Question

Describe the agency theory and resource dependence theory of corporate governance. What are their similarities and what are their differences?

Answer 1

Agency theory

Agency theories arise from the distinction between the owners (shareholders) of a company or an organization designated as "the principals" and the executives hired to manage the organization called "the agent." Agency theory argues that the goal of the agent is different from that of the principals, and they are conflicting (Johnson, Daily, & Ellstrand, 1996). The assumption is that the principals suffer an agency loss, which is a lesser return on investment because they do not directly manage the company. Part of the return that they could have had if they were managing the company directly goes to the agent. Consequently, agency theories suggest financial rewards that can help incentivize executives to maximize the profit of owners (Eisenhardt, 1989). Further, a board developed from the perspective of the agency theory tends to exercise strict control, supervision, and monitoring of the performance of the agent in order to protect the interests of the principals (Hillman & Dalziel, 2003). In other words, the board is actively involved in most of the managerial decisionmaking processes, and is accountable to the shareholders. A nonprofit board that operates through the lens of agency theories will show a hands-on management approach on behalf of the stakeholders.

Resource dependence theory of corporate governance

The basic proposition of resource dependence theory is the need for environmental linkages between the firm and outside resources. In this perspective, directors serve to connect the firm with external factors by co-opting the resources needed to survive. This means that boards of directors are an important mechanism for absorbing critical elements of environmental uncertainty into the firm. Environmental linkages could reduce transaction costs associated with environmental interdependency. The organization’s need to require resources leads to the development of exchange relationships between organizations. Further, the uneven distribution of needed resources results in inter-dependent organizational relationships. Several factors would appear to intensify the character of this dependence, e.g. the importance of the resource(s), the relative shortage of the resource(s) and the extent to which the resource(s) is concentrated in the environment .

In this context, many of the resources are directly and indirectly controlled by the government. Hence, appointing directors that have influence and access to key policy-makers and government is seen as an important strategy for survival because of their knowledge and prestige in their professions and communities, firms are able to extract useful resources. This could enhance the firm's legitimacy in society and to help it achieve their goals and improve performance. Through the resource dependence role, directors may also bring resources such as specialized skills and expertise. This concept has important implications for the role of the board and its structure, which in turn affects performance. In summary, resource dependence theory provides a convincing justification for the creation of linkages between the firm and its external environment through boards as firms that create linkages could improve their survival and performance.

The similarities between and their differences

As noted by Mintzberg (1979), the operation of a business firm gives rise to both cooperation and conflict. Conflicts can arise between owners and managers in the division of the value created by the firm as well as amongst managers in the struggle for power and control rights within the firm. We focus on the latter conflict in this paper, using the multinational corporation (MNC) as the subject organizational form. In the literature, this conflict has been analyzed within two quite disparate perspectives, namely agency theory and resource dependency theory. Within the agency perspective, conflict amongst managers has been framed as one where managers at headquarters are linked in an agency relationship with managers in operating divisions (e.g., Scharfstein and Stein, 2000). It is recognized that MNC subsidiaries pursue their own interests and are not a mechanical instruments of headquarters’ will. More importantly, ‘the local interests of the subsidiaries may not always be aligned with those of the headquarters or the MNC as a whole’ (Nohria and Ghoshal, 1994, p.492). However, while the agency perspective 1 incorporates autonomous decision-making by subsidiary managers, their decision-making autonomy may be categorized as discretion in the sense of Williamson (1996). The subsidiary has ‘delegated decision rights (that) are always “loaned, not owned”’ (Baker, Gibbons, and Murphy, 2002; Foss, Foss and Vazquez, 2006). Headquarters retains the power of veto, i.e., the ability to overrule any subsidiary decision. In contrast, the analysis of power in the management literature has been based on the basic notion that ‘power is the ability to get others to do something that they would not otherwise do’ (Dahl, 1957) and that the successful exercise of power requires that it be based on a set of ‘legitimating principles’ that are specific to the organization (Weber, 1968). This is the basis of resource dependency theory that posits that power is based on the control of resources that are considered strategic within the organization (Pfeffer and Salancik, 1977a) and is often expressed in terms of budgets and resource allocations (Pfeffer and Moore, 1980; Mudambi and Navarra, 2004). The game theoretic concept that is closest to the notion of power emerges from resource dependency theory is bargaining power (Osborne and Rubinstein, 1990). This is the extent to which players can influence the division of contested resources. Subsidiary autonomy based on bargaining power is fundamentally different from discretion in the sense that it is much more difficult for headquarters to revoke. In other words, subsidiaries with strong bargaining power have a degree of ‘ownership’ over their decision rights rather than holding them at the pleasure of headquarters. Resource dependency theory is externally focused in the sense that ‘power is held by divisions that are the most important for coping with and solving the critical problems of the organization that arise from its environment’ (Pfeffer and Salancik, 1977a). Organizational 2 survival in a competitive environment provides a logical basis for this position, since organizations that fail address their critical problems will disappear. However, while the theoretical basis for this position is convincing, empirical testing has been relatively limited. Such work as exists has focused on case study data (Pfeffer and Salancik, 1978) and data drawn from the non-profit sector like universities (Pfeffer and Moore, 1980) and hospitals (Pfeffer and Salancik, 1977b). On the basis of the foregoing discussion, it is clear that agency theory and resource dependency theory are two pillars upon which to understand decision-making by managers in MNC subsidiaries. We develop an over-arching theory that encompasses both agency theory and resource dependency theory. We propose that agency theory applies when the subsidiary’s decision rights are ‘loaned’ by headquarters, while resource dependency theory applies when the subsidiary ‘owns’ its decision rights. Agency theory is more applicable to the hierarchical model of MNC where subsidiaries mainly exploit competencies developed by their parents. However, modern MNCs are increasingly viewed as differentiated networks (Nohria and Ghoshal, 1994), where some subsidiaries continue to function the traditional competence exploiting role while other are competence creating and augment the advantages of their home-base (Cantwell and Mudambi, 2005). Resource dependency theory provides a better basis upon which to understand the relationships between competence creating subsidiaries and their parent MNCs. Thus, within the differentiated MNC network, both agency theory and resource dependency theory are required to understand the full range of headquarter-subsidiary relationships. Subsidiaries with strong power can resist headquarters attempts to control their resources in the MNC’s internal capital market (Mudambi, 1999; Mudambi and Navarra, 2004). This theory implies that subsidiary responsibilities are as much the result of subsidiary power arising 3 from resource dependency as of headquarters’ design based on agency theory. The development and consolidation of such power at the subsidiary level is facilitated by the ‘loose coupling’ promoted by the network structure of many modern MNCs (Ghoshal and Bartlett, 1991). An important point that arises in this context concerns the legal status of the subsidiary within the MNC. How can a subsidiary have bargaining power when it is not an independent legal entity and therefore has no legally defensible property rights? The legal status of a subsidiary implies that it has not ownership rights over its tangible assets and its control over such assets can only be in the form of discretion – headquarters can always re-take control of such assets. However, the MNC parent’s ownership rights do not always and automatically translate into defensible property rights (Foss and Foss, 2005). A subsidiary’s bargaining power will generally be based on assets over which property rights are hard to define and enforce. The bulk of such assets are in the form of intangible assets like knowledge (Nonaka and Takeuchi, 1995). Agency theory has been extensively tested in the context of MNC subsidiaries. However, resource dependency theory has not received much attention in the international business literature. As subsidiaries increasingly evolve towards higher levels of competence creation, we argue that resource dependency theory becomes increasingly relevant to developing an understanding of decision making in MNC subsidiaries. Hence, in this study, we propose to test resource dependency theory in the context of MNCs.

Differences

we propose that agency theory and resource dependency theory provide complementary frameworks within which to understand decision-making by managers in MNC subsidiaries. We show that agency theory applies when the subsidiary’s decision rights are ‘loaned’ by headquarters. Agency theory is more applicable to the traditional model of MNC 10 where subsidiaries differ in the extent to which they exploit home-base advantages and create benefits like profits or cashflow, over which the MNC parent can exercise defensible property rights. The degree of autonomy allowed to subsidiaries is directly related to the benefits that they create for the parent MNC. Headquarters uses hierarchical ‘hard control’ mechanisms to curtail the autonomy of subsidiaries creating large benefit streams. Subsidiaries creating limited strategic value may be allowed considerably more autonomy (illustrated in the figure). However, as modern MNCs increasingly depend on leveraging their entire networks to generate competitive advantage, some subsidiaries have evolved to augment home-base advantages. Such subsidiaries generally create competencies based on the control of intangible resources like knowledge assets over which property rights are difficult to define and defend. These subsidiaries exercise considerable power within the MNC and ‘own’ their decision rights. The MNC parent must design ‘soft control’ mechanisms to promote subsidiary competence creation while encouraging integration with the rest of the firm’s network (illustrated in the figure). Resource dependency theory provides a better basis upon which to understand the relationships between such subsidiaries and their parent MNCs.