What Does Agency Theory Mean?

A theory concerning the relationship between a principal (shareholder) and an agent of the
principal (company's managers).

Or

Essentially it involves the costs of resolving conflicts between the principals and agents and
aligning interests of the two groups.

An agency relationship arises whenever one or more individuals, called principals, hire one
or more other individuals, called agents, to perform some service and then delegate decision-
making authority to the agents.

The primary agency relationships in business are those

(1) Between stockholders and managers and (2) between debt holders and stockholders.

These relationships are not necessarily harmonious; indeed, agency theory is concerned
with so-called agency conflicts, or conflicts of interest between agents and principals.
This has implications for, among other things, corporate governance and business ethics.
When agency occurs it also tends to give rise to agency costs, which are expenses
incurred in order to sustain an effective agency relationship (e.g., offering management
performance bonuses to encourage managers to act in the shareholders' interests).
Accordingly, agency theory has emerged as a dominant model in the financial economics
literature, and is widely discussed in business ethics.

Agency theory in a formal sense originated in the early 1970s, but the concepts behind it have
a long and varied history. Among the influences are property-rights theories, organization
economics, contract law, and political philosophy. Some noteworthy scholars involved in
agency theory's formative period in the 1970s included Armen Alchian, Harold Demsetz,
Michael Jensen, William Meckling, and S.A. Ross.

Conflicts between Managers and Owners

Agency theory raises a fundamental problem in organizations—self-interested behavior. A

corporation's managers may have personal goals that compete with the owner's goal of
maximization of shareholder wealth. Since the owners authorize managers to administer the
firm's assets, a potential conflict of interest exists between the two groups.

SELF-INTERESTED BEHAVIOR.

1. Agency theory suggests that, in imperfect labour and capital markets, managers will
seek to maximize their own utility at the expense of the owner o the firm. Agents have
the ability to operate in their own self-interest rather than in the best interests of the
firm because of asymmetric information (e.g., managers know better than owners
whether they are capable of meeting the shareholders' objectives) and uncertainty.
2. Managers are interested in short-term profits against long-term shareholders value, as
it has a positive impact on their compensation, incentives , bonus and promotion.
 3. Management myopia short term profits also motivates them to resort to creative
accounting inflating the top line and bottom line. E.g. Satyam & Enron episode
exemplifies such myopia.
4. Managers deploy shareholder’s fund in risky investments so as to get quick and
immediate returns at the cost of shareholder’s wealth.
5. Shareholders’ funds are directed into projects in which the management may have
personal interest e.g deploying funds in a company that is owned by a relative of the
managing director.

Adam smith known as father of economics was highly sceptical and pessimistic about
the success of corporation as a model of creating wealth and pursuing economic
growth.

Smith believed that :

1. The cost of agency relationship would always be too high. There is a constant
debate in USA on ‘managerial remuneration’
2. Remuneration cost shall rise with the increase in size of business.
3. Bigger a business gets , the greater negligence would be from managers side.
4. Negligence, profusion and conflict of interest would ruin the corporation.

Conflict of interest leads to corporate debacles, be it Enron, World-com or Satyam. It is sad

but Smith predictions have been proven right.

COSTS OF SHAREHOLDER-MANAGEMENT CONFLICT.

Agency costs are defined as those costs borne by shareholders to encourage managers to
maximize shareholder wealth rather than behave in their own self-interests. There are three
major types of agency costs:

1) expenditures to monitor managerial activities, such as audit costs;

2) expenditures to structure the organization in a way that will limit undesirable managerial
behaviour, such as appointing outside members to the board of directors or restructuring the
company's business units and management hierarchy; and

(3) opportunity costs which are incurred when shareholder-imposed restrictions, such as
requirements for shareholder votes on specific issues, limit the ability of managers to take
actions that advance shareholder wealth.

Agency costs would be excessive if shareholders attempted to ensure that every managerial
action conformed with shareholder interests. Therefore, the optimal amount of agency costs
to be borne by Owner or shareholders is determined in a cost-benefit context—agency costs
should be increased as long as each incremental rupee spent results in at least a rupee increase
in shareholder wealth.

MECHANISMS FOR DEALING WITH SHAREHOLDER-MANAGER CONFLICTS

Stockholders could monitor every managerial action, but this would be extremely costly and
inefficient. The optimal solution lies wherein executive compensation is tied to performance,
but some monitoring is also undertaken. In addition to monitoring, the following mechanisms
encourage managers to act in shareholders' interests:

(1) performance-based incentive plans,

(2) direct intervention by shareholders,

(3) the threat of firing, and

(4) the threat of takeover.

Managers can be encouraged to act in the stockholders' best interests through incentives,
constraints, and punishments. These methods, however, are effective only if shareholders can
observe all of the actions taken by managers. A moral hazard problem, whereby agents take
unobserved actions in their own self-interests, originates because it is infeasible for
shareholders to monitor all managerial actions. To reduce the moral hazard problem,
stockholders must incur agency costs.