Economic Foundations of Strategy Chapter 4: Agency Theory

1. Economic Foundations of StrategyChapter 4: Agency Theory Joe Mahoney University of Illinois at Urbana-Champaign

2. Agency Theory: • Berle and Means (1932): The Modern Corporation • Pratt and Zeckhauser (1985): Principals and Agents • Arrow (1985): “The Economics of Agency” • Levinthal (1988): “Agency Models of Organizations” • Jensen and Meckling (1976): “Theory of the Firm: Managerial Behavior, Agency Costs, and Capital Structure

3. Berle and Means (1932):The Modern Corporation • Maintains that the separation of ownership fromcontrol produces a condition where the interests of owner(s) and managers often diverge and that discretionary power by managers exists. • Berle and Means ask: “Have we any justification for assuming that those in control of the modern corporation will also choose to operate it in the interest of owners?” (1932: 121)

4. Berle and Means (1932):The Modern Corporation • In their empirical study they find that 88 of the 200 largest American non-financial corporations were “management controlled” in 1929 because no individual, family, corporation, or group of business associates owned more than 20 percent share of all outstanding stock, and because evidence of control by a smaller ownership group was lacking. • They judged only 22 to be privately owned or controlled by a group of stockholders with a majority interest.

5. Berle and Means (1932):The Modern Corporation • They conclude that the State seeks in some respects to regulate the corporation, while the corporation, steadily becoming more powerful, makes every effort to avoid (or shape) such regulation. Where its interests are concerned, the modern corporation even attempts to dominate the State. The future may see the economic organization, typified by the corporation, not only on an equal plane with the State, but possibly even superseding the State as the dominant form of social organization. The law of the corporation, accordingly, might well be considered as a potential constitutional law for the new economic State, while business practice is increasingly assuming the aspect of economic statesmanship.

6. Pratt and Zeckhauser (1985):Principals and Agents • Given information asymmetries --- agents typically know more about their tasks than their principals do --- we cannot expect any business enterprise or business institution to function as well as it would if all information were costlessly shared or if the economic incentives of principals and agents could be costlessly aligned. • This shortfall is sometimes called the agency loss or agency costs.

7. Pratt and Zeckhauser (1985):Principals and Agents • In economic language, since the first-best outcome could only be achieved in the unrealistic world of costless information flow, our goal must be to do the best we can, to achieve what is sometimes called the second-best solution. • The building blocks of agency theory are information and economic incentives.

8. Pratt and Zeckhauser (1985):Principals and Agents • Information • At one extreme we have the perfect-market transaction, with standardized products and all information fully shared. • At the other end of the continuum are situations in which the agent has full discretion and is not observed at all by the principal.

9. Pratt and Zeckhauser (1985):Principals and Agents • Agency loss is more severe when the economic interests or economic values of the principal and agent diverge substantially, and information monitoring is costly; • The economic benefits of any reduction in agency loss will be shared by principal and agent in most market situations.

10. Pratt and Zeckhauser (1985):Principals and Agents • The principal and agent have a common economic interest in defining a monitoring-and-incentive structure that produces economic outcomes as close as possible to the economic outcome that would be produced if information monitoring were costless. • Human environments can change quickly and there is no assurance that the institutions we currently observe are best.

11. Arrow (1985):“The Economics of Agency” • Finds it useful to distinguish two types of agency problems: • Hidden action models (moral hazard) • “Moral hazard and observability” (Holmstrom, 1979) • Hidden information models (adverse selection) • “The market for lemons” (Akerlof, 1970)

12. Arrow (1985):“The Economics of Agency” • Arrow observes that in some cases where the principal-agent theory seems clearly applicable, real-world practice is very different from the model. In many respects, the physician-patient relation exemplifies the principal-agent relationship almost perfectly. • The principal (the patient) is certainly unable to monitor the efforts of the agent (the physician). • The relation between effort and outcome is random, but presumably there is some connection. • Yet in practice, the physician’s fee schedule is in no way related to outcome. In general, compensation of professionals shows only a few traces of the complex fee schedules implied by agency theory.

13. Arrow (1985):“The Economics of Agency” • Why is the divergence between agency theory and practice so stark? • One basic problem is the cost of specifying complex relations. • Second, superiors judge executives on criteria that could not have been stated in advance. Outcomes and even supplementary objective measures do not exhaust the information available on which to base rewards. • Professional responsibility is clearly enforced in good measure by a system of ethics, internalized during the education process and enforced in some measure by formal punishments and more broadly by reputations.

14. Levinthal (1988):“Agency Models of Organizations” • Provides the insightful perspective that the agency paradigm can be viewed as the neoclassical response to questions raised many years earlier by March and Simon (1958) and Cyert and March (1963) regarding the behavior of an organization of self-interested agents with conflicting goals in a world of incomplete information. • Judges, however, that the focus on the incentive problem in the organizational economics and strategic management literatures is excessive. The inability of top management to coordinate goes well beyond the problem of industriousness. The strategic management literature should also allocate time and attention to offering superior heuristics for management to achieve coordination.

15. Levinthal (1988):“Agency Models of Organizations” • Role of Time • Levinthal (1988) notes that the repetition of an agency relationship over time tends to improve its efficiency. • When the agency relationship repeats itself over time, the effects of uncertainty tend to be reduced and dysfunctional behavior is more accurately revealed, thus alleviating the problem of moral hazard.

16. Levinthal (1988):“Agency Models of Organizations” Multi-agent models and tournament contracts • Levinthal maintains that the risk imposed on an agent can be reduced by basing individual performance relative to that of other agents, who face similar states of nature. For example, in “tournaments,” the reward is a function of the rank order of performance relative to other agents.

17. Jensen and Meckling (1976):“Theory of the Firm: Managerial Behavior, Agency Costs, and Capital Structure • Jensen and Meckling (1976) integrate elements from agency, the theory of property rights and the theory of finance to develop a theory of the ownership structure of the firm. • Agency costs are defined as: • The monitoring costs by the principal; • The economic bonding costs by the agent; • The residual economic loss.

18. Jensen and Meckling (1976):“Theory of the Firm: Managerial Behavior, Agency Costs, and Capital Structure • Jensen and Meckling (1976) maintain that agency costs (i.e., monitoring costs, economic bonding costs, and the residual income loss) are an unavoidable result of the agency relationship. • Jensen and Meckling (1976) submit that contractual relations are the essence of the firm, not only with employees (Alchian & Demsetz, 1972), but also with suppliers, customers, creditors, and so on.

19. Jensen and Meckling (1976):“Theory of the Firm: Managerial Behavior, Agency Costs, and Capital Structure • Jensen and Meckling (1976) maintain that most organizations serve as a nexus for a set of contracting relationships among individuals. • Jensen and Meckling (1976) emphasize that since decision makers ultimately bear the agency costs, these decision makers have the economic incentive to minimize agency costs.

20. Jensen and Meckling (1976):“Theory of the Firm: Managerial Behavior, Agency Costs, and Capital Structure • Jensen and Meckling (1976) maintain that agency costs (i.e., monitoring costs, economic bonding costs, and the residual income loss) are an unavoidable result of the agency relationship. • Jensen and Meckling (1976) conclude that the level of agency cost depends, among other things, on statutory and common law, and human creativity in devising better contracts. Both the law and the sophistication of contracts relevant to the modern corporation are the products of an historical process in which there were strong economic incentives for individuals to minimize agency costs.