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HED 4101 Business Ethics
The Agency Theory
In the recent past, the discipline of economics has come to play an increasingly influential role in
the way decision makers in public and private organizations define and resolve issues
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 Project managers and analysts use discounted cash flow analysis to evaluate investment
and financing decisions
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Behind this growing influence lies a system of thinking that emphasizes notions such as scarcity
of resources, rational self-interest, and efficiency
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Decision-makers are relying on economic approaches to solve issues because among the social
sciences economics offers a systematic approach and analytic rigor that is similar to that of the
natural sciences
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The growth of
transaction cost economics, principal-agent analysis, and extensions of the game theory attest to
the emergence of a new field of study known as the economics of organization
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Normally, the agent will never act exactly as the principal
would like, because he has different interests and risk perceptions
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The use of principal-agent models
Principal-agent models offer insight into the complications of contracting for services: e
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a firm
contracting for labour from employees, a patient contracting for medical services from a doctor
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Jensen and Meckling define the agency theory on the basis of what they call agency
relationships, which they understand as contracts –not necessarily explicit or formal contractsunder which one or more persons (the principals) engage another person (the agent) to perform
some service on behalf that involves delegating some decision-making authority to the agent
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Stephen Ross :“The Economic Theory of Agency”, 1973, published in American Economic Review
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Maria Rosario G
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 The mechanism for articulating this relationship takes the form of a contract between the
principal and the agent
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 An agency relationship arises whenever there are two or more individuals who have
differing goals and interests and one of them holds a position of dominance over the
others, so that the others are obliged in such a way to achieve the objectives of the person
who is in the dominant position
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The managers are agents of the shareholders, and the
shareholders assume that the principle guiding the managers’ actions will be that of
implementing whatever policies increase the value of the firm
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It is
generally assumed in these models that the principal can dictate the terms of the contract,
subject only to the constraint that the compensation offered must equal or exceed the
agent’s next best known alternative
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Agents will not
accept contracts with expected values below the stipulated reservation utility
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These
conditions are goal incongruity, uncertainty, information assymetry, and agent risk
aversion
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The
agent is not sufficiently motivated by the satisfaction of a job well done
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 Uncertainty refers to the fact that the observable outcome of the agent’s work is not a
perfect measure of the input
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 Information asymmetry refers to the fact that the agent has better information about her
abilities, preferences, and level of effort than does the principal
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This asymmetry can only be reduced by the principal’s engaging in costly
investigation, monitoring or audit activities
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Accordingly the agent would resist having her compensation simply be a
function of the observable outcomes of her effort
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 Some contractual arrangements create incentives for underperformance on the part of the
agent
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This is known as adverse selection
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Nonetheless certain assumptions have gained wide use
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Another is that the agent has a negative utility for effort, a positive utility for money
and no other relevant preferences
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Opportunism is defined as self-interest seeking with guile
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As a consequence there is every
reason to suspect that the agent will not always act in accordance with the best interests of the
principal
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Agency theory thus has to resolve the so-called agency problem which arises when the desires
and goals of the principal and the agent come into conflict, and when it is difficult or costly for
the principal to monitor the agent’s actions
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These agency costs are those caused by the divergence (or the failure to maximize the principal’s
wealth) and costs incurred to reduce the divergence (or costs incurred by the principal to control
the agent’s behaviour or costs in the form of incentives that make it attractive for the agent to
bring his actions in line with the shareholders’ interest)
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In practice, that means ensuring that the agent serves the principal’s interests by
reducing agency costs to the minimum
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The individual is construed as
being concerned for his own interests, determined to maximize his utility, and willing to
engage in immoral conduct if such conduct is strategically convenient (opportunism)
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 Ethics is seen as a cheap way of overcoming agency costs
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 There is an overemphasis on the need “to control” the individual
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