Economic Foundations of Strategy Chapter 4: Agency Theory

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Economic Foundations of StrategyChapter 4
Agency Theory

• Joe Mahoney
• University of Illinois at Urbana-Champaign

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Agency Theory

• Berle and Means (1932)
  The Modern Corporation
• Pratt and Zeckhauser (1985)
  Principals and Agents
• Arrow (1985) The Economics of Agency
• Levinthal (1988)
  Agency Models of Organizations
• Jensen and Meckling (1976)
• Theory of the Firm Managerial Behavior, Agency
  Costs, and Capital Structure

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Berle and Means (1932)The Modern
Corporation

• Argues that the separation of ownership from
  control produces a condition where the interests
  of owner(s) and managers often diverge and that
  discretionary power by managers exists.
• They ask Have we any justification for
  assuming that those in control of the modern
  corporation will also choose to operate it in the
  interest of owners? (1932 121)

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Berle and Means (1932)The Modern
Corporation

• In their empirical study they find that 88 of the
  200 largest American non-financial corporations
  were management controlled in 1929 because no
  individual, family, corporation, or group of
  business associates owned more than 20 percent
  share of all outstanding stock, and because
  evidence of control by a smaller ownership group
  was lacking.
• They judged only 22 to be privately
  owned or controlled by a group of stockholders
  with a majority interest.

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Berle and Means (1932)The Modern
Corporation

• They conclude that the State seeks in some
  respects to regulate the corporation, while the
  corporation, steadily becoming more powerful,
  makes every effort to avoid (or shape) such
  regulation. Where its interests are concerned,
  the modern corporation even attempts to dominate
  the State. The future may see the economic
  organization, typified by the corporation, not
  only on an equal plane with the State, but
  possibly even superseding the State as the
  dominant form of social organization. The law of
  the corporation, accordingly, might well be
  considered as a potential constitutional law for
  the new economic State, while business
  practice is increasingly assuming the
  aspect of economic statesmanship.

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Pratt and Zeckhauser (1985)Principals and
Agents

• Given information asymmetries --- agents
  typically know more about their tasks than their
  principals do --- we cannot expect any business
  enterprise or business institution to function as
  well as it would if all information were
  costlessly shared or if the economic incentives
  of principals and agents could be costlessly
  aligned.
• This shortfall is sometimes called the
  agency loss or agency costs.

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Pratt and Zeckhauser (1985)Principals and
Agents

• In economic language, since the first-best
  outcome could only be achieved in the unrealistic
  world of costless information flow, our goal must
  be to do the best we can, to achieve what is
  sometimes called the second-best solution.
• The building blocks of agency theory are
  information and economic incentives.

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Pratt and Zeckhauser (1985)Principals and
Agents

• Information
• At one extreme we have the perfect-market
  transaction, with standardized products and all
  information fully shared.
• At the other end of the continuum are situations
  in which the agent has full discretion and is not
  observed at all by the principal.

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Pratt and Zeckhauser (1985)Principals and
Agents

• Agency loss is more severe when the economic
  interests or economic values of the principal and
  agent diverge substantially, and information
  monitoring is costly
• The economic benefits of any reduction in agency
  loss will be shared by principal and agent in
  most market situations.

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Pratt and Zeckhauser (1985)Principals and
Agents

• The principal and agent have a common economic
  interest in defining a monitoring-and-incentive
  structure that produces economic outcomes as
  close as possible to the economic outcome that
  would be produced if information monitoring were
  costless.
• Human environments can change quickly and there
  is no assurance that the institutions we
  currently observe are best.

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Arrow (1985)The Economics of Agency

• Finds it useful to distinguish two types of
  agency problems
• Hidden action models (moral hazard)
• Moral hazard and observability (Holmstrom,
  1979)
• Hidden information models (adverse
  selection)
• The market for lemons
  (Akerlof, 1970)

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Arrow (1985)The Economics of Agency

• Arrow observes that in some cases where the
  principal-agent theory seems clearly applicable,
  real-world practice is very different from the
  model. In many respects, the physician-patient
  relation exemplifies the principal-agent
  relationship almost perfectly.
• The principal (the patient) is certainly unable
  to monitor the efforts of the agent (the
  physician).
• The relation between effort and outcome is
  random, but presumably there is some connection.
• Yet in practice, the physicians fee schedule is
  in no way related to outcome. In
  general, compensation of professionals shows only
  a few traces of the complex fee
  schedules implied by agency theory.

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Arrow (1985)The Economics of Agency

• Why is the divergence between agency theory
  and practice so stark?
• One basic problem is the cost of specifying
  complex relations.
• Second, superiors judge executives on criteria
  that could not have been stated in advance.
  Outcomes and even supplementary objective
  measures do not exhaust the information available
  on which to base rewards.
• Professional responsibility is clearly enforced
  in good measure by a system of ethics,
  internalized during the education process and
  enforced in some measure by formal punishments
  and more broadly by reputations.

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Levinthal (1988)Agency Models of
Organizations

• Provides the insightful perspective that the
  agency paradigm can be viewed as the neoclassical
  response to questions raised many years earlier
  by March and Simon (1958) and Cyert and March
  (1963) regarding the behavior of an organization
  of self-interested agents with conflicting goals
  in a world of incomplete information.
• Judges, however, that the focus on the incentive
  problem in the organizational economics and
  strategic management literatures is excessive.
  The inability of top management to coordinate
  goes well beyond the problem of industriousness.
  The strategic management literature should also
  allocate time and attention to offering superior
  heuristics for management to achieve coordination.

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Levinthal (1988)Agency Models of
Organizations

• Role of Time
• Levinthal (1988) notes that the repetition of an
  agency relationship over time tends to improve
  its efficiency.
• When the agency relationship repeats itself over
  time, the effects of uncertainty tend to be
  reduced and dysfunctional behavior is more
  accurately revealed, thus alleviating the problem
  of moral hazard.

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Levinthal (1988)Agency Models of
Organizations

• Multi-agent models and tournament contracts
• Levinthal maintains that the risk imposed on an
  agent can be reduced by basing by basing
  individual performance relative to that of other
  agents, who face similar states of nature. For
  example, in tournaments, the reward is a
  function of the rank order of performance
  relative to other agents.

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Jensen and Meckling (1976)Theory of the Firm
Managerial Behavior, Agency Costs, and Capital
Structure

• Jensen and Meckling (1976) integrate elements
  from agency, the theory of property rights and
  the theory of finance to develop a theory of the
  ownership structure of the firm.
• Agency costs are defined as
• The monitoring costs by the principal
• The economic bonding costs by the
  agent
• The residual economic loss.

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Jensen and Meckling (1976)Theory of the Firm
Managerial Behavior, Agency Costs, and Capital
Structure

• Jensen and Meckling (1976) argue that agency
  costs (I.e., monitoring costs, economic bonding
  costs, and the residual loss) are an unavoidable
  result of the agency relationship.
• Jensen and Meckling (1976) argue that contractual
  relations are the essence of the firm, not only
  with employees (Alchian and Demsetz, 1972), but
  also with suppliers, customers, creditors, and so
  on.

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Jensen and Meckling (1976)Theory of the Firm
Managerial Behavior, Agency Costs, and Capital
Structure

• Jensen and Meckling (1976) argue that most
  organizations serve as a nexus for a set of
  contracting relationships among individuals.
• Jensen and Meckling (1976) emphasize that since
  decision makers ultimately bear the agency costs,
  these decision makers have the economic incentive
  to minimize agency costs.

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Jensen and Meckling (1976)Theory of the Firm
Managerial Behavior, Agency Costs, and Capital
Structure

• Jensen and Meckling (1976) argue that agency
  costs (i.e., monitoring costs, economic bonding
  costs, and the residual loss) are an unavoidable
  result of the agency relationship.
• Jensen and Meckling (1976) conclude that the
  level of agency cost depends, among other things,
  on statutory and common law, and human creativity
  in devising better contracts. Both the law and
  the sophistication of contracts relevant to the
  modern corporation are the products of an
  historical process in which there were strong
  economic incentives for individuals to minimize
  agency costs.