Chapter 9: Agency Theory
Agency theory discusses the relations between two people - a principal
and an agent who makes decisions on behalf of the principal. A few
examples of agency relations:
The owner of a firm (principal) and the manager of a firm (agent), who
makes decisions affecting the owner's wealth.
A manger (principal) and his/her subordinate, who makes decisions
affecting its managers reputation.
A patient (principal) and her physician (agent), who makes decisions
affecting the patient's health.
Agency relations can be found both within firms and between firms. Within
agency theory two streams of literature can be distinguished: the positive
theory of agency and the theory of principal and agent. In the positive
theory of agency, the firm is viewed as a connection of contracts. The
main research question in this theory are how contracts affect the
behaviour of participants and why do we observe certain organizational
forms in the real world? The positive theory of agency thus sets out to
explain why organizational forms are as they are. In the theory of principal
and agent, the central question is how should the principal design the
agent's reward structure?
Separation of ownership and control
Large corporations are owned by so many shareholders that no single
shareholder owns a significant fraction of the outstanding stock.
Therefore, no single shareholder has the power really to control the
actions of the officers of the corporation. The interests of the officers and
shareholders diverge widely. In some large corporations the officers own a
large percentage of the share. Those corporations might be called owner-
controlled and the corporations with widely dispersed shareholdings
manager-controlled.
There are powerful mechanisms that prevent managers from engaging in
excessive on-the-job consumption. Some of those potential mechanisms
are:
First, there is the stock market. If a corporation performs badly
because the managers of that corporation are incompetent, lazy or not
really interested in running the corporation as well as they can, the
market price of that company's stock will decline. Managers who
perform poorly must always fear that their company can be taken
over. There is a market for the rights to manage corporations, the
Agency theory discusses the relations between two people - a principal
and an agent who makes decisions on behalf of the principal. A few
examples of agency relations:
The owner of a firm (principal) and the manager of a firm (agent), who
makes decisions affecting the owner's wealth.
A manger (principal) and his/her subordinate, who makes decisions
affecting its managers reputation.
A patient (principal) and her physician (agent), who makes decisions
affecting the patient's health.
Agency relations can be found both within firms and between firms. Within
agency theory two streams of literature can be distinguished: the positive
theory of agency and the theory of principal and agent. In the positive
theory of agency, the firm is viewed as a connection of contracts. The
main research question in this theory are how contracts affect the
behaviour of participants and why do we observe certain organizational
forms in the real world? The positive theory of agency thus sets out to
explain why organizational forms are as they are. In the theory of principal
and agent, the central question is how should the principal design the
agent's reward structure?
Separation of ownership and control
Large corporations are owned by so many shareholders that no single
shareholder owns a significant fraction of the outstanding stock.
Therefore, no single shareholder has the power really to control the
actions of the officers of the corporation. The interests of the officers and
shareholders diverge widely. In some large corporations the officers own a
large percentage of the share. Those corporations might be called owner-
controlled and the corporations with widely dispersed shareholdings
manager-controlled.
There are powerful mechanisms that prevent managers from engaging in
excessive on-the-job consumption. Some of those potential mechanisms
are:
First, there is the stock market. If a corporation performs badly
because the managers of that corporation are incompetent, lazy or not
really interested in running the corporation as well as they can, the
market price of that company's stock will decline. Managers who
perform poorly must always fear that their company can be taken
over. There is a market for the rights to manage corporations, the
