Vol. 5, No. 2, 5-18 
doi:10.17708/DRMJ.2016.v05n02a01 
 
 Dynamic Relationships Management Journal, Vol. 5, No. 2, November 2016 5 
 
 LOOKING AT HRM THROUGH THE LENS OF AGENCY THEORY – 
ARE SUBOPTIMAL HRM PRACTICES A CONSEQUENCE OF MORAL 
HAZARD? 
 
 
Nina Pološki Vokić 
 
Faculty of Economics and Business, University of Zagreb 
Trg J. F. Kennedyja 6, 10 000 Zagreb Croatia 
npoloski@efzg.hr 
 
 
Abstract 
 
The aim of the paper is to provide theoretical evidence that agency problems do exist and could cause 
under-performance in the HRM area, but as well to systematize and elaborate HRM control systems 
which reduce agents’ moral hazard in general, and especially when making HRM decisions. A substantial 
quantity of the literature indirectly connected to the field, as focused literature on the agency theory 
implications for HRM so far is scarce, is analysed. The organisation of the existing knowledge in the 
following areas is provided: (1) introduction to agency problem and moral hazard, (2) agency problems 
related to managing employees, (3) HRM control mechanisms for managing agents, and (4) HRM control 
mechanisms for reducing agents’ suboptimal HRM decisions. 
 
Keywords: human resource management (HRM), agency theory, agency problem, moral hazard,  
HRM decisions, HRM control mechanisms 
 
 
 
 
1. INTRODUCTION  
 
Agency theory has been used by scholars 
mostly in corporate governance, economics, 
and finance (Eisenhardt, 1989; Gomez-Mejia 
& Balkin, 1992; Lan & Heracleous, 2010), but 
as well in accounting, marketing, 
organizational behaviour, human resource 
management (HRM), family business, 
political science, and sociology (Caza, 2011; 
De Kok, Uhlaner & Thurik, 2006; Eisenhardt, 
1989). Although it has been recognized as a 
potentially valuable perspective for HRM 
research, it has received little attention in 
the strategic HRM literature (Caza, 2011; 
Krausert, 2014). Moreover, the agency 
theory has been criticized because its overly 
simplistic assumptions do not reflect the  
 
 
real-world business environment, and 
because empirical research has failed to 
support its basic tenets (Miles, 2012), but it 
was found to support HRM-related practices 
in contemporary organizations (Welbourne 
& Cry, 1996). 
Nevertheless, HRM studies were 
predominantly focused on agency theory 
implications related to agents’ compensation 
(remuneration schemes, incentives and 
stock sharing). Only sporadic studies dealing 
with other HRM issues concerning agents 
can be found, such as selection (e.g. Yu & To, 
2011) or subsidiary staffing (e.g. Gong, 2003; 
Harvey, Speier & Novecevic, 2001).  
Nina Pološki Vokić: Looking at HRM through the Lens of Agency Theory – Are Suboptimal HRM Practices a Consequence of 
Moral Hazard? 
  
 Dynamic Relationships Management Journal, Vol. 5, No. 2, November 2016 6 
However, agency problems related to HRM 
are not only those considering agents. 
Principal-agent issues facing firms occur as 
well when agents do not encourage or adopt 
best HRM practices, despite the fact that 
proficient HRM practices contribute to 
organizational performance by improving 
productivity, financial performance, social 
outcomes, and reducing turnover (Arthur, 
1994; Collins & Clark, 2003; Huselid, 1995; 
Ichniowski, Shaw & Prennushi, 1997), which 
is obviously a first principals’ goal. 
HRM decisions that serve managers’ own 
interests and not the interest of the principal 
are many. Some agents are not excited 
about implementing high performance HRM 
practices, as those practices require 
considerable budgets but impact the 
company performance only in the long run. 
Agents could as well be interested in 
securing private benefits though employing 
people from their personal social networks 
instead of best candidates, or in recruiting 
unproductive subordinates to protect their 
positions and career prospects. As well, in 
order to favour their devotees, many 
demonstrate favouritism in performance 
evaluation or promotion decisions, as well as 
non-transparency when rewarding and 
deciding on additional training and 
development (T&D). 
The aim of the paper is to provide 
theoretical evidence that agency problems 
do exist and could cause under-performance 
in the HRM area, but as well to systematize 
and elaborate HRM control systems which 
reduce agents’ moral hazard in general, and 
especially when making HRM decisions. A 
substantial quantity of the literature 
indirectly connected to the field, as focused 
literature on the agency theory implications 
for HRM so far is scarce, is analysed. In the 
following sections the organisation of the 
existing knowledge in the following areas is 
provided: (1) introduction to agency 
problem and moral hazard, (2) agency 
problems related to managing employees, 
(3) HRM control mechanisms for managing 
agents, (4) HRM control mechanisms for 
reducing agents’ suboptimal HRM decisions. 
 
2.  INTRODUCTION TO AGENCY PROBLEM 
AND MORAL HAZARD 
 
Agency theory assumes that the 
principal/owner employs the agent/manager 
to perform some service on behalf of the 
principal (Jensen & Meckling, 1976), under a 
contract determining compensation for 
achieving desired outcomes (Miles, 2012). 
The principal delegates work to the agent 
(Eisenhardt, 1989), as the agent possesses 
specialized knowledge and skills (Gomez-
Mejia & Balkin, 1992), with the interest that 
the agent will perform in a manner that 
maximizes stockholder wealth and 
satisfaction (Harrell-Cook & Ferris, 1997).  
However, managers of other people’s 
money cannot be expected to watch over it 
with the same zeal as the owner (Smith, 
1776/1952 as cited in Miles, 2012). So, if 
both parties to the relationship are utility 
maximizers, there is good reason to believe 
that the agent will not always act in the best 
interests of the principal (Jensen & Meckling, 
1976). It is assumed that the agent is 
opportunistic and pursues personal interests 
which are highly unlikely to be identical, and 
are even typically not fully compatible with 
those of the principal (Ellis & Johnson, 1993; 
Harrell-Cook & Ferris, 1997). The divergence 
between agents’ and principals’ interests, 
goals and risk preferences arises conflicts 
(Eisenhardt, 1989; Miles, 2012; Yu & To, 
 
 Dynamic Relationships Management Journal, Vol. 5, No. 2, November 2016 7 
2011) and potential mischief (Dalton, Hitt, 
Cert & Dalton, 2008; Lan & Heracleous, 
2010) – so-called agency problem, as well as 
necessary expenditures to overcome it – so-
called agency costs (Jensen & Meckling, 
1976; Pereira & Esperança, 2015). 
The agency problem arises because (a) 
the principal and the agent have different 
goals and (b) the principal cannot determine 
if the agent has behaved appropriately 
(Eisenhardt, 1989). Concerning the latter, as 
the principal tends to have imperfect 
information with which to evaluate the 
agent, the information asymmetry exists 
(Miles, 2012; Yu & To, 2011). In other words, 
the agent has more information than the 
principal about his characteristics and the 
decisions and actions he pursues, and it 
becomes convenient for him to act in his 
own interests at the expense of the 
shareholders (Fama & Jensen, 1983 as cited 
in Supangco, 2006). 
Agency costs come from many sources, 
from agents’ recruitment and adverse 
selection costs, through costs associated 
with regulating and monitoring agents, to 
self-serving motivations costs – so-called 
moral hazard costs. A moral hazard exists 
when the agent takes undue advantage of 
the entrusted authority, and incurs 
undesirable costs for the principal (Harrell-
Cook & Ferris, 1997). By making decisions 
deviating from the firm’s best interest, 
managers secure private benefits for 
themselves. Self-serving behaviours which 
arise as a consequence of agency problem 
are, for example, using work time and 
organizational resources for personal gains, 
perquisites, earnings manipulations, 
shirking/laziness, favouritism, pet projects, 
professional status related to empire 
building, side deals, corporate riding, 
stealing, but as well greenmail, golden 
parachutes and managerial myopia (Chng, 
Rodgers, Shih & Song, 2012; Eisenhardt, 
1989; Eisenhardt, 2009; Gomez-Mejia & 
Balkin, 1992; Shapiro, 2005 as cited in Miles, 
2012; Pereira & Esperança, 2015; Ponzo & 
Scoppa, 2010; Shleifer & Vishny, 1997).  
All those consequence of managerial 
discretion reduce performance (Caza, 2011). 
Therefore, in order to align agents’ interest 
with those of the principals, and reduce 
agency costs, different mechanisms are put 
in place to manage agents’ behavior. As 
agency theory assumes that everyone is 
naturally inclined to perform detrimental 
behaviors at work and will therefore behave 
opportunistically if given the chance (Kidder, 
2005), it is vital to establish mechanisms 
which discipline agents who abuse their 
agency roles. 
 
3. AGENCY PROBLEMS RELATED TO 
MANAGING EMPLOYEES 
 
Although human capital is considered to 
represent the only sustainable source of 
competitive advantage (Hamel & Prahalad, 
1994; Pfeffer, 1994), and therefore 
investment in these resources should be a 
strategic competitive priority (Harrell-Cook 
& Ferris, 1997), the adoption of effective 
HRM systems is oftentimes hindered by 
short-term performance pressures and 
private benefits of managers (Krausert, 
2014). 
The evidence suggests that although high 
performance HRM practices increase 
financial performance through increased 
human resources productivity (Mitchell, 
Obeidat & Bray, 2013), they incur 
considerable implementation costs, while 
the manifestation of benefits lags behind 
their implementation for years (Krausert, 
2014). Therefore, even if an agent believes 
that human capital investment improves 
Nina Pološki Vokić: Looking at HRM through the Lens of Agency Theory – Are Suboptimal HRM Practices a Consequence of 
Moral Hazard? 
  
 Dynamic Relationships Management Journal, Vol. 5, No. 2, November 2016 8 
long-term value for the above reasons, 
he/she may still under-invest in it, because  
the results are intangible and difficult for the 
market to verify in the short-term (Edmans, 
2008).  
Namely, the only immediately-observable 
effect from such an investment is reduced 
earnings, and since low profits may signal 
that the firm is of poor quality, its stock price 
may fall (Edmans, 2008). Fearing such a 
decline, managers whose pay and reputation 
are tied to the stock price may choose to 
forgo such investment (Edmans, 2008), 
supporting claims of ‘managerial myopia’ – 
sacrificing of investments required to sustain 
performance in the longer term in order to 
bolster near-term performance (Krausert, 
2014). More to it, risk-aversion on the part 
of the agent and a bias toward short-term 
efficiency could be created by short-term 
performance pressures (Hoskisson & Hitt, 
1994 as cited in Harrell-Cook & Ferris, 1997; 
Krausert, 2014). Therefore, given the 
vulnerability of agents’ positions and the 
competition for top management jobs, 
managers realize it is to their advantage to 
maintain an outstanding track record of 
profitability (Borcherding, 1978 as cited in 
Harrell-Cook & Ferris, 1997). This shift in 
perspective may result in reduced 
management support (Krausert, 2014), and 
decreased investment in activities that 
contribute to long-term organizational 
welfare (Harrell-Cook & Ferris, 1997), such 
as high performance HRM systems. 
Finally, the non-adoption of high 
performance HRM practices could be 
entailed by private agent’s costs, as its 
implementation requires changes in 
behavioral routines and power relations 
(Krausert, 2014). Among other, high 
performance HRM practices hinder 
favoritism, the second major moral hazard 
related to managing employees. 
3.2. Favouritism 
 
Favouritism, as a preferential treatment 
of an employee on the basis of factors that 
do not directly relate to a person’s ability to 
perform his or her job function (Tyler, 2012), 
such as person’s background/ideology or 
social/family connections with the agent, 
leads to substantial agency costs as it was 
found to be a morale killer and detrimental 
for the firm’s overall performance (Bandiera, 
Barankay & Rasul, 2009; Tyler, 2012). In the 
same time, it generates value for those who 
exercise it (Prendergast & Topel, 1996). As 
such, supervisors derive utility from 
exercising bias when making decisions on 
selection, performance appraisal, 
remuneration, promotion, etc. 
Favouritism in recruitment is a form of 
moral hazard in an agency framework in 
which a manager obtains private benefits by 
hiring connected people of lower abilities 
(Ponzo & Scoppa, 2010). Relatives, friends 
and individuals belonging to “old boy 
networks” are preferred for reasons 
unrelated to productivity – family ties, social 
connections, clanship, exchange of favours 
or even bribes, over more competent 
workers for access to good jobs (Ponzo & 
Scoppa, 2009, 2010). By recruiting low 
quality workers, agents impose a cost on the 
principal and on other, more competent job 
applicants (Ponzo & Scoppa, 2010). As it 
affects the quality of staffing decisions, it has 
an overall negative impact on the 
performance of the organization (Bandiera 
et al., 2009; Ponzo & Scoppa, 2009). 
Favouritism in recruitment was shown to be 
associated with agents’ low powered 
incentives, strong family ties, low 
 
 Dynamic Relationships Management Journal, Vol. 5, No. 2, November 2016 9 
educational levels, low productivity jobs, 
small firm size, high unemployment areas, 
and less developed regions (Bandiera et al., 
2009; Ponzo & Scoppa, 2009). 
An agent may derive private benefits as 
well from favoritism in performance 
evaluation, by favorably evaluating 
performance of those he/she has social 
connections with, because they receive 
utility if his/her preferred subordinates’ 
wages are higher (Krausert, 2014; 
Prendergast & Topell, 1996). The door to 
favoritism is opened by subjectivity in 
measuring employee’s performance, as 
evaluators can use their power to misreport 
their evaluations to accord with their 
preferences, and reward favored 
subordinates beyond their true performance 
(Prendergast & Topel, 1996). However, 
distorted performance appraisals may cause 
problems not only in incentive systems, but 
could harm placement decisions 
(Prendergast & Topel, 1996). The worst case 
scenarios are bribing and wasting valuable 
productive time on lobbying superiors to 
obtain desirable performance evaluations 
(Prendergast & Topel, 1996). 
Furthermore, agents may derive private 
benefits from raising preferred subordinates’ 
compensation (Edmans, 2011). Firms must 
balance the costs of favouritism in 
remuneration (Prendergast & Topel, 1996), 
as arbitrary rewards, undeserved pay rises 
and benefits which are not merit-based are 
direct financial costs. Rampant favouritism 
in promotion decisions is the next form of 
favouritism, detected to be a widely-spread 
phenomena in the contemporary business 
(Tyler, 2012). When members of families, 
friends or other socially connected people 
are appointed to valuable jobs because of 
their connections rather than their merits 
(Ponzo & Scoppa, 2010), so-called bad 
promotions occur (Tyler, 2012). Finally, 
favoritism could happen in training and 
development decisions, when it is invested 
in the development of favored employees, 
and not in facilitating learning of job-related 
or future-needed knowledge and skills of 
most talented employees. 
Favoritism was found to be prevalent 
when the intensity of family ties is strong, 
when agents suppose that the exchange of 
favors within the group can be repeated 
over time, when the uncertainty of 
connection process is low, in jobs paying 
high wage rents, in organizations in which 
managers face low-powered incentives, and 
when it is easier to make hidden payments 
(Bramoullé & Goyal, 2009 as cited in Ponzo 
& Scoppa, 2010; Ponzo & Scoppa, 2010). 
 
3.3. Recruitment of unproductive  
subordinates 
 
Agents who fear being replaced by more 
productive subordinates have an incentive 
to deliberately recruit lower ability, less 
dangerous candidates in order to protect 
their own positions and career prospects in 
the firm (Friebel & Raith, 2004; Krausert, 
2014; Ponzo & Scoppa, 2010). As well, they 
are induced to abuse their personnel 
authority in other ways to protect their 
status when they see their subordinates as 
threatening, such as retain from developing 
employees under their purview (Friebel & 
Raith, 2004).  
Aforementioned behaviours directly 
decrease the productivity of the workforce 
and jeopardize the function of internal 
labour markets as a screening device for 
talent, implying substantial costs (Friebel & 
Raith, 2004). However, although such 
behaviours hide substandard agents’ 
performance (South & Matejka, 1990), they 
hurt the agent too, as hiring unproductive 
subordinates reduces the performance of 
Nina Pološki Vokić: Looking at HRM through the Lens of Agency Theory – Are Suboptimal HRM Practices a Consequence of 
Moral Hazard? 
  
 Dynamic Relationships Management Journal, Vol. 5, No. 2, November 2016 10 
the manager’s unit reflecting badly on the 
manager’s ability (Friebel & Raith, 2004). 
 
4.  HRM CONTROL MECHANISMS FOR  
 MANAGING AGENTS 
 
To minimize the agency problem – to 
counter the agent’s propensity to engage in 
self-serving, counter-productive behaviour 
and limit divergences from principal’s 
interests, the literature advocates three 
control mechanisms: (1) monitoring agents’ 
behaviour through boards of directors, (2) 
establishing appropriate remuneration 
systems for rewarding agents, and (3) 
market control.  
Boards of directors can monitor managers 
and assure that their interests do not 
diverge substantially from those of 
principals, as they are supposed to be 
independent of management (Dalton et al., 
2008; Jensen & Meckling, 1976). However, 
when an agent has high autonomy, and 
highly specialized knowledge, monitoring 
becomes very difficult and expensive, so 
principals rely on incentives to reward 
agents for appropriate outcomes (Gomez-
Mejia & Balkin, 1992; Tosi & Gomez-Mejia, 
1989). They principally rely on equity 
ownership – the idea that agents which are 
equity holders direct the firm in their joint 
(principals’ and agents’) interests (Dalton et 
al., 2008; Jensen & Meckling, 1976), but 
tying agent’s rewards to the outcome of the 
action is another option (Petersen, 1993). 
Lastly, based on the efficient market 
hypothesis, capital markets may operate to 
discipline agents, as self-serving executives 
may subject the firm’s assets to be devalued 
(stock price declines), which makes the firm 
vulnerable to a hostile takeover (Dalton et 
al., 2008; Fama, 1980 as cited in Pereira & 
Esperança, 2015). 
Additionally, agents’ opportunism could 
be curbed by information systems 
(budgeting systems, reporting procedures, 
etc.) (Eisenhardt, 1989) or electronic 
monitoring which limits the agent to deceive 
the principal (Kidder, 2005), as well as by 
different HRM-based mechanisms. 
There are many HRM control mechanisms 
which enable to align agents’ and principals’ 
interest. Already mentioned compensation 
alignment is one of the most effective ones, 
and therefore elaborated independently. 
 
4.1. Compensation alignment 
 
Looking through an agency theory lens, 
one of the primary functions of HRM is to 
structure agents’ pay to align agents’ actions 
with the needs of principals, i.e. to create 
incentives that reduce agent’s self-interests 
(Bender, 2007; Caza, 2011; Jensen & 
Meckling, 1976; Petersen, 1993). The issue 
at hand is how the principal should 
compensate its agent for the work 
performed (Ellis & Johnson, 1993). Various 
compensation plans/contracts are put 
forward to compensate agents, while the 
most important element is to determine the 
optimal contract – to predict the conditions 
under which particular types of 
compensation strategies (e.g. fixed vs. 
variable pay; behaviour vs. outcome 
contracts) are most appropriate (Eisenhardt, 
1989; Gomez-Mejia & Balkin, 1992; Miles, 
2012). 
Agency theory identifies two types of 
compensation schemes – behaviour-based 
and outcome-based compensation, that 
facilitate two forms of control – behaviour 
 
 Dynamic Relationships Management Journal, Vol. 5, No. 2, November 2016 11 
and output control. A behaviour-based 
system compensates the agent strictly on 
the basis of its activities (typically through 
straight salary), while outcome-based 
compensation is calculated on performance 
against stated objectives (such as 
commission or stock options) (Ellis & 
Johnson, 1993). Principals prefer to base 
agent’s pay on non-contingent 
compensation (behaviour contacts) when 
agent’s behaviour can be observed, and on 
financial returns (incentive contracts) when 
agent’s behaviour cannot be adequately 
monitored or assessed (Eisenhardt, 1989; 
Gomez-Mejia & Balkin, 1992; McLean Parks 
& Conlon, 1995; Stroh, Brett, Baumann & 
Reilly, 1996).  
Behaviour-based compensation result in 
agents behaving in a compliant manner 
because it is in their best interests (e.g. do 
what’s in your job description, and you get a 
raise) (Welbourne & Cyr, 1996). They imply 
that the behaviour of agents is closely 
controlled through policies and procedures, 
standardization of work, adherence to rules, 
explicit monitoring of routines, and 
adequate information regarding cause-effect 
relations, consequently resulting in rigid and 
cautious behaviour (Welbourne & Cyr, 1996; 
Yu & To, 2011). 
Agents’ compensation contingent on 
company performance – output-based 
compensation, are associated with desirable 
managerial behaviours that can contribute 
to firm performance, including greater 
perseverance, greater focus on key 
organizational tasks, higher risk taking, 
willingness to assume responsibility for a 
longer-term orientation, and even enhanced 
ethical behaviours (Chng et al., 2012; 
Schuler, 1987 as cited in Welbourne & Cyr, 
1996). Implicit in the agency theory 
approach is the assumption that linking pay 
to performance will not only mitigate moral 
hazard (Eisenhardt, 1989; Kalmi, Pendleton 
& Poutsma, 2005; Kidder, 2005), but will 
motivate agents to perform better and act as 
owners (Bender, 2007; Becker & Olson, 1989 
as cited in Welbourne & Cyr, 1996). The 
underlying premise is that increasing 
employee ownership in the firm (both true 
ownership through possessing stocks, and 
psychological ownership through 
participating in firm’s results) coaligns the 
preferences of agents with those of the 
principal because the rewards for both 
depend on the same actions/behaviours 
(Eisenhardt, 1989; Jensen & Meckling, 1976; 
Krausert, 2014; Welbourne & Cyr, 1996). 
More to it, a greater link between pay and 
performance implies greater alignment 
(Bender, 2007). Incentive compensation is 
therefore common in practice (Shleifer & 
Vishny, 1997), and comes in many forms – 
variable pay, commissions, short-term and 
long-term bonuses, profit-sharing, stock-
based compensation, etc. 
In recent years, the popularity of equity-
based compensation, particularly stock 
options, as a device for linking principals’ 
and agent’s interests has gained importance 
(Conyon, 2006 as cited in Dalton et al., 2008; 
Dalton et al., 2008; Souder & Shaver, 2010). 
Through the use of stock option plans, 
agents are encouraged to not only think like 
owners, but to behave as owners 
(Welbourne & Cyr, 1996). As well, stock 
options are useful incentive to overcome 
managerial reluctance to make long horizon 
investments (Souder & Shaver, 2010), and 
hence ensure the long-term success of 
companies (Dalton et al., 2008; Welbourne 
& Cyr, 1996). Namely, managers are often 
overly focused on short payoff horizons as 
their compensation historically came from 
salaries and bonuses tied to short-term 
performance feedback, and because they 
may be concerned about dismissal for low 
performance during the period before the 
Nina Pološki Vokić: Looking at HRM through the Lens of Agency Theory – Are Suboptimal HRM Practices a Consequence of 
Moral Hazard? 
  
 Dynamic Relationships Management Journal, Vol. 5, No. 2, November 2016 12 
value of long horizon investments is realized 
(Souder & Shaver, 2010).  
A positive relationship between firm 
performance and the proportion of equity-
based executive compensation was found 
(Mehran, 1995 as cited in Dalton et al., 2008; 
Li, Yang & Yu, 2015; Welbourne & Cyr, 1996). 
However, companies should be aware of 
differences between unexercisable and 
exercisable stock options. As unexercisable 
options only have value in the future, they 
provide managers with an incentive to make 
longer horizon investments, while the value 
of exercisable options can be obtained 
immediately, and therefore deters long 
horizon investments and encourages 
managers to favor short horizon investments 
instead (Souder & Shaver, 2010). More to it, 
it has been demonstrated that high powered 
incentive contracts, and especially stock 
options, can actually motivate dishonest 
managerial behaviors, such as self-dealing 
and criterion manipulation, manipulating 
with accounting numbers and investment 
policies, and earnings manipulations (Chng 
et al., 2012; Shleifer & Vishny, 1997; Gomez-
Mejia & Balkin, 1992). 
Apart from the easiness of monitoring 
agents, other arguments for using behavior- 
or performance-contingent compensation 
exist, as exhibited in Table 1. What is, 
however, provoking is that the majority of 
academics present the two systems as 
alternatives, although they could be 
mutually reinforcing. There are already 
empirical proofs that some firms, such as 
technology-intensive ones, perform better 
when they adopt both output and behavior 
control (Makri, Lane & Gomez-Mejia, 2006 
as cited in Yu & To, 2011). 
 
4.2. Other HRM control mechanisms for 
managing agents 
  
Previously elaborated forms of control 
systems – behavior and output control, are 
as well in the origin of different HRM control 
mechanisms organizations could use to 
control agents’ harmful behavior. However, 
the third form of formal control system – 
input control, is as well an option (Snell, 
1992 as cited in Yu & To, 2011; Yu & To 
2011). Namely, all three formal control 
systems affect work performance (Yu & To, 
2011). The implication is, consequently, that 
organizations should use a combination of 
HRM practices which assures the control on 
all three levels. Table 2 exhibits HRM-based 
mechanisms for diminishing moral hazard, 
indicating whether a practice is input-, 
behavior- or output-oriented. 
 
 Dynamic Relationships Management Journal, Vol. 5, No. 2, November 2016 13 
Table 1: HRM control mechanisms for managing agents 
HRM 
activities 
HRM control mechanisms 
HRM 
philosophy 
   Administrative/bureaucratic HRM – formalizing policies and procedures, controlling costs, 
performing human resource audits, etc. in order to standardize and control employee behavior to 
minimize uncertainty (BC). 
   Usage of different codes (e.g. ethical, diversity) that inculcate the agents not to take unfair 
advantage of the principals (BC) 
HR planning    Dismissing an agent (OC) 
Recruitment     Rigorous selection that ensures that the agent possesses required knowledge, skills and abilities 
in order to avoid adverse selection (IC) 
   Looking for specific personality traits (e.g. trustworthiness, honesty) and values (e.g. morality) by 
using identity tests or similar to screen out potentially unsuitable job applicants (IC)  
   Looking for person-organization (P-O) fit (including shared values), as well as person-job (P-J) fit 
when hiring agents (IC) 
   Selecting managers that match the compensation arrangement already in place (fixed vs. 
incentive compensation) (IC) 
Performance 
management 
   Standardized responsibilities with an overriding concern for procedures and methods enabling 
the accountability for actions (BC) 
   Performance appraisal based on results (accomplishing performance targets) (OC) 
Remuneration    Behavior-based compensation contracts, such as salaries (BC) 
   Monetary rewards closely linked to performance outcomes (pay for performance) – incentive 
compensation, such as variable pay, commissions, short-term and long-term performance-based 
bonuses, profit-sharing, equity ownership (e.g. stock options), golden parachutes (OC) 
   Group incentives which relate agent’s pay with his/her co-workers’ performance, as it might 
elicit more effort at the same cost to the principal (OC) 
   Benefits that motivate desirable managerial behaviors, such as loyalty rewards (BC) 
Training and 
development 
   Training for newly employed (a part of socialization) with the purpose of organizational 
identification (aligning the goals of agents with those of the firm) (IC) 
   Investments in T&D as it signals to agents that the firm expects to maintain a long-term 
relationship (IC) 
Career 
management 
   Clear promotion ladders as it signals to agents that the firm expects to maintain a long-term 
relationship (IC) 
Working 
atmosphere 
   Fostering job satisfaction, employee engagement, organizational commitment and loyalty as 
they eliminate divergent interests and create an environment of cooperation (IC) 
   Developing favorable socio-emotional climate and culture (IC) 
   Developing trust as even normally honest and ethical employees may resort to deviant 
behaviors if they feel that they work in an unjust environment and that their trust has been 
violated (IC) 
 Note: IC = input control; BC = behaviour control; OC = output control 
Source: Bandiera, Barankay & Rasul, 2005; Caza, 2011; Chng et al., 2012; De Kok et al., 2006; Eisenhardt, 1989; Gong, 2003; 
Kidder, 2005; Tucker, 1993 as cited in Kidder, 2005; Krausert, 2014; Lan & Heracleous, 2010; Miles, 2012; Petersen, 1993; 
Pereira & Esperança, 2015; Welbourne & Cyr, 1996; Yu & To, 2011 
 
 
 
 
 
 
 
 
 
 
 
 
 
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Moral Hazard? 
  
 Dynamic Relationships Management Journal, Vol. 5, No. 2, November 2016 14 
5. HRM CONTROL MECHANISMS FOR 
REDUCING AGENTS’ SUBOPTIMAL HRM 
DECISIONS 
 
In response to the managers’ tendency to 
make HRM decisions that serve their own 
rather than the firm’s interests, 
organizations can formalize, they can 
monitor, or they can centralize those 
decision. First, agents’ suboptimal HRM 
decision could be reduced by prescribing 
HRM policies and procedures. Unfortunately, 
the majority of companies do have 
procedures to avoid favouritism and other 
suboptimal HRM decisions, but they are 
found not to be effective (Tyler, 2012).  
Monitoring and centralizing those decisions 
implies that HRM professionals are an 
objective third party (Tyler, 2012). HRM 
decision are thus shifted to a centralized 
HRM department (Friebel & Raith, 2004), but 
managers should stay involved as it is vital 
that they participate actively in various HRM 
activities, such as final employment or 
promotion decisions, performance appraisal, 
subordinates T&D, etc. 
Table 3 exhibits potential HRM control 
mechanisms for reducing agents’ suboptimal 
HRM decisions, by specifying which 
particular suboptimal decision (see chapter 
3) could be therewith resolved. 
Table 2: HRM control mechanisms for reducing agents' suboptimal HRM decisions 
HRM 
activities 
HRM control mechanisms Suboptimal HRM decisions resolved 
Recruitment  Prescribed selection criteria (bureaucratic rules in 
selection decisions), such as required educational 
qualifications, knowledge or skills, minimum number 
of years of experience 
Favouritism in recruitment 
Rigorous selection based on competences Favouritism in recruitment 
Performance 
management 
Clear performance criteria, such as more quantitative 
criteria and more quantified development criteria 
Favouritism in performance evaluation 
Remuneration Clear remuneration systems (bureaucratic rules of 
awarding compensation) less sensitive to supervisor 
evaluations 
Favouritism in remuneration 
Less merit-pay Favouritism in recruitment 
Incentives for mentors Non-investing in younger workers T&D 
Career 
management 
Clear promotion criteria Favouritism in promotion decision, 
recruitment of unproductive subordinates 
Promotion decisions based on competences Favouritism in promotion decision, 
recruitment of unproductive subordinates 
Promotions done by committees Favouritism in promotion decision, 
recruitment of unproductive subordinates 
Nonreplacement rules – never promoting an employee 
to the position of his/her immediate superior 
Recruitment of unproductive subordinates, 
non-investing in younger workers T&D 
Source: Friebel & Raith, 2004; Krausert, 2014; Ponzo & Scoppa, 2004; Prendergast & Topel, 1996; Tyler, 2012
 
 Dynamic Relationships Management Journal, Vol. 5, No. 2, November 2016 15 
6. CONCLUSION 
 
It is believed that the agency framework 
is an unusually rich and relevant framework 
for studying behavior in organizations 
(Petersen, 1993), including behaviors related 
to HRM.  
Not only that HRM practitioners should 
be proactive in detecting existing/potential 
HRM agency tensions in their organizations 
associated with managing employees, but 
they have to devise HRM control 
mechanisms both for managing agents’ 
behavior and for reducing agents’ 
suboptimal HRM decisions. The paper lists 
three main agency problems related to 
managing employees: (1) the non-adoption 
of effective HRM systems, (2) favouritism, 
and (3) recruitment of unproductive 
subordinates. As well, HRM mechanisms for 
managing agents’ behavior and reducing 
agent’s suboptimal HRM decisions, that 
minimize agency costs and result in 
maximization of firm performance, are 
systematized. Namely, as agency theory 
reminds us that much of organizational life, 
whether we like it or not, is based on self-
interest (Eisenhardt, 1989; Gong, 2003), one 
of the solutions to the agency problem could 
be the design of appropriate HRM systems 
for controlling agents behaviors and their 
decisions in the HRM area. 
EXTENDED SUMMARY / IZVLEČEK 
Cilj članka je predstaviti teoretično ozadje problema dvojnosti v razmerju 
lastnik manager, ki lahko pripomore k nedoseganju zadostne uspešnosti področja 
kadrovskega managementa znotraj združb.  
Poleg tega članek predstavi sistematizacijo in dodatno pojasni sisteme 
nadzora za področje kadrovskega management, ki lahko zmanjšajo moralno 
tveganje agentov, še posebej ob sprejemanju odločitev, povezanih s kadri.  
Literature, ki bi (posredno ali neposredno) povezovala področji kadrovskega 
management ter teorijo principal-agent, je zelo malo. Prav ta povezava 
predstavlja področje teoretične analize članka, in sicer z metodo pregleda 
literature ter teoretične konceptualizacije.  
Rezultat je sistematiziranje do sedaj dostopnega znanja iz naslednjih področij: 
(1) uvod v kadrovske izzive, povezane s teorijo principal-agent; (2) izzivi, ki 
 izhajajo iz teorije principal-agent in so povezani z ravnanji z zaposlenimi; (3) 
kadrovski mehanizmi nadzora managerjev ter; (4) kadrovski mehanizmi nadzora 
za zmanjševanje neoptimalnih odločitev managerjev, povezanih s kadrovskim 
področjem.
Nina Pološki Vokić: Looking at HRM through the Lens of Agency Theory – Are Suboptimal HRM Practices a Consequence of 
Moral Hazard? 
   
 Dynamic Relationships Management Journal, Vol. 5, No. 2, November 2016 16  
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APPENDICES  
Appendix 1: Guidelines for using behavior- or output-based compensation 
Behavior-based compensations Output-based compensations 
 when more information about an agent’s 
behavior is available (when agents can be 
monitored) 
 when actions are easy and cheap to observe 
and measure 
 when outcomes are either difficult to measure 
or difficult to measure within a practical amount 
of time 
 when principals and agents are involved in 
long-term relationships/transactions, as 
principals are better-informed about the agents’ 
behavior and the goals of the principal and the 
agent are aligned 
 when agent’s job is programmable (routine 
tasks) 
 when the environment in stable 
 when the expected length of an agency 
relationship is longer (when it is preferred that 
agents stay longer in a company and that they 
are committed/loyal to the company) 
 when a company wishes to retain talented 
agents during times of high levels of turbulence 
 when outcome uncertainty is high, as it is 
expensive to shift risk to the agent despite the 
motivational benefits of outcome-based 
contracts 
 when agents have a lower core self-evaluation, 
as the greater uncertainty presented by incentive 
compensation may overwhelm their meagre self-
belief and reduce their propensity to respond to 
incentive compensation in the desired manner 
 when an agent is more risk averse, as in that 
situation it is increasingly expensive to pass risk 
to the agent 
 in companies with less ambitious and difficult 
strategies 
 when direct supervision is infeasible or counterproductive 
because of information asymmetries 
 when outcomes are easy to observe, measure and assess in 
terms of their value 
 when the information asymmetry between principal and agent 
is likely to be greater because of the short-term agency 
relationships 
 when agent’s job is less programmable, because when task 
programmability is low an agent’s behavior is difficult to monitor 
 when accomplishing the task entails risks for the agent 
 when principals want to motivate agents to engage in risk-
taking behavior that enhance long-run firm performance 
 when a company is undergoing significant/rapid 
change/growth, experiencing high degrees of 
uncertainty/turbulence in the environment, or is a high-risk 
company, as compliant behavior curtails actions that are needed 
for quick response to unknown problems 
 when outcome uncertainty is low, as the costs of shifting risk 
to the agent are low 
 when high levels of turnover, for example for “bring in new 
blood”, are preferred 
 when agents have a higher core self-evaluation, as they are 
more comfortable with the increased uncertainty associated 
with incentive compensation, and more confident in their ability 
to achieve the stated performance goals and earn the promised 
rewards 
 when principals want to reduce favouritism, as agents target 
high ability workers irrespective whether they are socially 
connected to them or not when they are paid performance 
bonuses  
 when an agent is increasingly less risk averse (e.g. a wealthy 
agent), as in that situation it becomes more attractive to pass 
risk to the agent  
 when the principal is more risk averse, as in that situation it is 
increasingly attractive to pass risk to the agent 
 in companies that adopted more ambitious and difficult 
strategies (risk-taking organizations) 
Source: Bandiera et al., 2009; Chng et al., 2012; Eisenhardt, 1989; Gomez-Mejia & Balkin, 1992; McLean Parks & Conlon, 
1995; Dow & Raposo, 2005 as cited in Pereira & Esperança, 2015; Pereira & Esperança, 2015; Petersen, 1993, Stroh et al., 1996; 
Jensen & Murphy, 1990 as cited in Welbourne & Cyr, 1996; Welbourne & Cyr, 1996; Yu & To, 2011