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AgencyTheoryandBoundedSelf-Interest

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Q Academy of Management Review2016, Vol. 41, No. 2, 276–297.http://dx.doi.org/10.5465/amr.2013.0420

AGENCY THEORY AND BOUNDED SELF-INTEREST

DOUGLAS A. BOSSEROBERT A. PHILLIPS

University of Richmond

Agency theory draws attention to certain behaviors of CEOs and boards that, in ag-gregate, create losses for society. The empirical literature, however, characterized bycontentious findings, suggests that the current form of agency theory is not supportinga clear understanding of these behaviors and their costs. We propose a change to oneassumption, with potentially profound implications. Expanding on the assumption ofnarrow self-interest underlying agency theory, we apply an empirically well-established refinement that self-interest is bounded by norms of reciprocity and fair-ness. The resulting logic is that perceptions of fairness mediate the relationshipsderived from standard agency theory through positively and negatively reciprocalbehaviors. This mediating variable provides a parsimonious new way to help explainextreme results found in prior studies. Rather than aiming to limit CEOs’ self-servingbehaviors, boards that apply these arguments improve social welfare by initiat-ing positive reciprocity and avoiding unnecessary, welfare-reducing “revenge”behaviors.

Agency theory is undeniably among the dom-inant theories of economic organization andmanagement. As such, agency theorists areroutinely challenged to more fully explain theubiquitousagencyproblemandhow toaddress it(e.g., Dalton, Hitt, Certo, & Dalton, 2007; Ghoshal,2005; Hill & Jones, 1992). The problem ariseswhenever one party (a principal) employs an-other (an agent) to create value. The essentialfeatures of the agency problem are that the in-terests of the principal and agent diverge and theprincipal has imperfect information about theagent’s contribution. These features definethe problem, and the problem results in costs andinefficiencies ultimately borne by society, oneprincipal at a time. While the costs to society aredifficult to measure precisely, they are signifi-cant. Estimates at largemanufacturing firmsandsmall firms place the costs at 0.2 and 5.0 percentof revenue, respectively (Ang, Cole, & Lin, 2000;Dobson, 1992).

Agency theory states that principals seek toinfluence agents in order to economize on thesecosts. The theory, building from assumptions that(1) all actors are narrowly self-interested, (2) allactors are boundedly rational, and (3) agents aremore risk averse than principals, has earneda place of prominence (Eisenhardt, 1989). Still,mixed empirical findings challenge us to refinethe theory in search of more nuanced explana-tions. For example, standard agency theory logicsuggests that payingCEOswith stockoptionswillalign their behaviors with the interests of the firmand result in higher firm performance, but someempirical results show that this practice leadsto more big losses than big gains (Sanders &Hambrick, 2007).We agreewith Jensen (1998) that the deductive

logic of standard agency theory is sound, givenits assumptions. As such, future refinements inlogic are likely to arise through reexaminingthese assumptions. The insight that drives ourcontributions is that, even in competitive mar-ket situations, economic actors are not narrowlyself-interested but boundedly self-interested.The volume of research showing that actors’self-interest is bounded by norms of fairnessis blossoming (even exploding) in fields as di-verse as strategy (Ariño & Ring, 2010; Fong,Misangyi, & Tosi, 2010; Fong & Tosi, 2007), or-ganizational behavior (Conlon, Porter, & Parks,2004; Greenberg, 1990; Li & Cropanzano, 2009),economics (Akerlof, 1982; Fehr & Gӓchter, 2000),

The contributions to this manuscript by special issue editorThomas Jones cannot be overstated. We presented prior ver-sions of this work at theMid-Atlantic StrategyColloquium, theGeorge Washington University Institute for Corporate Re-sponsibility, and the Global Business and Society Seminar atAmerican University. We specifically thank Shawn Berman,Steve Brammer, Parthiban David, Rebecca Dewinter-Schmitt,Heather Elms, Virginia Gerde, Kathleen Getz, Jeff Harrison,Michael Johnson, Jeff Pollack, Kathy Rehbein, Steve Tallman,and Michelle Westermann-Behaylo for helpful comments anddiscussions.

276Copyright of the Academy of Management, all rights reserved. Contents may not be copied, emailed, posted to a listserv, or otherwise transmitted without the copyrightholder’s express written permission. Users may print, download, or email articles for individual use only.

political science (Ostrom, Walker, & Gardner,1992), philosophy (Becker, 1986; Rawls, 1999/1971),biology (Nowak, 2011), sociology (Cropanzano &Mitchell, 2005), psychology (Rabin, 1998), and so-cial psychology (Cialdini, 1984). Boundedly self-interested actors do seek to maximize their ownself-interest, but only so long as perceived normsof fairness are not violated.When actors perceivefair treatment in competitive situations, they re-ward it through positively reciprocal behaviors;when they perceive unfair treatment, they punishit—often at a cost to themselves—through nega-tively reciprocal behaviors (Bosse, Phillips, &Harrison, 2009; Hahn, 2015; Uhl-Bien & Maslyn,2003).

In this article we examine the implications ofapplying bounded self-interest as an assump-tion of agency theory. Our resulting propositionsargue that perceptions of fairness mediate therelationships derived from standard agencytheory through positively and negatively reci-procal behaviors. We are unaware of any priorattempts to examine perceptions of fairnessspecifically and exclusively as an agency theoryconstruct. At least three novel contributions thataddress well-documented limitations in the the-ory stem from this tractable and parsimoniousextension.

First, CEOs who perceive that treatment fromboards exceeds their expectations can gener-ate what we term agency benefits that are un-recognizable using standard agency theoryassumptions. Our analysis—consistent withempirical findings from corporate governance(Fong et al., 2010), organization studies (Coyle-Shapiro, Kessler, & Purcell, 2004), labor econom-ics (e.g., Shapiro&Stiglitz, 1984;Weiss, 1991), andorganizational justice (e.g., Li & Cropanzano,2009) showing that people exert exceptional ef-fort when they perceive fair treatment that ex-ceeds their expectations—explains how boardscan initiate positive reciprocity with a CEO thatgenerates agency benefits. Our contributionclearly accounts for extraordinary behavior thatwe observe but cannot explain with existingagency theory.

Second, agents’ perceptions of unfair treat-ment can generate greater agency costs thananticipated by existing theory. The costscreated by ignoring fairness and reciprocitycan actually be greater because, unlike nar-rowly self-interested executives, boundedlyself-interested executives are willing to incur

additional costs in order to enforce the value ofjustice (Fehr & Gӓchter, 2000; Henrich et al.,2010; Hoff, 2010). The logic we develop pro-vides one bridge for the gap in agency theoryarticulated by Dalton et al. that “some agency-driven interventions have actually exacer-bated the fundamental agency problem” (2007:39; see also Sanders, 2001a).Finally, a contribution that goes beyond

a deeper understanding of the agency costsborne by society when firms and CEOs aremisaligned comes from acknowledging the so-cial welfare improvements that accompany anappreciation of bounded self-interest. In addi-tion to being facts of human psychology, fair-ness and reciprocity are social values that havebeen systematically undermined by the as-sumption of narrow self-interest in our most in-fluential management theories. Our analysisnot only stems this undermining but also goeson to explain that when CEOs interact with theirboards in ways that reinforce their expectationsfor justice, they affect social norms of justice.CEOs are socially influential around the world.To the extent that expectations of fairness andjustice are acknowledged and legitimated byinfluential parties, that pattern has ripple ef-fects through society. Thus, in addition to thesocial welfare created through improved man-agerial practice, welfare is enhanced when oneof ourmost powerful theories of economic actionbegins to show an appreciation of social andmoral norms.We proceed by providing a brief overview of

agency theory, including its assumptions, thecosts it seeks to economize, and the mechanismsthat power its propositions. Then we explainbounded self-interest and apply it to agencytheory to deduce new explanations for howagents respond to principals. The testable prop-ositions we develop suggest that our under-standing of how principals use incentivealignment and monitoring mechanisms can bealtered to improve the social welfare produced byfirm performance and the enforcement of jus-tice norms. We discuss the implications of thisnew logic on future research that promises toaccount for both exacerbated agency costs andheretofore unrecognized agency benefits. Theconclusion suggests that applications of stan-dard agency theory can lead to reductions insocial value and that our modification basedon a less pessimistic assumption about human

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behavior helps develop theory better able toadvance social welfare.

AGENCY THEORY: OVERVIEW AND REACTIONS

Theory Overview

One party (a principal) employs another (anagent)when the first party thinks thiswill result invalue creation. It is not possible for the principalto know, ex ante, howmuch value will result fromsuch an agreement because of uncertainty re-garding the agent’s level of effort and exogenousfactors. Nevertheless, the basis for the agreementis that the principal expects it to result in the cre-ationof a certainamount of value in the future.Wecall this expected amount E(V).

Assuming the agent and principal are self-interested utility maximizers, a problem arisesfor the principal when (1) the two parties havedivergent interests and (2) the agent has betterinformation than the principal. This problem,the fundamental agency problem, is that theseconditions create the possibility, even likeli-hood, that the agent will not act in the bestinterests of the principal; consequently, theprincipal will not get the full expected amount ofvalue (E(V)) from the agreement but, rather,something less: E(V – C).

Jensen and Meckling (1976) argued that theagency problem characterizes the corporate gov-ernance choices of firms (principals) and theresulting behavior of CEOs (agents). This is be-cause CEOs seek to increase their utility at theexpense of firms by withholding effort or in-creasing their own compensation through self-dealing (or perhaps honest incompetence; seeHendry, 2002). When owners do not have perfectinformation about CEO behavior, self-interestedCEOs conceal selfish actions, and firms bearthe cost.

Agency theory explains how principals effi-ciently organize exchanges with agents byemploying mechanisms—incentive alignmentand monitoring—in appropriate combinations(Eisenhardt, 1989; Jensen & Meckling, 1976). Theprincipals’ challenge is to realize the benefits ofcooperation with agents while minimizing thesumof productivity losses due to shirking plus thecosts of mechanisms employed to mitigate suchbehavior.

One point of explanation is vital here. Jensenand Meckling’s work and the majority of prior

positive agency theoretic research consistentlyconflate the board, the firm, and shareholders,including referring to shareholder as “owners.”This has, technically, been mistaken from thebeginning (Clark, 1985; Stout, 2012).1 Neither theboard nor shareholders are coextensive withthe firm, but the board speaks and acts on behalfof the firm in interactions with the CEO. And noneof them “own” the firm in any meaningful sense.Eschewing references to shareholders or ownersas principals, the convention we adopt here isreferring to the board when discussing actionstaken by the principal and referring to the firmwhen discussing the party affected by CEObehaviors.Anexhaustive reviewof thevast bodyof agency

theory literature is beyond the scope of this article(as of this writing, Jensen andMeckling’s seminal1976 paper has been cited over 24,000 times).However, the following brief and partial overviewprovides the critical cornerstones for ourpurposes(several excellent reviews of the agency theoryliterature are available, including Bradley,Schipani, Sundaram, & Walsh, 1999; Dalton et al.,2007; Eisenhardt, 1989; Finkelstein & Hambrick,1996; Jensen, 1998; Kim &Mahoney, 2005; Walsh &Seward, 1990).Wehave simplified the theory to itsessential core and therefore focus on the primarymechanisms for counteracting two prominentfacets of the agency problem: divergent interestsand informationasymmetry (Cohen,Holder-Webb,Sharp, & Pant, 2007).To counteract a portion of the agency costs that

arise from the diverging interests of the principaland agent, the principal can structure the agree-ment in a way that more closely aligns bothparties’ interests (Fama & Jensen, 1983; Jensen &Meckling, 1976). Tounderstandhow thisworks it isimportant to specify that agents’ and principals’interests conflict in at least two ways. First, they

1 Clark writes, “To an experienced corporate lawyer whohas studied primary legal materials, the assertion that corpo-ratemanagers are agents of investors, whether debtholders orstockholders, will seem odd or loose. The lawyer would makethe following points: (1) corporate officers like the presidentand treasurer are agents of the corporation itself; (2) the boardof directors is the ultimate decision-making body of the cor-poration (and in a sense is the group most appropriatelyidentified with ‘the corporation’); (3) directors are not agents ofthe corporation but are sui generis; (4) neither officers nor di-rectors are agents of the stockholders; but (5) both officers anddirectorsare ‘fiduciaries’with respect to thecorporationand itsstockholders” (1985: 56).

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have conflicting interests regarding how mucheffort the agent will supply. Principals wantagents to supply high effort, because their out-come value (V) depends on agent effort (more onthis below); the assumption is that agents havea disutility of effort. Second, they have conflictinginterests regarding how much risk the agent willbear. Principals want agents to assume some ofthe risk for the outcome value; agents do not wantthis risk.

Rewarding the agent based on his or heroutcomes rather than behavior is a commonincentive alignment mechanism (Eisenhardt,1989). However, this ties risk-averse agents’compensation to outcomes they do not fullycontrol. Consequently, CEOs are assumed toprefer behavior-based compensation schemes(e.g., salary) over outcome-based compensation(e.g., equity shares). Boards that wish to mitigatethe risk a CEO will shirk by aligning their in-centives with an outcome-based contract, then,must increase the size of the CEO’s potentialpayment in order to compensate the CEO forsharing some of the outcome risk. Agency theorysuggests an astute principal can spend Xia onincentive alignment mechanisms to save Xia 1Yia in potential losses due to selfish agent be-havior (Hill & Jones, 1992).

To counteract the agency costs that arise frominformation asymmetry, the principal can employa monitoring mechanism (Fama, 1980; Fama &Jensen, 1983; Jensen & Meckling, 1976). Withouta monitor, the self-interested agent who prefersleisure over work can be expected to shirk be-cause his or her true effort is concealed fromthe principal (Alchian & Demsetz, 1972). Usinga monitoring device makes the CEO’s behaviormore visible. Agency theory explains that princi-pals can spend Xm on monitoring mechanisms tosave Xm1 Ym in potential losses due to otherwiseunobserved agent behavior (Hill & Jones, 1992).

The costs a principal can expect according toagency theory range from the full costs of the un-mitigated agency problem to the combined costsof employing multiple mitigation mechanismsplus the residual agency costs. Principals do notget the full value they could expect absent theagency problem (i.e., E(V)). Figure 1 illustrates thisstandard agency theory logic. We hold separatethe two mechanisms—without emphasizing theextent to which incentive alignment and moni-toring mechanisms can be substitutes or com-plements (Rediker & Seth, 1995)—in order to

maintain the simplest focus on the core logic ofagency theory.

Empirical Evidence

Oneof themost commonapplicationsof agencytheory is examining corporate governance phe-nomena in which the board of directors acts onbehalf of the firmandCEOsare theagentshired torun the firm (Jensen&Meckling, 1976). The body ofempirical studies testing agency theory in thissetting is impressive. Many of these studies showsupport for its general propositions (e.g., Certo,Daily, Cannella, & Dalton, 2003; Jensen &Murphy,1990; Sanders, 2001a). It is also true, however, thatother empirical tests suggest that further re-finements are needed to better explain the con-ditions that influence how principals’ actionsmitigate or intensify the agency problem. In thissection we briefly summarize recent reviews andmeta-analyses showing gaps between agencytheory and the phenomena it attempts to explain.One way to align the interests of a firm and its

CEO is to have the CEO hold equity or options tobuy equity in the firm (Fama& Jensen, 1983; Jensen&Meckling, 1976). CEOswhoarealso shareholdersshould be more interested in decisions that maxi-mize the value of the firm than CEOs who are notalso shareholders. Several recent studies, how-ever, show that forcing CEOs to hold stock or com-pensating CEOswith stock options can sometimesexacerbate theagencyproblem(e.g.,Bergstresser&Philippon, 2006; Dalton, Daily, Certo, & Roengpitya,2003; Sanders & Hambrick, 2007; Wowak &Hambrick, 2010). Symptoms of increased agencycosts that havebeenassociatedwith these policiesinclude securities fraud (Denis, Hanouna, & Sarin,2006), timing of options grants (e.g., Lie, 2005), op-tions backdating (e.g., Heron & Lie, 2007), and op-tions repricing (e.g., Carter & Lynch, 2004).Monitoring—the other main mechanism used

to mitigate agency costs—can also be accom-plished in several ways. A board of directors, forexample, has a formal responsibility to monitorthe CEO. Agency theory logic suggests that theefficacy of this monitoring role depends, at leastin part, on the independence of board members(e.g., Walsh & Seward, 1990; Westphal, 1998).Corporate performance should be higher whena firm’s board is composed of outside directorswho neither are officers of the firm nor have sub-stantial linkages to the firm. The logic is that in-dependentoutsidedirectorswillbe less influenced

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by the CEO relative to inside or affiliated di-rectors who work for (or are) the CEO. Meta-analyses of this relationship, however, concludethat board independence does not consistentlyimprove firm performance (Dalton, Daily, Ellstrand,& Johnson, 1998; Dalton & Dalton, 2011). A reviewof the research empirically testing the effects onfirm performance of separating CEO and chairper-son roles shows that this, too, receives inconsis-tent support (Dalton et al., 2007). In a later sectionwe give examples of how the logic we developoffers potential explanations for these variedfindings.

This brief review suggests that key parts ofagency theory deserve further examination andrefinement. Dalton et al. conclude that “there ap-pear tobeseveremisspecificationsofkeyvariablesand a host of seemingly relevant, but unexamined,variables that may be obscuring the mitigation ofthe fundamental agency problem” (2007: 38).

Reactions and Responses

There are several possible reactions to thesometimes withering criticisms of agency theory(e.g., Bergstresser & Philippon, 2006; Dalton et al.,

2003; Sanders & Hambrick, 2007; Wowak &Hambrick, 2010). In this section we briefly ad-dress these reactions and place our proposed re-sponse in the context of this prior work, payingparticular attention to how bounded self-interestdiffers. The first question for critics of agencytheory is “Repair or replace?” One response hasbeen to suggest replacements for agency theoryusing entirely different assumptions across theboard.For example, stewardship theory (Davis,

Schoorman, & Donaldson, 1997) adopts more gen-erous assumptions of human motivation andbehavior and has proven influential. Despitesome affinities, there are two important differ-ences between our work here and stewardship.First, stewardship theory explicitly offers analternative to agency. Herewe hewmuch closerto the received literature on agency theory,proposing an option to repair rather than re-place it. Similarly, stewardship theory involveswholesale changes to several of the core assump-tions of agency theory (see Davis et al., 1997:Table1, andSundaramurthy& Lewis, 2003: Figure1).Most antithetically, it replaces the core agencytheory assumption of divergent interests. Davis

FIGURE 1Standard Agency Theory

Unitsof

value

Illustration

E(V)

E(V − C)

Firmperfor-mance if no agencyproblem

Un-mitigatedagencycost

Cost ofincentivealignmentmechanism

Expectedbenefit ofincentivealignmentmechanism

Cost ofmonitoringmechanism

Expectedbenefit ofmonitoringmechanism

Firmperfor-mance aftermitigatingagencyproblem

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et al. write, “Stewardship theory defines situa-tions in which managers are not motivated byindividual goals, but rather are stewards whosemotives are aligned with the objectives of theirprincipals” (1997: 21).

In other words, stewardship theory assumesaway the fundamental agency problem from theoutset.We do not.Wemaintain all of the standardagency theory assumptions, including that of di-vergent interests—“the cornerstone of agencytheory,” according to Hill and Jones (1992: 132).This allows us to stay in close touch with the vastcorpusof findings fromagency theoretic research.Thus, while sympathetic to the larger goal of ex-amining the potential complementarity of agencyand stewardship, our work represents a moremodest step in that direction, maintaining closercontact with extant agency theoretic work.

Others have responded to the critiques ofagency theory by proposing options for repairingrather than replacing. In “Problems of Explana-tion in Economic Sociology,” Granovetter (1992)analyzed the challenges of “oversocialized” and“undersocialized” theories. The latter, typified bythe assumptions of neoclassical economics andreflected in standard agency theory, do not showan appreciation of the social and psychologicalcomplexities of human actors. In response to thisundersocialization, scholars have introducednew behavioral insights and assumptions thatmight be applied to those theories.

We argue that attempts to bridge the “sociali-zation gap” in agency theory have leapt too far inthe direction of oversocialization. As Granovettersaidof anearlier generation, “Modern economistswho do attempt to take account of social in-fluences typically represent them in an over-socialized manner” (1992: 31). With the recentexplosion of research in the behavioral sciences,suchoversocializationhas renderedanagent thatis too complex for the sort of analysis historicallytypical of agency theory.

In another example, Van de Ven and Lifschitz(2013) propose “reasonable microfoundations”from the jurisprudential literature and behavioralsciences literature that help socialize our un-derstanding of economic organization. “Reason-ableness” provides a potentially useful umbrellaterm for including the growing mountain of re-search on human tendencies in social and eco-nomic interaction and is remarkable for its range,encompassing the behavioral theory of the firm,transaction cost economics, institutional theory,

and population ecology. This scope is also a dis-advantage in terms of depth and specificity.Indeed, Van de Ven and Lifschitz explicitlyacknowledge that theirs is only a sketch of thepossibilities. Even with an established jurispru-dential and philosophical history of usefulnessthat predates that of the rational economic man,“reasonableness” remains “less parsimoniousand elegant than its rational counterpart,” re-sulting inmodels forwhich “quantitative analysisis clearly challenging” (Van de Ven & Lifschitz,2013: 168). Using perceptions of fairness as a me-diating variable builds on this sketch whilemaintaining the tractability of standard agencytheory and the bulk of its elegance.Closer to the ideas presented here in terms of

specific application to agency theory, Cohen et al.found that “when individuals perceive an actionto be unfair, they are less likely to do so [take theaction] regardless of the potential payoff” (2007:1120).2 Their findings are provocative and sup-portive of bounded self-interest. Their study of anactor’s expressed willingness to act unfairly to-ward others on command, however, is somewhatdifferent from how agents (i.e., CEOs) will actwhen they perceive themselves as being unfairlytreated. Additionally, Cohen et al. address onlyunfairness, whereas our mediated model in-cludes the possibility of positive reciprocity inaddition to negative or resistant reactions. Evenwith these differences, the ideas are mutuallyreinforcing concerning the importance of percep-tions of fairness to agency theory.In sum, prior theorizing has tended toward

a replace rather than repair approach or has beenoverly broad in introducing prior social and psy-chological findings at the expense of specificityand parsimony. Using CEO perceptions of fair-ness as a mediating variable for measuring theeffectiveness of agency theoretic interventionsmaintains the closest contact with prior work inagency theory while offering a compelling, con-servative, tractable stepping-stone toward thesort of behavioral agency theory others haveproposed but that has so far not gained the sametraction as similar work in economics and fi-nance. This closer, more specific contact (both interms of logic and constructs) with agency theoryallows scholars to retain the compelling internallogicof the theorywhileproposinga reinterpretation

2 We thank an anonymous reviewer for pointing us to thisstudy.

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of some of the inconsistent findings (a project webegin below).

In the next section we distinguish betweennarrow self-interest and bounded self-interest.Our objective is to explore how adopting an as-sumption that actors’ self-interest is bounded bynorms of fairness—while maintaining the funda-mental agency logic—might lead to an explana-tion that more accurately captures the agencyphenomena of interest to scholars.

BOUNDED SELF-INTEREST

The assumption of narrowly self-interestedactors has contributed to numerous insightsexplaining complex behavior in a wide variety ofsettings—this we do not dispute but, rather, ap-plaud. However, in light of the sustained critiquereferencedabove (e.g.,Ghoshal, 2005;Miller, 1999;Schwartz, 1997;Wowak&Hambrick, 2010), as wellas recent empirical findings in social psychologyand behavioral economics and finance, we be-lieve its use as a foundational assumption ofagency theory merits reexamination.

Bounded self-interest provides a parsimoniousalternative assumption about the motivation ofeconomic actors. This assumption refers to well-established findings that actors’ efforts to maxi-mize their own utility are influenced by norms offairness. When actors perceive that a norm offairness has been violated, they will seek to en-force that norm in subsequent interactionswith the responsible party (Fong et al., 2010;Greenberg, 1990). For example, if an actor per-ceives that someone else has acted unfairly, he orshe will negatively reciprocate to preserve jus-tice. People are consistently willing to incur coststo enforce norms of fairness. The result is thatnegatively reciprocal behavior can be more hos-tile and punitive (e.g., vengeance) than thebehavior described by narrow self-interest or op-portunism (Fehr & Gӓchter, 2000; Henrich et al.,2010; Hoff, 2010). Note that even opportunisticallyself-interested actors will not incur personal costto punish others; this would be seen as irrationaland contrary to narrow self-interest. Negativereciprocity, as we explain below, can destroymore total value and social welfare thanopportunism.

Alternatively, if a boundedly self-interestedactor perceives that someone else has actedfairly, in excess of expectations, he or she willpositively reciprocate by rewarding the other

actor. Once again, this is (arguably) irrationalaccording to the standard assumption of narrowself-interest, notwithstanding its pervasiveness.Through positive reciprocity, the behavior de-scribed by bounded self-interest can generatebeneficial outcomes and additional social wel-fare unaccounted for by the assumption of narrowself-interest (e.g., Cialdini, 1984; Fong et al., 2010).Such reciprocal behavior is so common acrosstime and human cultures that Dunfee (2006) clas-sifies it as a “hypernorm.” Bounded self-interesteven extends beyond human beings (Clutton-Brock & Parker, 1995) to address important ques-tions in evolutionary biology (de Waal, 2009;Nowak, 2011).Negatively (or positively) reciprocal behavior is

a response to a perception of fairness that is less(more) than an actor’s expectation for fairness inthat setting. Actors’ expectations for fairness in-corporate at least two types of fairness: distribu-tive and procedural.Building on an extensive body of literature from

social psychology, Bosse et al. (2009) argued thatall economicactorsbase their reciprocal behavioron multiple types of fairness. Here we focus ontwo. The first type, distributive fairness, accountsfor the allocation of material outcomes in an ex-change (Deutsch, 1985). Both boundedly self-interested agents and principals want to receivethe maximum material outcome they can justifyas being fair according to distributional norms(Adams, 1965). They also want the other partyto receive a fair distribution of materialoutcomes—and they will sacrifice a portion oftheir own material outcomes, if necessary, tomake the other party’s portion fair. Reciprocally,they expect the other party to do the same, ifnecessary, to restore the balance of fairness intheir exchange. The material outcomes associ-ated with distributive fairness are related to thetypical components of utility captured in the nar-row self-interest assumption, such as materialeffort, rewards, and risk.A second type of fairness that boundedly self-

interested actors seek to enforce is proceduralfairness. Procedural fairness refers to an actor’sperception of the degree to which the decision-making process is fair. Actors typically evaluatethe fairness of decision processes based, for ex-ample, on the extent to which their opinions areconsidered in the process, the process is consis-tently executed, the information used in the pro-cess is accurate, and poor decisions resulting

282 AprilAcademy of Management Review

from the process can be amended (Colquitt,Conlon, Wesson, Porter, & Yee Ng, 2001).

Actors also assess and reassess their percep-tions of distributive and procedural fairness inrelation to one another (Colquitt et al., 2001). Lindand Tyler (1988) explained that people who per-ceive a material outcome that falls below theirexpectation for distributive justice can still posi-tively reciprocate when they simultaneouslyperceive procedural fairness that exceeds thenorm. Proposing exactly how any individualweighs these two types of justice is beyond thescope of this article, but following Bosse et al.(2009), we do suggest that a perceived deficiencyin one type of justice can sometimes be offset byjustice of the other type (Luo, 2007).

The assumption of bounded self-interest re-quires, in addition to an understanding of thetypes of fairness that actors evaluate, some basisfor comparing these types of fairness. Norms offairness establish expectations for what is fair.But not all actors in a given setting will apply thesame norm or arrive at the same expectation.Asymmetrical expectations of what is fair be-tween an agent and a principalmay arise. For ourpurposes we assume that CEOs form their ex-pectations of fairness from their boards of di-rectors by comparing their perceived ratio ofinputs toandoutcomes fromanexchangewith theinput/outcome ratios of other relevantly similarlysituated CEOs (see Adams, 1965; for importantrecent refinements see Conlon et al., 2004, andHayibor, 2012; for a review of studies on CEOs’equity-based comparisons of compensation fair-ness, see Wade, O’Reilly, & Pollock, 2006). Ifa CEO sees another CEO at a similar firm put inthe same effort but get a greater reward, the CEOwill perceive unfairness. She will act to correctthis perceived injustice by either lowering effort(input) to match her lower compensation ormaintaining level of effort and seeking greatercompensation (Greenberg, 1988). These expec-tations have both distributive and proceduralcomponents.

The reverse applies as well. If the CEO is re-ceiving more compensation than what she per-ceives as equitable—based on a comparisonwithother CEOs’ input/output ratios—she will act tocorrect this by either putting in greater effort tomatch the greater compensation or maintainingher level of effort and redistributing that portion ofher compensation that she deems is generousbeyond expectations (Greenberg, 1988). Equity (in

contrast, for example, with other bases of distri-bution, such as equality and need) provides theimplicit basis for most, if not all, of standardagency theory’s solutions; properly designed in-centive alignment and monitoring mechanismsare expected to assure the equitable distributionof inputs and benefits.The assumption of bounded self-interest rep-

resents a subtle but significant and empiricallywell-established change to one of agency theory’sstandard assumptions. Boundedly self-interestedactors are not solely concerned with maximizingtheir material outcomes the way narrowly self-interested actors are. Instead, these actors’ moti-vations include a combination of (1) a materialoutcome that is distributed fairly and (2) a pro-cedural component that is seen as fair (Harrison,Bosse, & Phillips, 2010). Recognizing these dif-ferent bases for evaluating fairness begins toanswer the vital question, “Howcanorganization-level policies and management practices be al-tered to improve the welfare of society?”3 In thenext section we apply the assumption of boundedself-interest to the agency problem setting anddevelop testable propositions that explicitly ac-commodate the behavioral assumption of boun-ded self-interest.

AGENCY THEORY AND BOUNDEDSELF-INTEREST

Agency theory has earned its place of promi-nence because it provides a parsimonious andclear explanation of a common problem found ineconomic organization. It also has been found toincompletely explain wide variance in empiricaltests. The collective empirical support for the ef-fects of incentive alignment (e.g., Dalton et al.,2003) and monitoring (e.g., Dalton et al., 1998) onperformance outcomes suggests that somethingelse (heretofore unidentified) is acting to mediatethe efficacy of these mechanisms. We maintainthat bounded self-interest provides just sucha mediator: the CEO’s perception of fairness.

Negative Reciprocity, Positive Reciprocity, andFirm Performance

Applying the bounded self-interest assump-tion does not eliminate either of the mandatory

3 This was a question asked in the call for papers for thisspecial topic forum.

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features of the agency problem: diverging in-terests and information asymmetry. Boards arestill challenged to enact governance thatmaximizes the firm’s outcomes by minimizingagency-related costs of certain CEO behav-iors. Although neither party is motivatedby intractable selfishness, a boundedly self-interested CEO does not always act in the bestinterests of the firm; bounded self-interest isstill self-interest. In fact, sometimes the firmwill incur greater agency costs in light ofbounded self-interest than it would under thenarrow self-interest assumption (Actual (V2 C),E(V 2 C)). A CEO who perceives that he is beingtreated unfairly can generate more costs for thefirm than conventionally expected under theassumption of opportunism because of irratio-nal costly punishment behaviors. This sort ofcounterproductive behavior is well documented inthe industrial-organizational psychology litera-ture (see Dalal, 2005). Figure 2 provides a com-parative illustration of negative reciprocitygenerating exacerbated agency costs in relationto the illustration in Figure 1. In this illustrationthe CEO negatively reciprocates because he

perceives that both incentive alignment andmonitoring mechanisms are unfair.At the other extreme, one outcome from

principal-agent exchanges that is unrecogniz-able using an assumption of narrow self-interestis the possibility that CEOs will put forth greaterthan expected effort or seek to reallocate morematerial value to the firm than otherwise ex-pected. Under the assumption of bounded self-interest, a CEO who perceives that the board hasexceeded the relevant norm of fairness in thepositive direction will positively reciprocate. Theresult of this positive reciprocation could be thatthe firm realizesmorevalue thanexpectedexante(Actual (V 2 C) . E(V 2 C)).We hold that CEOs are like all other employees

(i.e., humans) in that, under certain conditions, theycananddoperformextrabehaviors that benefit thefirm inwaysunanticipatedby rational, narrowself-interest. The fact that employees sometimes putforth greater effort than stipulated in their laboragreements isevident in several relevant literaturestreams. Wowak and Hambrick (2010) explainedthat the executive compensation literature regu-larly links pay arrangements to varying levels

FIGURE 2Negative Reciprocity and Exacerbated Agency Costs

Unitsof

value

Firmperfor-mance if no agencyproblem

Un-mitigatedagencycost

Cost ofincentivealignmentmechanism

Net costof unfairincentivealignmentmechanism

Cost ofmonitoringmechanism

Net costof unfairmonitoringmechanism

Firmperfor-mance aftermitigatingagencyproblem

Actual (V − C)

E(V − C)

E(V)

Negative reciprocity illustration

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of executive contribution (more on this in theDiscussion section). In industrial-organizationalpsychology, researchers have considered the ante-cedents and performance effects of organiza-tional citizenship behaviors (OCBs). According toBergeron, “These behaviors normally exceed theminimum role requirements of the job, they are noteasily enforceable, and performing them is usuallyat the discretion of the individual,” and they includesuchactivities as “volunteering for additional tasks,orienting new employees, offering to help othersaccomplish their work, and voluntarily doing morethan the job requires” (2007: 1078). Coyle-Shapiroet al. (2004) showed that perceptions of proceduraljustice are positively associated with OCB.

Labor economics studies also show thatwhenanemployer compensates an employee at a levelabove the employee’s reservation wage, the em-ployee positively reciprocates by putting forthgreater effort than expected or contracted (Akerlof,1982). Organizational justice researchers have alsonoted this phenomenon. Greenberg (1988), for ex-ample, found that managers boosted their perfor-mance when they were unexpectedly moved toa higher-status office. Figure 3 provides an illus-trationof the concept of positive reciprocity leading

to agency benefits. In this illustration the CEOpositively reciprocates because she perceives thatboth incentive alignment and monitoring mecha-nisms are fair beyond her expectations.In sum, this logic suggests that a CEO will

generate additional agency costs or benefits forthe firm if her net perception of the justice sheexperiences in her interactions with the board isbelow or above her expectation, respectively. ACEO’s perception of fairness partially mediatesthe effects of agency theoretic interventions ac-counting for a significant proportion of the vari-ance in firm performance that is associated withthe use of incentive alignment and monitoringmechanisms. In the next section we develop de-tailed propositions that explain how specifictypes of fairness are linked with the primarymechanisms prescribed by agency theory andhow they mediate the relationship between ef-fective mechanism use and firm performance.

Incentive Alignment, Perceptions of Justice, andFirm Performance

Agency theory, as described above, proposesthat boards counteract the effect of diverging

FIGURE 3Positive Reciprocity and Agency Benefits

Positive reciprocity illustration

Units

of

value

E(V)Actual (V − C)

E(V − C)

Firmperfor-mance if no agencyproblem

Un-mitigatedagencycost

Cost ofincentivealignmentmechanism

Net benefitof fairincentivealignmentmechanism

Cost ofmonitoringmechanism

Net benefitof fairmonitoringmechanism

Firmperfor-mance after mitigatingagencyproblem

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interests by structuring the contract in a way thataligns the CEO’s material interests with those ofthe firm. Material outcomes are assessed byboundedly self-interested CEOs against their ex-pectations for distributive justice. As explainedby Wiseman and Gomez-Mejia (1998: 138), align-ing incentives typically requires the compensa-tion committee of the board (1) to allocate theexecutive’s compensation scheme among fixedand variable components, (2) to design the vari-able (performance-based) component, (3) to seta performance target on which to base the vari-able component calculation, and (4) to selectmeasures for evaluating the performance. TheCEOmayperceiveall four of these components asmore or less fair than expected. For example,Fong et al. (2010) found that in public firms con-trolled by a dominant shareholder, CEOs whoperceive they are unfairly underpaid (distributiveinjustice) relative to other CEOs in similar condi-tions will negatively reciprocate by withdrawingfrom the firm or seeking to increase the size of thefirm (empire building), often at the expense of thefirm, in an effort to increase their own rewards.

Incentive alignment mechanisms can, alterna-tively, exceed the CEO’s expectation for distribu-tive fairness. For example, a CEO who recognizesthat an incentive alignment mechanismwill resultinpersonalwealthexceeding thatofherpeergroupwill be motivated to positively reciprocate. Fonget al. (2010) found that in public firms controlled bya dominant nonexecutive shareholder and in pub-lic firms in which the CEO is the dominant share-holder, CEOs who perceive they are overpaidrelative to other CEOs in similar conditions willpositively reciprocate in ways that increase firmprofitability. Thus, we propose the following.

Proposition 1: The CEO’s perception ofdistributive justice mediates the effectof an incentive alignment mechanismon firm performance.

Another facet of the perceived fairness of anincentive alignment mechanism is whether theexecutive has voice in the process through whichmaterial outcomes are allocated. CEOs comparethe process through which the compensationcommittee of the board designs incentive-basedcompensation policies and the process throughwhich the outcomes are determined against theirexpectation for procedural justice. When CEOsperceive that the process for establishingthe performance target for their variable

compensation is based on firms that are not sim-ilarly situated or constrained or is pegged tomeasures outside of the executive’s control, theymay reduce effort or even resort to duplicity inorder to realign their perceptions of fairness. Forexample, CEO pay can be aligned with the firm’sinterests through annual adjustments or long-term contingent mechanisms like stock options.Which approach is used, however, matters.Finkelstein and Hambrick (1996) concluded thatthe use of long-term contingent compensationplans does not improve firm performance, whileSanders (2001b) showed that the alternate choiceto align incentives via year-end pay adjustmentsdoes improve firm performance. Viewing thesefindings through the lens of bounded self-interestreveals a plausible explanation based on CEOs’perceptions of procedural fairness:CEOsprefer tohave their variable compensation decided byboard members with whom they can negotiate ordriven by accounting-based performance mea-sures that are more subject to their own control(althoughsometimes to thepoint of abuse through“managed earnings”) than market-based mea-sures (Wiseman & Gomez-Mejia, 1998).Incentive alignment processes perceived as fair

beyond expectations trigger positive reciprocityfrom executives. Thus, we propose the following.

Proposition 2: The CEO’s perception ofprocedural justice mediates the effectof an incentive alignment mechanismon firm performance.

Monitoring, Perceptions of Justice, andFirm Performance

The expected effect of monitoring in agencytheory is to make the CEO’s behavior more pro-ductive for the firm bymaking it more observable.To establish a monitoring mechanism, membersof the board (often those serving on the boardsubcommittees—more on this below) must (1) es-tablish criteria for evaluating the CEO’s behaviorand (2) assign a direct supervisor to observe andevaluate the CEO (Wiseman & Gomez-Mejia,1998). CEOs assess these activities and their im-plementation against their expectations for dis-tributive and procedural justice.Monitoring does not always make CEOs more

productive, however. Under the bounded self-interest assumption, CEOs respond positively ornegatively to the board’s monitoring based on

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a comparison between their expectations andtheir perceptions of fairness. For example, con-scientious executives who expect to experiencea drag on their productivity in order to complywith an excessively time-consuming or unneces-sarily bureaucratic boardmay require higher payto reestablish distributional justice. Hoskisson,Castleton, and Withers (2009) argued that moreintense monitoring mechanisms (such as boardindependence and separating the CEO fromboard chairperson duties) lead CEOs to demandhigher compensation, which, in turn, drives evenmore intense monitoring, and so on, in a cycle ofnegative complementarity. The cycle they de-scribe fits neatly into the logic of bounded self-interest—that is to say, when CEOs perceive theyare being treated unfairly, they exacerbate theagency problem by seeking to reestablish justice.

Under the bounded self-interest assumption,monitoring can also be perceived by CEOs asdistributionally fair beyond their expectations,thereby stimulating positive reciprocity. For ex-ample, aCEOmight credit theboard for observingand acknowledging beneficial behaviors thatwould otherwise go unnoticed and therefore un-rewarded. This would be recognized as an un-expected improvement in distributional outcomes.Thus, we propose the following.

Proposition 3: The CEO’s perception ofdistributional justice mediates the ef-fect of a monitoringmechanism on firmperformance.

The procedural justice of a monitoring mecha-nism is also evaluated by the CEO. CEOs whoperceive that the board is inaccurately capturingtheir true effort or contribution may conclude thatthemonitoringmechanism is procedurally unfair.For example, Zajac and Westphal (1994) showedmonitoring efficacy to be limited by decision-making complexity. It is likely that monitoring ina context of complex decision-making processesgives rise to greater ambiguity and asymmetry inexpectations and, hence, greater opportunity fordivergent expectations of fairness between theboard and CEO.

A CEO might find that a certain monitoringmechanism makes the related decision-makingprocesses fairer thanexpectedbecause it improvesthe quality of information on which decisions arebased. For example, the CEOwho is invited to alsoassume the board chair position where these tworoleshavehistoricallybeenseparatemightsee this

as a procedural sign of confidence. Conversely, thethreat to CEO recruiting from micromanaginghedge fund–selected boards has been used asa rationale against takeovers (e.g., Darden Res-taurants used this rationale in arguing againstStarboard Value in 2014). A board that eschews“micromonitoring”maybe perceived as fairer thanexpected by a CEO steeped in standard agencytheory’s prescriptions for limiteddiscretion (Shen&Cho, 2005). If theCEOearnswider praise or respectbecause of themonitor’s findings, the perception ofadditional fairness could beapositive influenceonhis or her effort.In proposing solutions to the cycle of negative

complementarity uncovered in their study,Hoskisson et al. (2009) suggested that boards(e.g., the audit committee) and CEOs might co-operate on thedesignof themonitoringmechanismso that both parties can establish trust in eachother. In another study Westphal (1999) found thatCEOs and board members cooperate more—andgenerateperformancegains—whentheyhavemoresocial ties binding them together. This is seeminglycontrary to the board independence hypothesis ofagency theory. We speculate that if a CEO’s per-ceptions of procedural fairness were measured, fa-vorable perceptions of fairness likely wouldstimulate positive reciprocity and, ultimately,agency benefits. Thus, we propose the following.

Proposition 4: The CEO’s perception ofprocedural justice mediates the effectof a monitoring mechanism on firmperformance.

In sum, Figure 4 illustrates the partiallymediatedmodel proposed here. A board uses incentivealignmentandmonitoringmechanisms to influenceand guide the CEO’s behavior. The CEO’s percep-tions of how fair those mechanisms are in terms ofbothdistributiveandprocedural justicemotivate theCEO to reciprocate in ways that partially mediatetheeffect of thosemechanismson firmperformance.There is no reason to believe that the effect sizesamong the fourmediatorswill be equal. SometimesCEOs negatively reciprocate, which negatively af-fects firm performance, all else being equal, andsometimes they positively reciprocate, which posi-tively affects firm performance.

DISCUSSION

To this point, simplicity and parsimony havebeen the touchstones for the description of agency

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theory with bounded self-interest. This is not tosay, however, that there are not complexities thatboth underlie and result from this modest adjust-ment of assumptions. Below we elaborate onsome of these complexities.

Bases of Comparison

For agency theoretic and scientific predictionpurposes, the ideal would be an objective ex antemetric of fairness. Using suchameasure, scholarsand practitioners could simply include distancefrom the ideally fair distribution as an additionalconsideration that could then be included in anoptimization function, along with other agencycosts and the costs of theirmitigation (i.e., incentivealignment and monitoring), and subsequentlyeconomized. Or, with knowledge of the inde-pendently just outcome in hand, a procedurecould be determined that would lead to thatresult—what Rawls (1971) calls “perfect pro-cedural justice.” However, both what counts asa fair distribution and the costs this will createare a function of the perceptions and expecta-tions of the parties to the joint effort.

This same challenge has bedeviled the as-sumption of narrow self-interest for economists.Attempts to include other-regarding interestsas part of a self-interested utility functionhave resulted in rhetorical combinations ofself-contradiction and tautology in turns. One re-sponse has been to assume that whatever an ac-tor does must have resulted from self-interest

(very broadly defined). This rather tightly circularreasoning (people act from their narrow self-interest, but this narrow self-interest can includeanything that interests a “self,” ergowhatever theself does must have been self-interested, QED)means that it is empirically impossible to observeanaction thatwas not self-interested. Rather thanengage in such rhetorical gymnastics concern-ing ideals of fairness, we must be content inthe knowledge that fairness is perceptual andintersubjective.Fairness, like beauty, is in the eye of the be-

holder. All that is required for positive and nega-tive reciprocity to alter agency theoretic predictionsis that the agent perceives an (un)fair distribu-tion. Generally speaking, such perceptions arenot derived from an a priori ideal of what is de-served (cf. Rawls, 1971) but result, rather, fromexpectations created by observations. Agents’expectations are affected by, among otherthings, their perceptions of contributions to thejoint effort and compensation of comparableothers, experiences in prior exchanges withthe principal, experiences in exchanges withother principals, experiences serving as princi-pals themselves, knowledge of other agents’ ex-periences in exchanges with the principal(i.e., reputation), beliefs about the operative ba-sis for fairness, and so forth. In short, fairnessperceptions are intersubjective. Because fair-ness is perceptual and intersubjective—that is,because there is no ideal, formal, or objectivebasis for what actors will consider fair—we refer

FIGURE 4Agency Theory Partially Mediated by the CEO’s Perceptions of Justice

Use of agency theory

mechanisms

Incentive

alignment

P1

P2

P3

P4

Monitoring

CEO’s perceptions

of justice

Distributive

justice

Procedural justice

Firm

performance

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to expected levels of fairness. Because they areintersubjective, fairness and equity perceptionsare unavoidably comparative concepts. Thisraises questions concerninghowCEOsestablishtheir bases of comparison.

Standard agency theory simplifies much aboutthe role of the board and the relationship betweenthe board and CEO. The board is, for some, theultimate monitoring mechanism. The board alsoplays a role in incentive alignment; however, animportant link in the chain of decision makingabout executive compensation is the role playedby the compensation committee of the board. Thiscommittee, in turn, is typically advised by com-pensation consultants who conduct salary sur-veys of “comparable” executives. This processplays a pivotal role in setting CEO expectationsandsubsequentperceptionsof fairness.While thelatter (the advice of compensation consultants) isexplicitly comparative, the former (the compen-sation committee of theboard) also invokes equityconsiderations.

O’Reilly, Main, and Crystal (1988) relied on so-cial comparison theory (anolderandbroader termfor the sorts of social psychological consider-ations discussed here) to reveal a relationshipbetween the compensation levels of CEOs andthat of the members of the compensation com-mittee of the firm’s board. This (among other fac-tors) creates expectations on the part of the CEOthat will then serve as the basis for fairnessevaluations. What is considered fair compensa-tion among large-corporation CEOs raises eye-brows in nearly every other sector of society.While it may be difficult to accept that CEOs aretreated unfairly as a group, the perception offairness that matters here is the one held by a fo-cal CEO. And his or her perception is likely in-formed by the input/outcome ratios he/sheobserves among other relevantly similar CEOs,including members of the board and the com-pensation committee.

ThesecondconsiderationconcerningCEObasesof comparison is temporal.What is the durability ofexpectations? While the wider evidence for nega-tive and positive reciprocity as reactions to per-ceptions of fairness is overwhelming, one mightwonder about the durability of these effects in theagency setting. Studies of the “hedonic treadmill”(Brickman & Campbell, 1971; Diener, Lucas, &Scollon, 2006) indicate that people react to bothnegative and positive life events by reverting tothat level of happiness felt prior to the event. There

may be a similar baseline level of perceived fair-ness that will influence future perceptions offairness—hence the effects of bounded self-interest—over time. Will negatively or positivelyreciprocal effects diminishor intensify over timeasonce novel situations become normalized? Does“more than expected” become “expected,” witha concomitant diminution of additional effort? Dofeelings of negative reciprocity (e.g., vengeance)normalize or intensify over time? Will other psy-chological tendencies (e.g., self-serving bias, attri-bution error) mitigate or confound expectations?These effects and others on agency theoreticmechanisms and interventions become quite trac-table using the lens of bounded self-interest.

Assumptions Regarding CEO Effort andFirm Performance

One unstated assumption of agency theory thatis, arguably, intensified in importance when in-voking bounded self-interest is that there is a sig-nificant positive relationship between CEO effortand firm performance. We are sensitive to thecontroversial natureof thisassumption. Somehavesuggested that executives actuallymake very little(positive) difference in firmperformance, subject asthey are to the controlling powers of environmentalforces, external stakeholders, and, notably, theirown self-interest (for recent discussions see Phillips,Berman, Elms, & Johnson-Cramer, 2010, and Shen &Cho, 2005). Shen and Cho (2005) characterized man-agerial discretion specifically in agency theory aslargely harmful to firm performance because of thenarrow self-interested opportunism critiqued here.For our current purposes we assume that CEOs areable, in fact, to affect firm performance—potentiallyfor the better.Along similar lines, we also assume that

greater effort towardachieving firmgoals leads tobetter firm performance. Again, this connectionis itself mediated by such things as ability,4

4 The relationship between and among effort, ability, andfairness is a complicated oneandone thatmay create frequentdisagreements between agents and principals. How muchreward is due to someone who presides over times of broadereconomic growth compared to anotherwho is able tominimizelosses during a downturn implicates different ideas of skilland effort andwhat rewards are due to each. Similarly, we seeexamples where an executive is given a retention bonus toprevent his or her departure froma failing company—a failureover which the executive presided. Such complications areamong the reasons we emphasize perceptions of justice.

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a common mutual understanding of the goals ofthe firm, the ability to measure performance in anaccurate, valid manner, and so on. Again, for thesake of simplicity, we assume that effort typicallyleads to desired, agreed upon, and measurableresults, other things being equal, and vice versa(i.e., lower effort leads to lower performance).

Finally, we assume that, for the most part,achievement of firm goals is beneficial for socialwelfare. This is perhaps the most controversial ofour assumptions. Critiques of for-profit businesssimpliciter are legion (e.g., Bakan, 2005, who ar-gues that the modern corporation itself exhibitsall of the clinical definitions of psychopathy). Weassumehere that in awell-ordered, relatively freesociety (Rawls, 1971), characterized by a function-ing and generally democratically established le-gal system,most of the goals of most corporationsat least do not harm social welfare. We furtherassume that most corporations are a reflection ofthe basic human rights of free association andproperty and that they produce goods and ser-vices that are generally consistent with the ag-gregate desires of those affected by them. Again,although controversial, a critique of this as-sumption is beyond the bounds of the currentstudy.

Summarizing the assumptions about the chainof logic from CEO performance to social welfare,(a) managersmatter, (b) level of managerial effortvaries, (c) level of effort affects firm performance,and (d) better firm performance increases socialwelfare. If any one of these assumptions is false,this will represent additional limitations.We turnnow to a more general discussion of how a betterunderstanding of bounded self-interest improvessocial welfare.

Bounded Self-Interest and Social Welfare

Aggregate social welfare is improved throughthe division of labor and through specializationof the sort engaged in by agents and principals.Much of agency theory concerns how the spoilsof this joint production are allocated, rather thanhow much is created (Blair & Stout, 1999). Theseaggregate social gains are, in turn, diminishedin the amount of the costs of enforcing particulardistributions. Strictly speaking, total welfare isnot destroyed by narrowly self-interested be-havior itself; value is merely reallocated—fromprincipal to agent, or vice versa. Changesin aggregate social welfare arise from the

deployment of assets in service of this realloca-tion and in the efficiency of the mechanismsused for this task. First and foremost, a betterunderstanding of these mechanisms and thebounded self-interest underlying them will ren-der their functioning more efficient and, hence,less costly.Additionally, with an understanding of positive

reciprocity and the chain of reasoning suggestingthat CEO effort improves performance, incentivealignment and monitoring mechanisms have thepotential to improve aggregate social welfare bycreating agency benefits as well as agency costs.Conversely, and perhaps more enduringly, theloss of social welfare where perceptions of un-fairness prevail can be much more severe andmay even include actual destruction of value.Negative reciprocity includes accounting for ir-rational, non-self-interested, “costly punishment”(revenge) behaviors. Revenge for perceivedunfairtreatment at cost to the agent is irrational and soassumedawayby narrow self-interest. Not only issuchcostly revengebehavior commonly observedbilaterally but often others will act to punish thirdparties for perceived violations of fairness (Fehr &Gӓchter, 2000).This is not amere reallocation of social welfare

but, rather, an actual destruction of value from themoment an agent expends resources to avengea perceived injustice against him/herself orothers to the time when the principal’s welfare isdamaged by this expenditure. In sum, the widelyobserved destruction of social welfare in re-sponse to perceived unfairness is not only un-accounted for under the assumption of narrowself-interest but is, in fact, assumed away be-cause of its irrationality. Inclusion of boundedself-interest recognizes this prospect and allowsfor its inclusion in cost-economizing efforts.Finally, perhaps the most compelling way that

moving from narrow to bounded self-interest inagency theory advances the cause of social wel-fare is by—theoretically and practically—simplygetting out of our own way. The self-fulfilling na-ture of assuming narrow self-interest is wellestablished. And efforts to untie the Gordian knotof social welfare in aworld of narrow self-interestare legion, occasionally even heroic. Our ap-proach is simply getting out of our own way.Much of the obstacle to greater efficiency, re-duced agency costs, and improved aggregatesocial welfare is of our own creation. Ceasing tobe overly concerned about narrow self-interest

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could reduce the cost of trying to prevent itsmanifestations.

We should recall also the self-fulfilling ten-dencies of assuming narrow self-interest. CEOswho have internalized the assumption that ev-eryone always acts in their own narrow self-interest will be more likely to commit fraud andmore vigorously game compensation systemsbecause of a belief that others are acting inprecisely this way in implementing these verysystems.

Agency theory, standard or with bounded self-interest, is not about completelyeliminating fraudor the gaming of compensation systems. It isabout economizing on the total costs of agencylossesand themechanismsdesigned to eliminatethem. To the extent that fairness-sensitive agencyinterventions are more effective than those thatignore these perceptions, total costs to principalsare reduced.

Probable Effects of Bounded Self-Interest on PriorEmpirical Studies

Bounded self-interest provides a compellingexplanation for recent findings that challenge thelogic of standardagency theory.While itwouldbeimpossible to profile how this new logic wouldsupport all of theprior empirical studiesof agencytheory had they measured the construct “CEO’sperceptions of distributive [or procedural] fair-ness,”weprovide selected exampleshere for bothincentive alignment and monitoring studies.

Incentive alignment mechanisms sometimesprompt CEO behavior that hurts firms’ fiduciaryinterests. Harris and Bromily (2007) found thatCEOs who are compensated with more stock op-tions and whose firms are performing below theirpeers are significantly more likely to mis-represent their firms’ financial position. Mis-representations lead to restatements, andrestatements linked to aggressive accountingpractices precede an average decline in marketvalue of 18 percent (General Accounting Office,2003). Zhang, Bartol, Smith, Pfarrer, and Khanin(2008) similarly found that CEOs possessingmorestock options are the most likely to manipulateearnings when their firms are performing rela-tively poorly (resulting in more out-of-the-moneyoptions). Viewed through the lens of bounded self-interest, these situations likely include CEOswhose perception of distributive justice is lowcompared to what their peer CEOs receive. This

raises the likelihood of increased agency costs(e.g., accounting manipulation) in our model. If ineither of these studies the researchers had mea-sured either or both types of CEO perceived jus-tice, we expect this would have mediated therelationship between the incentive alignmentmechanism and the firm’s performance, thusadding to the explanatory power of our revisedagency theory.One might also see fraud and options gaming

as perfectly consistent with standard agencytheory and narrow self-interest. The question weraise is “Can agency theory with bounded self-interest do a better job of mitigating agencyproblemsandeconomizingon the total costs to theprincipal, thereby improving aggregate socialwelfare?” For example, to what extent is fraudpartially justified or rationalized in the agent’smind by perceptions of unfairness? Could stockoptions be more effective at interest alignmentand agency cost reduction if accompanied by anawareness of the mediating role of fairness intheir evaluation by agents? The fact that optionsdid not have the intended effect is evidence someimportant element is missing from standardagency theory.Narrow self-interest also struggles to explain

repricing options as amatter ofmonitoring. It wasthe board that approved such repricing. As thepractice became more and more common (asevidenced by the transparency of its use), it ulti-mately became a matter of equity between CEOsof different firms. We would anticipate that per-ceptions of fairness played a role in justifying thedecision to reprice.Looking further at monitoring, separation of the

roles of CEO and board chair is among the morecommonly researched CEO monitoring mecha-nisms. Standard agency theory logic suggeststhat firms underperform when the board assignsthe CEO and board chair roles to the same person(CEO duality), because an agent cannot effec-tively monitor him/herself. A popular counterar-gument is that CEO duality provides unity ofcommand that supports stronger leadership(Fayol, 1949). Dalton et al. (1998, 2007), however,reported that there is insufficient support in theempirical literature for a negative relationship(agency theory) or positive relationship (unityof command) between CEO duality and firmperformance.Recent research in which scholars looked more

closely at the process of separating these roles

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provides insight about the potential for findingthe mediating role of CEO perceptions of fairnessin agency theory. One alternative when separat-ing theCEOand board chair is to keep the currentperson in theCEO role and appoint a new chair tooversee the CEO. Krause and Semadeni (2013)refer to this as a demotion separation and showthat when the CEO of a high-performing Fortune1000 firm is demoted this way, firm performancedecreases about 42 percent the next year. Theopposite separation process, where the personremains chair and a new person is brought in asan apprentice CEO, has no such performanceimpact. We suggest that a high-performingCEO who is forced out of the chair role throughdemotion is likely to perceive a procedural in-justice that violates his or her expectation of howdecisions would get made and therefore is likelyto negatively reciprocate, resulting in lower firmperformance. Alternatively, the chair who is pro-vided an apprentice CEO is not as likely to per-ceive an injustice.

Limitations

Wehaveused the context ofCEOcompensationas our sample case because it is among the mostfrequently addressed in studies of agency theory.However, not all of the findings used to motivatethis theorizing are taken from this context. Theagency theoretic studies we examined concernCEOs, but those about fairnessmore generally donot (indeed, this is among our contributions here).We have suggested that concerns with fairnessare widely generalizable to human behavior. Ithas been suggested,5 however, that the context ofCEO compensation may be unlike others. It is aninteresting, provocative, and somewhat troublingsuggestion. Is there reason to believe that CEOsor boards care less about fairness than the gen-eral population? Some have even suggested thatthe population of CEOs may contain a higherproportion of clinical psychopaths (Babiak &Hare, 2006; Ronson, 2011) than the general pop-ulation.Wedonot report this to be trite, and, to ourknowledge, there are insufficient credible data toback up this speculation. But if CEOs are, in fact,more likely to be clinically psychopathic, wewould expect fairness concerns to play a lesser

role in the context described here. This representsa potential limitation of the theory.Another possible limitation is that perceptions

of unfairness may merely correlate with in-creased agency costs (e.g., fraud and optionsmanipulation), rather than cause them. That is, itmay be that CEOs feel a cognitive need to ratio-nalize their behavior through some socially jus-tifiable norm such as fairness. Future researchcould analyze this question with an eye towardestablishing causality. Depending on those find-ings, asameans to improvingsocialwelfare, suchrationalization could be usedasa lever for criticalevaluation of CEO compensation. In other words,if narrow self-interest is a self-fulfilling assump-tion, could bounded self-interest prompt greaterawareness of justice considerations?There are numerous sources of additional

complexity that we intentionally ignored here forthe sake of simplicity and theoretical parsimony.These also represent potential limitations.Among them are varieties of equity structure,culturally disparate reactions to perceived un-fairness, and gender differences in such re-actions. Regarding equity structure, researchershave examined deviations from standard theorybased on whether a firm is closely held, familyowned, or has a dominant shareholder, amongothers. Such deviations may also mitigate thesimplicity of the model.Similarly, there may also be cross-cultural dif-

ferences in the intensity of reactions to injusticeand violations of reciprocity (Nisbett & Cohen,1996). While every culture has norms of fairnessand reciprocity, how powerfully they are enforcedmay present a limitation on the strength of medi-ation. This may manifest specifically in thestructure and interactions of international sys-tems of corporate governance. There may also begender effects on the parts of both board andCEOthat influence the strength of the mediatingeffects.While the role of the agent is generally more

important than that of the principal in de-termining firm performance, the principal’s ex-pectations of fairnesshavebeenunderemphasizedhere. The bounded self-interest assumption ap-plies to all actors, as part of a complex system ofinteractions, not just to agents. The modificationsto agency theory proposed here align with theview of firms as systems of complementary ar-rangements that serve to mitigate conflicts(Holmstrom & Milgrom, 1994).

5 By, among others, an anonymous reviewer of thismanuscript.

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Finally, the literature on the psychology of fair-ness and justice has grown quite extensively inrecent years, including attention to two newforms—interactional and informational—and pres-ents nuancewell beyond themodel presented here.Wewould expect this additional nuance to becomebetter integrated over time as these finding areconsolidated in ways that permit the sort of sim-plicity agency theory has historically demanded.

Future Research

Milton Friedman famously claimed that

the relevant question to ask about the “assump-tions” of a theory is not whether they are de-scriptively “realistic,” for they never are, butwhether they are sufficiently good approximationsfor the purpose in hand. And this question can beansweredonlyby seeingwhether the theoryworks,which means whether it yields sufficiently accu-rate predictions (1966: 15).

Contrariwise, Tsang (2006) argued that the be-havioral assumptions underlying strategy theo-ries can be—in fact, need to be—tested forempirical accuracy (cf. Lam, 2010). Tsang’s (2006)argument applied to agency theory is thatscholars need to explain and test how incentivealignment and monitoring actually changeagents’ behavior. It is not enough to test agencytheory by measuring the presence of thesemechanisms and regressing them on firm perfor-mance, because the theory hinges on theassumption that agents are exclusively self-regarding in all situations. Our arguments—thatagents are boundedly self-interested—imply thatfuture empirical studies of agency phenomenamight effectively borrow research methods fromstudies in labor economics, organizational jus-tice, and corporate governance (e.g., Fong et al.,2010; Wade et al., 2006) to measure the mediatingeffects of CEOs’ perceptions of fairness.

Following Cohen et al. (2007), an interestingextension of bounded self-interest would be anexamination of CEOs’ willingness to execute or-ders perceived as ex ante unfair. Using the termsderived here, would CEOs require additional in-centives or monitoring to assure execution of or-ders perceived as unfair? Would additionaldissonance arise for CEOs in executing such or-ders, and how might this manifest?

Thus far, the discussion of replacing narrowself-interest with bounded self-interest has beenlargely analytical in nature. That is, we propose

ways in which empirical findings about firm per-formance could be made more robust with theaddition of a mediating variable. However, thisanalysis has some reasonably clear prescriptiveimplications as well.As a matter of instrumental (if/then) pre-

scription, there are implications of fairness me-diation on questions of corporate governance.While incentive alignment and monitoring re-main the key mechanisms for addressing agencyproblems, the content of these mechanisms willbe significantly affected by the new assumption.In short, if boards wish to improve the chances ofsuccess of their incentive alignment and moni-toring, they would be well-advised to considerhow these mechanisms will be received and per-ceived by their CEO.As a matter of normative (moral) prescription,

fairness has received extensive and sustainedattention in the corporate social responsibilityliterature and stakeholder literature (Aguilera,Rupp,Williams,&Ganapathi, 2007; Phillips, 2003).There have also been increasing calls to betterassimilate agency theory with these bodies ofliterature, including some successful and in-fluential ones (e.g., Hill & Jones, 1992). These callshave prompted Dalton et al. to write:

In addition, we readily concede that one mightproperly regard agency theory and its mitiga-tions as a subset of broader literatures (e.g., cor-porate social responsibility, shareholder valuemaximization/stakeholder theory, stewardship).We also accept the responsibility for our perhapsoverly targeted focus on that subset. On that point,however, both the dominance of agency theoryas a theoretical perspective over the last approxi-mately 70 years and the extensive researchgrounded in its tenets have guided us. Even so,there are common attributes of agency theory andits mitigations and the broader lens of corporatesocial responsibility that are notable. With each,the empirical evidence is unconvincing, the de-bates concerning the adequacy of empirical pro-tocols continue, and the search for moderators/mediators is unabated (2007: 35).

While maintaining a similar “perhaps overlytargeted focus,” we are optimistic about theprospects for a theoretical joining of forces amongperspectives such as agency theory, corporatesocial responsibility, and stakeholder theory, withbounded self-interest providing a keystone in thisconceptual bridge.After the initial propositions of the new theory

are tested in several settings, scholars mightexamine possible interactions between the two

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types of justice used here or expand the exami-nation to additional dimensions of justice thatmight be perceived by CEOs, such as inter-personal and informational justice. Following thedirection taken in the organizational justice liter-ature, the targets of CEOs’ reciprocative behav-iors might be examined, with possibilitiesincluding someperson (e.g., a boardmember) anda collective as a whole (e.g., the firm). Finally, fu-ture studies might test the influence of other topexecutives’ pay on the expectations of CEOs(Wright, Kroll, Lado, & Elenkov, 2005).

CONCLUSION

In the same essay quoted above, Milton Fried-man went on to write:

As we have seen, criticism of this type is largelybeside the point unless supplemented by evidencethat a hypothesis differing in one or another ofthese respects from the theory being criticizedyields better predictions for as wide a range ofphenomena. Yet most such criticism is not so sup-plemented; it is based almost entirely on suppos-edly directly perceived discrepancies between the“assumptions” and the “real world” (1966: 31).

Past critiques of agency theory (and economicsmore generally) have tended to criticize in-accurate assumptions without considering im-portant questions of parsimony or proposingsuperior alternatives. Our contribution navigatesthe narrow (but growing) space between realismand parsimony. Agency theorywith bounded self-interest renders more accurate predictions of theeffects of agency theoretic interventions whilecontinuing to make those predictions scientifi-cally and mathematically manageable.

Bolstered by an overwhelming tide of evidencefrom a variety of disciplines, we argue that thebounded self-interest assumption provides amore accurate lens for explaining the ubiquitousagency problem among firms and their CEOsthan the pure self-interest assumption, and it isbothparsimoniousandgeneral enough toprovidemore accurate predictions. Our logic suggeststhat treating CEOs unfairly can produce costlyoutcomes that have, until now, been under-anticipated in agency theory. Perhaps more sur-prising, the agency benefits we define that resultfrom treating CEOs in ways they perceive as ex-ceptionally fair, beyond their expectations, are anentire category of outcomes that standard agencytheory has not, until now, explained.

The call for papers for this special topic forumasked, “Have applications of agency theory ledto improvements in social welfare? Or can theo-ries based on less pessimistic assumptionsabout human behavior—that is, other thanopportunism—help us develop theory better ableto advance social welfare?” By ignoring costly re-venge behaviors and the potential for agencybenefits, agency theory’s assumption of narrowself-interest not only miscalculates social welfarebut may, in fact, reduce it through normativelyprescribing6 practices and arrangements that mo-tivate social welfare–reducing behaviors. More-over, and more constructively, if boards and thoseadvising them and negotiating on their behalfconsider the positive effects of unexpected fairness,they canstructure relationshipswith topexecutivesso as to take advantage of agency benefits andminimize unfairness-related agency costs.Making the assumption of bounded self-

interest a part of agency theory provides some-thing Ghoshal (2005) sought—an optimisticassumption about human behavior (positivereciprocity) that simultaneously allows for theseemingly untoward behavior we know exists(negative reciprocity; see also, Lubatkin, Ling, &Schulze, 2007).The modest reconceptualization envisioned

here might ultimately help to break the patternthrough which the use of the pure self-interestassumption in management theories stimu-lates purely self-interested behavior in firms(e.g., Miller, 1999). Our logic assumes that allagents are not purely self-interested actors de-termined tograba larger slice of pieat theexpenseof all principals. Some agents might act in a waythat leads principals to think this only because theprincipals are unaware of the unfairness theyunwittingly impose on the agents. As Andrewswrote, “Personal values, aspirations, and idealsdo, and in our judgment quite properly should,influence the final choice of purposes. Thus, whatthe people in a company want to do must bebrought into the strategic decision” (1987: 19).The combination of ceasing pessimistic, un-

flattering, psychologically unrealistic, and self-fulfilling assumptions about human behavior andreplacing them with more optimistic, realistic, aspi-rational, and scientifically founded assumptions

6 As Donaldson points out, “What is notably different aboutagency theory, in contrast to TCE, is its unabashed use of ex-plicitly normative language from the outset” (2012: 262).

294 AprilAcademy of Management Review

creates space for business to become the socialwelfare–maximizinginstitution it iscapableofbeing.

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Douglas A. Bosse (dbosse@richmond.edu) is an associate professor of strategic man-agement at theUniversity of Richmond’s Robins School of Business. He receivedhis Ph.D.from The Ohio State University’s Fisher College of Business. His current researchexamines how firms manage key stakeholder relationships to improve firm-levelperformance.

RobertA.Phillips (rphilli3@richmond.edu) isprofessorofmanagementat theUniversityofRichmond’s Robins School of Business and has a joint appointment with the program inphilosophy, politics, economics, and law. He received his Ph.D. from the University ofVirginia’s Darden School. His research interests include stakeholder theory and organi-zational ethics.

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