Agency Theory

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Definition of the theory

Agency theory has long concerned disciplines as diverse as economics, finance, law, politics and psychology. Scholars who approached the concept attempted (and to a large extent still attempt) to explain with it the relationship that exists, typically within a business in corporate form, between ownership (or the owner) and control (or the one who is charged with managing).  

Jensen and Mecking, two scholars in finance, defined the agency relationship, in a groundbreaking article published in 1976, as “a contract under which one or more persons (the principal(s)) engage another person (the agent) to perform some service on their behalf which involves delegating some decision making authority to the agent”.

The same authors, in formulating this felicitous definition, also introduced the fundamental issue: “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”. This divergence of interests, which often manifests itself in practice, notably between the shareholders and the directors of a company, makes it (generally) structurally impossible for the agent to make zero cost decisions that are optimal from the principal's point of view.

Agency costs

In light of this consideration, the authors of the research identified the fundamental agency costs, which increase, proportionally, as the divergence of goals and interests between agent and principal increases; inversely proportionally, as trust between the two parties decreases.

Specifically, according to the authors agency costs can be enucleated as follows:

  • “the monitoring expenditures by the principal”: that is, the costs that the principal has to incur in carrying out, essentially, monitoring activities on the agent's activity in order to prevent and limit opportunistic behavior;
  • “the bonding expenditures by the agent”: i.e., the costs that the agent is required to incur in order to gain the principal's trust, notably by assuring the principal that he or she will not make decisions likely to cause him or her harm and that, even if this happens, the harm will be compensated;
  • “the residual loss”: it occurs whenever there is a divergence between the interests of the principal and the agent and between the decisions taken in one or the other direction, despite monitoring and bonding activities.

The costs thus described occur indeed whenever there is a “separation of ownership and control”, since it is always difficult to induce the agent to behave in a way that maximizes the principal's profit (or interests). This happens in every organization and corporation, lucrative or not, as well as at every level of management, in universities, and even at the governmental level.

Information asymmetry

A problem related to agency theory is that of information asymmetry, which structurally exists between ownership and control.

Information asymmetry refers to the difference in information available to the two parties (or contractors). As a rule, in fact, managers have access to information regarding the internal organization of the company and the operations carried out by the company. At the same time, shareholders do not have the necessary expertise to understand whether corporate operations are in fact consistent with their own interests. Therefore, it is often possible for managers to engage in opportunistic behavior also and precisely because of information in their possession. And indeed, the presence of information asymmetries hinders, in general terms, the achievement of a social optimum through free bargaining between the parties.

Information asymmetry generates two problems:

  • c.d. adverse selection: the principal, in choosing the agent, cannot make an optimal choice, as he lacks useful information to accurately assess the actual capabilities of each candidate;
  • c.d. moral hazard: it occurs when the agent abuses the principal's lack of information. In this sense, the agent indulges in misbehavior because he knows that the principal does not have the information, or, in any case, the expertise, to discover such improprieties.

References

  • M. C. Jensen, W. H. Meckling, Agency costs and the theory of the firm, in Journal of Financial Economics, 1976, pp. 305-360, particularly p. 308.
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