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>studynotes

Fundamentals of
business economics
Stephen Adams traces the development of theory on the principal-
agent problem – an issue that companies have yet to solve satisfactorily.
The inclusion of the principal-agent Three decades later, J K Galbraith argued Principal-agent activities are clearly
problem in the CO4 syllabus can be taken as that a divorce of ownership from control, common. The problematic element usually
evidence of growing concerns about the with managers, not shareholders, dominating concerns the inability of principals to ensure
nature of organisations, corporate governance decision-making had resulted from the that the agent always acts in their best
and the possibility of conflict among growth of large corporations and interests. The relevant factors here are
stakeholders. But the issue is not the organisational consequences knowledge and power, which can be
new: Adam Smith, writing in An of advanced technology analysed in the wider context of
Inquiry into the Nature and and mass production. organisational stakeholders. A stakeholder is
Causes of the Wealth of “Corporate size, the an individual or group that has some interest
Nations (1776), stated that passage of time and in the way an organisation is structured,
he doubted the value of the dispersion of stock managed and behaves. In the case of a
joint-stock companies ownership do not hospital, for instance, the stakeholders will
because he felt they disenfranchise the include the medical staff, the managers, the
reduced the financial stockholder. Rather, he patients and the government that funds it.
incentive for managers to can vote, but his vote is In this group we can distinguish among:
perform, since the capital valueless,” Galbraith n Internal stakeholders, such as managers
was provided by declared in The New and medical staff.
shareholders rather than the Industrial State (1967). n Connected stakeholders, who have a
managers themselves. The principal-agent direct link to the organisation but function
Adam Smith.
He had this to say about the problem is now seen as a crucial outside it, such as the government.
directors of such a business: “Being element in our understanding of n External stakeholders, who have an
the managers rather of other people’s management and decision‑making in interest in the organisation but are not part
money than of their own, it cannot be well enterprises. But it is not a purely business of it, such as patients.
expected that they should watch over it with phenomenon. It arises in a wide range of Two types of stakeholder involvement can
the same anxious vigilance with which human activities and is part of what is known also be identified and measured: their level of
partners in a private copartnery frequently as agency theory. This is concerned with the interest in the organisation and their level of
watch over their own.” Perhaps Smith was relationship between a principal and an agent influence on its behaviour. Sometimes a
still influenced by the scandal of the South who acts on behalf of that principal. positive correlation between interest and
Sea bubble 60 years earlier. Examples include: influence exists. Internal stakeholders such as
In the 19th century the issue lost its n Shareholders delegating powers to managers have a lot of interest and a lot of
attraction for economists, indicating the boards of directors. influence, whereas external stakeholders may
apparently crucial role that joint-stock, n Patients leaving decisions about their have little of either. But this correlation does
limited-liability companies played in treatment to doctors. not always hold. A patient will have a high
economic growth during that period. Even n House-buyers employing solicitors to level of interest in his or her treatment, but
corporate scandals, particularly evident in the purchase houses on their behalf. may have far less influence on the process
US, failed to arouse much academic n Local authorities appointing private firms because they will tend to lack medical
enthusiasm. But interest revived in the 20th to perform routine council services. knowledge. In other cases, a lack of power
century. This reflected partly the academic
discussion of organisations in other
disciplines and partly the growing awareness If the enterprise reflects
Photographs: Corbis

of the increasing dominance of large


companies in western economies. the aims of its managers,
In 1932 Adolf Berle and Gardiner Means
coined the phrase “the separation of can we still apply the
ownership and control” in their book The
Modern Corporation and Private Property. profit-maximising theory?
46 financial management
PAPER CO4

As long as company failures


come as a surprise to investors,
the principal-agent issue
will retain its shock value
may prevent stakeholders from influencing an Conventional economic theory assumes that businesses. But is this really the case?
organisation, despite high levels of interest. shareholders are solely interested in Two arguments suggest otherwise. First,
In a principal-agent relationship, the key maximising their wealth, so the aim of the shareholders may have more power and
question is: can the principal ensure that the business is assumed to be profit knowledge than the model assumes. Most
agent always acts in a way that’s consistent maximisation. But this assumption is shares traded on the London Stock
with the principal’s objectives? When there is weakened if the management team is, in Exchange are owned not by individuals, but
a divorce of control from ownership, the effect, controlling the business. If the by institutions such as pension funds. These
question becomes: can the shareholders enterprise reflects the aims of its managers, organisations may own considerable blocks
(principals) ensure that managers (agents) can we still apply the profit-maximising theory of shares in companies and can be expected
always act in their interests? to the organisation? The argument here is to have extensive knowledge about these
Why might shareholders lose control of that managers have no reason to be businesses. In some countries – notably,
an organisation that they legally own? motivated to maximise the wealth of remote France, Germany, Italy and Japan –
Galbraith suggested a number of reasons shareholders who have no real influence over shareholding is even more concentrated in
for this, including: them. Instead, they will pursue their own these institutions than it is in the UK or the
n Lack of power. As businesses became objectives, which, it’s suggested, concern US. But a shareholder will incur considerable
larger, the capital requirements expanded. financial reward, power, prestige, status and costs guarding its interests by monitoring the
And, as technology became more capital- independence of action. The problem is how performance of firms in which it owns stock,
intensive, the growth in demand for capital to translate this mix of objectives into an and it will reap only a proportion (depending
exceeded the growth of the businesses. assumption about business motivation. on the size of its holding) of the benefits of
The need to secure economies of scale William Baumol (Business improved business performance. So
further encouraged the development of Behaviour, Value and Growth, there’s an incentive to sit back
large businesses. It was argued that the 1959) argued that and let other shareholders bear
capital to finance this could come only these objectives were a these costs, which creates a
from the savings of large numbers of small function of the scale of the risk that all shareholders will
investors – hence the rationale for the plc. enterprise. For example, try to take a “free ride” and
But, if there are many investors, it implies financial rewards for none of them will do
that individual investors will have little directors tend to correlate the monitoring.
power over the company. In Galbraith’s to business size. The second counter-
words, the stockholder’s vote is valueless. Baumol’s model assumed argument is that
n Lack of knowledge. With the development that businesses were shareholders may be able
of modern IT, few people in high-tech firms sales growth maximisers, to create reward systems
understand every aspect of their business. albeit with a profit in which the management
Specialists are, by definition, experts in only constraint – the level of team has powerful financial
some fields and knowledge rests more with profit sufficient to keep J K Galbraith. incentives to act entirely in their
groups of experts in the organisation – shareholders happy (and quiet) – interests. The problem here lies in
what Galbraith called the techno-structure. but profit was not an objective in determining these packages. If
This now extends to the non-technological itself for the managers. Robin Marris shareholders could directly observe the
areas of the business, including finance. (The Economics of Managerial Capitalism, effectiveness of the management team, they
The challenge for investors is to acquire a 1969) abandoned the idea of could devise reward schemes that oblige the
minimum level of understanding of their maximisation itself, suggesting that we directors to put in the level and direction of
firm. Since the flow of information from it should regard organisations as satisficers effort that maximises shareholder wealth. But
to its shareholders is controlled by the rather than maximisers, and that managers shareholders don’t have perfect information
directors, the problem is compounded. would aim at satisfactory levels of growth, of this kind. If they have limited knowledge
Since the objectives of an organisation will profitability and share price value. and don’t know whether the company’s
reflect the objectives of those who control it, The theory, therefore, was that companies’ performance outcomes have resulted from
this conclusion has important implications. owners had lost effective control of their directors’ actions or from other factors,

financial management 47
>study notes
designing effective incentive packages
becomes an extremely difficult task.
Shareholders don’t normally design
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48 financial management