contracts Sommetaalalelet fae is i difficult for se ‘to establish a credible threat when ‘power is diffused among many individuals and collective action is difficult 0 achieve, Similarly, the concentration of management power reduces the choice set of stakeholders, again limiting the effectiveness of exit and voice as enforcement mechanisms. Stakeholder diffusion also makes monitoring more difficult. Less powerful stakeholders are less able to demand that management make itself account- able. They are less able to use the implied threat to exit or exercise voice as a means of gaining access to insider information or demanding that manage- ment regularly provides them with information concerning its activities. Moreover, the pursuit of diversification strategies by the firm obscures data ‘relating to the efficiency of individaal divisions (firms only have to publish Consolidated accounts). This exacerbates the information asymmetry between ‘management and stakeholders, making monitoring more problematic. Managers may also take advantage of power differentials unilaterally to reyrite the terms of the implicit or explicit contract between managers and stakeholders. Thus, managers may take advantage of power differentials to revoke warranties, retract hostages posted as bonds, or retract other credible commitments such reciprocal purchasing agreements, posted prices, or union shops. Similarly, management may take advantage of a temporary power dliflerential over its employees to rewrite employment contracts. Ina ofthese eases, the effect of power differentials is to educe the effectiveness of existing ‘institutional structures and to increase the residual loss that must be born by stakeholders. Stakeholder Responses ‘Stakeholder responses to the creation of power differentials can be analysed bby way of figure 2. This shows the marginal benefit and marginal cost curves underlying figure 1. We start the analysis by accepting the convenient fiction fof an initial equilibrium solution involving institutional structures of Cl ‘complexity, a reduction in utility loss of 0c, and a remaining utility loss of 5. ———————150 CW.L HILL AND TM, JONES. vey f Figure 2 ‘an equilibrium positon, the perceived gross return gained from the innova tion of more efficient structures must be equivalent to the perceived costs of such innovation. Given this, the power shift has created an incentive to innovate equivalent to the discounted present value of Bed. Our thesis is that the existence of such an incentive following the emergence of a power differential has driven much of the historical evolution of institutional struc ‘don, and s0 on, can be traced back to such incentives? and upset the balanee of power that existed between those who made products to those who managed the production process, with management benefiting ‘Lanes, 1966). ‘Those who made products now became ‘employees nl were ata power disadvantage sic those who managed the process. Traditio- nally, eraft guilds had governed the implicit contract between managers’ and ‘subcontractors’. One consequence of the shift to a factory system was that craft guilds lost thei effectiveness as institutional structures, and declined ‘dramatically in influence (Landes, 1966). Thus, the decline in the marginal hbenefit curve from MB, to MB» (i, existing institutional structures were no longer effective). However, this shift increased the incentive that those who‘STAKEHOLDER- AGENCY THEORY 151 ‘OF course, such adjustments are anything but smooth and will be resisted boy the advantaged party. Indeed, there is Tong history of management resistance tothe development of union power following the introduction ofthe factory system, Moreover, the conflict between management and stakeholders following the development ofa power diferential cane expected to spill over 1 the explicitly political arena, That is, both parties can be expected to try {0 use the power of law to further their interests. This is hardly surprising tiven that many institutional structures either havea legal component or are Fupported by the lav, butt does give usa way of explaining the sclective use of Political Action Committe (PAC) money, along with more general lob- bring by corporate trade amsociations and public interest groups. Spefically, at any point in time sich monies and lobbying will be devoted to ongoing ‘management-stakeholder confics, the amount of activity and money being roughly proportional to the size of the perceived power dilerential and the Anticipated gains ftom either changing the systent or maintaining the stata: om, Finally, it is important to remember that powerieentials:worksboth ‘ways Although we have concentrated on the benefits enjoyed by manage: ‘ment from their control aver the decision-making apparatus ofthe firm, and although this contol probably does give management an inbuilt advantage, management may be put on the defensive by increases in stakeholder power in stakeholder power have their genesis in disequilibrium conditions created either by exogenous shocks, or by innovations in the way that stakeholders do business CONCLUSION ‘The objectives ofthis article were ambitious en seen as offering mutually exclusive interpretations of organizationalaonge dled, 152 (G.W.L. HILL AND T.M. JONES phenomena (Perrow, 1986). While agency theory assumes efficient markets and rejects the idea of power differentials between managers and stakehol- ders, resource dependency theory (¢,., Pfeffer and Salancik, 1978) imy assumed inefficient markets which allow for the existence of unequal resource dependencies (power differentials) between managers and stakeholders. The adoption of an ‘Austrian’ perspective on market processes allows us 10 treat notions of power and efficiency within the framework of the same model Following the theme of Austrian economies, we accept that markets are elfcient. However, the existence of short-run disequilibrium arising from ‘exogenous and endogenous change has been argued to give rise to temporary evolution of new incentive structures and institutional mechanisms for moni- toring and enforcing the contractual relationships between managers and stakeholders can be seen as long-run market-generated responses to dise- quilibrium conditions and unequal resource dependencies, Unlike earlier theories, the paradigm explicitly focuses on the causes of conflict between ‘managers and stakeholders following the emergence of disequilibrium condi- tions, Stakeholder-agency theory also points the way towards a theory of the adjustment mechanisms that realign management and stakeholder interests following disruption. Notes * Our thanks to Peter Mills, Tom Thomas and an anonymous referee for their helpfl comments on an carier draft ofthis manuscript (1 There isin feta large body of empirical evidence suggesting this is indeed the case. See Branch (1980), Bronzen (1970) snd Jacobsen [2] 1's where the gradients ofthe two curves are equivalent: fx, where ¢(bencits)/ 4 (complexity) = d (conts)/d (complexity). [3] There are exceptions to this, however. For example, stockholders often stand to sain large profits if they sell out to corporate raiders. At this juncture, the ontinued fate of the firm is of lie interest to them, REFERENCES: Ate 211-1 1 A.A. (1950). ‘Uncertainty, evolution theory” Juma! of Plitial Kowomy, 58, Ava, Y. and Ley, B, (1981) ‘Risk reduction as & managerial motive for conglo: ‘merate mergers. Bul Jounal of Ezoomics, 12, 303-406,‘STAKRHOLDER-AGENCY THEORY 153 Banaty, J. B: and Ovon, W,G. (1986): Orgenicatinal Reonomict. San Francisco: Jossey-Bass. Bavwot, W. J. (1959). Busines Behavior, Value ond Growth. New York: Macmillan, But, A.A. aid Mians;G,C. (1932), The Moder Curporation and PricatePrpety. New ‘York: Macmillan Buasest, B. (1980). “The laws of the marketplace and ROI dynamic’. Financial Management, 9, 58-69. Bhravinaias, H. (1974), Labor and Munyoly Captl. New York and London: Monthly Review Press Browzen, Y. (1970). “The antitrust task force deconcentration recommendation’ Jeera of Lae and Ecamomies, 18, 279-92. eee an 5). Conporate Profits and Oplaton. New York: Academic Pres. Giawion, D. (1980). Bureaucracy and the Labor Prezs. New York and: London: Monthly Review Press, Dnaiset7, H. (1983) "The structure of corporate ownership and the theory of the firm’. Journal of Law and Econics, 26, 375-89. Enwakhs, R. (1979). Contsted Terain. New York: Basic Books Eisewuseor, KM. (1985). “Control: organizational and economic approaches’ Managenent Science, 31, 134-49. Esestanpt, K, M. (1988) *Agency and institutional explanations of compensation in retail sales’ Academy of Management Journal, 81, 488-511 Exsewanor, KM. (198, ‘Agency theory a astssment and review, Acad of Managemen Review, 1, Emote A. (1862). Poves dependence relatos’ Aman Secale, 27, 31-AL Faats, EF (1980). “Agency problems and the theory ofthe firm’, Joual ef Police Exonomy, 88, 97-90, Paots, EF and Jessen, M. C. (1983). ‘Separation of ownership and contol. Journal of Lats and Economic, 26, 301-26. Faaan, B, (1984). Shape Managment: A Siakeolder Approach, Boston: Pitman Press. Huis, M. T, and Pktaniay, J. (1984). ‘Structural inertia and organizational change’. American Sociological Rixiew, 49, 149-64, Hassox, G. and Hus, C. W. L. (1091). "Are institutional investors myopic? A pooled time series analysis in four industries’. Srazgie Managemont Jounal, 12, 1-16 Hinges, A: (1970) Bs, Vand Lye. Cambridge, Mass: Harvard Universisy Jrcowses, R. (1988). “The persistence of abnormal returns’. Swale Management Jounal 8, $15-30. Jissix, M. . (1983). ‘Organization theory and methodology’. Acsounting Revie, 50, 319-30. Jessix, M. C. (1986). ‘Agency costs of free cash ow, corporate finance and. takeovers’: American Economic Review, 76, 323-9. ‘Jussex, M. G. and Meckiine, W. H. (1976). “Theory of the frm: managerial Dehavior, agency costs, and ownership structure’. Jounal of Financial Exons, 3, 305-60. Joys, MoE. and Muxmy, K. (1990), “Performance pay and top management incentives’. Journal of Palical Economy, 98, 225-64,154 (G.W.L. HILL AND T.ML JONES Kinzxes, I. M. (1979). Parton, Opprtsiy, and Prof. Chicago: Unive ‘Chicago Press Keston, F, (1921). Rist, Uncertainty, and Prof. Boston: Houghton-Mifin ‘Kosuik, R. (1987). ‘Greenmail: a study of board performance in corporate gover- ance! Administrative Science Quarter, 82, 168-85. Laxpts, D. 8. (1960). The Rs of Capitation. New York: Macmillan. Lirnizcatn, 8. C. and Owns, G. (1980). "An Avstrian model ofthe entrepreneurial ‘market proces’ Journal of Econie They, 28, 361-79. iy of Luts, $. (1974). Pauer, A Reda! Vie. London: Macmillan. Mace, ML. (1971). Directors: Myth and Reality. Cambridge, Mass: Harvard Business School Press. Mancn, J. G. and Sivos, H. A. (1958). Orgariations. New York: Wiley. Mankis,R. (1964). The Ezonamic Theor of ‘Managerial Capialom. London: Macmillan, Muyray'B. and Scuwakr2, M. (1085). The Paer and Strctre of American Business. Chicago: University of Chicago Press. Mrrnotr 1.1. (1988). Stakeholders ofthe Organizational Mind. San Francisco: Jossey- as Academy of Management Kevsew, By 420-39. © Nutsoy, RRs and Wirt, 8G. (1082) An Enon Thy of Exc Cheng. ‘intra Mate Harvard Unive Pre ‘Nesta Band Bowzvoan, J (1987) “The bate for corporate cont: Buss Wie, 18 Mas 102-2 Pease, J, A (982). “The company mision asa stratepic tot Slam Menagemnt Reis, Spring, 15-24 Penne, ©. (190). Gonpler Organica: A Cita Ey, New York: Random Howse. Framer, J (1981): Pern Organon, Marae, Mase: Pan Publating Praran Jan Satan, (1978. The Esra Gone! of Oganizetn A eae iperdnes Perc New York: Harpe & Rove Porte, Ne A980). Conte Shay. New York: Froe Bese Porras, Le (1984). On some recent explanations of why capital hires labor ‘amon Inga, $8, 171-87. Ross 8 (198) “tse economic theory of gency: the pins problem’. Amin Economie Review, 68, 134-9. Rae ee Seanano, TC. (1960), Te Sate of fi. Cambridge, Masa Harvard Unive iy Pres Seater J. A. (192). Capitation, Siam, and Decry. New York: Harper Brother. Scomr, (1979), nprtn, Claes and Caplio. London: Hutchinson Water, KE. 1979). Te Soc Poet of Ogeiing, Reading, Mase’ Addison Wes. Wiuinason, OE (1964), The Ecmomic of icrtionany Bebo: Managerial Obes ina Th of be Fim Bingo Cli Nye Prone Hal Witstatson, ©. (198). "Corporate govemtance’ Yl Las Raven 98, 1197-250 Wrtsason, 0. E. (1989) Tae Bowen Tetons of Cptatin. New York. Free en Wont, D. (1965). Paver: ts Roms, Base, and Uses. Chicago: University of Chicago Pro