Agency theory is a fundamental concept in economics and management that explores the relationships between principals (owners or shareholders) and agents (managers or leaders) within organizations.
This theory analyzes how conflicts of interest and information asymmetries can influence the behavior of agents and how contracts and incentive mechanisms can be used to mitigate these problems. In this comprehensive course, we will dive into the details of agency theory to understand how it works and its practical application.
Table of Contents
Definition of the agency theory
Jensen and Meckling (1976) define the agency theory as: “A contract whereby one or more persons (the principal) engages another person (the agent) to perform some task on their behalf. which implies a delegation of some decision-making power to the agent. »
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Under assumptions that break with standard theory (agency theory considers the possibility of a divergence between the principal and the agent and assumes that the agent has information that the principal does not have), this theory is commonly illustrated by the agency relationship between owners of capital (the principal) and the managers of the company (the agent).
In particular, it is at the heart of corporate governance issues, and in particular of the so-called “shareholder” model.
Definition: We speak of an “agency relationship” when a company or individual (principal) entrusts all or part of the management of its interests to a third party (agent).
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Contracts, Moral Hazard and Incentives
In general, there is an agency relationship when an individual, the “principal”, requests something from another individual, the “agent”, without knowing all the relevant information. For example, when an employer mandates an employee (the agent) to carry out a task provided for in a contract, he is not always able to perfectly observe the intensity of the efforts made by the latter.
The agent, who masters the content of the task to be carried out and knows his real professional capacities, is better informed than the principal; he may therefore seek to take advantage of this “information asymmetry” to increase his satisfaction at the expense of the principal. The latter then incurs a “moral hazard”.
Most economic relationships are characterized by principal-agent relationships where a moral hazard exists due to an asymmetry of information: the patient and his doctor, the private individual having recourse to an expert… The motorist who has his car repaired (he is then the principal) can imagine that the mechanic will take advantage of his ignorance of mechanics.
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An insurance company (the principal) is never certain that the insured (the agent) will make every effort to avoid an accident or theft, which he can also cause himself. More generally, all salaried work situations fall within this analysis scheme: by what type of incentives can an employer limit the risk that the employee “pulls to the side”?
Incomplete contracts and agency costs
In agency theory, individuals are rational and seek to maximize their utility function. From this point of view, we remain in neoclassical orthodoxy. The new hypotheses concern the asymmetry of information, the divergence of interests between principal and agent and the uncertainty linked to the impossibility for the first to perfectly observe the efforts of the second.
Added to this is the incompleteness of contracts in most agency relationships. Indeed, the negotiation of a contract being expensive, it is not possible, except to imagine extremely complex contracts which do not exist in reality, neither to envisage all the occurrences which can occur, nor the impact they would have on the performance of the contract.
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If he limits himself to a simple contract providing for payment according to the result, the principal may think that the agent will take advantage of the loopholes in the contract to maximize his utility at his expense. To compensate for the incompleteness of the contracts, the principal will seek to invest in the monitoring and direct control of the action of the agents. He will then have to bear additional costs called “agency costs”.
The whole problem that the theory seeks to solve is then to find an appropriate contractual system and mode of remuneration to encourage the agent to act in the interest of the principal and to limit the agency costs linked to the monitoring of the contract.
The implications of agency theory are traditionally illustrated by the agency relationship with moral hazard between owner-shareholders and managers in listed companies. An agent (the manager) is mandated and remunerated by a principal (the shareholders); there may be a divergence of interests between them, with the former favoring the objective of maximizing profit, the former favoring the objectives of growth or personal prestige.
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Finally, there is asymmetry of information: the manager knows the details of the operation of the company. As the shareholder does not have the possibility of controlling all the actions of the manager, he will have to find an incentive remuneration system both to ensure that the latter will act in the interest of the holders of the capital and to avoid agency costs associated with possible conflicts with the manager.
In brief the agency costs:
For the principal : Cost of supervising the agent and Cost of complying with orders of the agent
For the agent : Cost of poor execution by the agent
Scope and limits of agency theory
Another development of agency theory concerns the understanding of the structure and functioning of organizations.
Completing the theory of property rights, the ambition of which is to affirm the supremacy of private property over collective forms of property, agency theory proposes to demonstrate the superiority of free contractual systems which must lead spontaneously to the selection of the most efficient organizational forms (Coriat and Weinstein, 1995).
Since the company is considered as a specific set of contracts, the most efficient contractual structure is the one that will minimize, in a given situation, the agency costs. The agency theory thus explains why there is not a single legal form of business.
Depending on the sector, one or other of the possible forms of organization will tend to dominate: individual companies, companies, mutuals, cooperatives, non-profit associations, etc.
The interest of agency theory for understanding organizations is obvious. Indeed, under realistic assumptions such as uncertainty, information asymmetries, and the existence of divergent interests between individuals, it analyzes the firm as a complex organization structured by the interactions between economic actors.
It offers a stimulating theoretical framework to explain the emergence of efficient organizational forms, the behavior of shareholders and managers in joint-stock companies, and, more generally, the modes of resolution of potential conflicts in cooperative situations.
That said, centering the analysis on contracts and on inter-individual relations (what is called “methodological individualism”) has a major drawback: agency theory does not take into account the collective dimension of company, no more than the hierarchical system and internal power relations.
On the other hand, analyzing the firm as a legal fiction grouping together a specific set of contracts does not make it possible to clearly distinguish it from the market. The agency theory certainly makes it possible to get away from the traditional opposition in economics between these two forms of regulation.
But, by neglecting the question of the boundaries of the firm, the agency theory does not see a fundamental opposition between the firm and the market. It is on the opposite assumption that the economy of transaction costs has developed.
Measures to limit agency problems
Firms use an astonishing variety of instruments to reduce the costs associated with principal-agent situations. We will cite three main categories of strategies that can be put in place to combat agency problems: Monitoring (or control), performance-based incentives and bureaucracy.
Monitoring
To limit the problems related to an agency relationship, the principal increases control over the agent by increasing the resources related to its monitoring and/or by improving the collection of information on its real actions.
For example, one of the most important roles of a company’s board of directors, which represents shareholders, is to check the decisions of the CEO. But, this can create a new agency problem between the board of directors and the shareholders.
In other words, there will always be the question of who keeps the guards?
Performance-based incentives
Another way for companies to mitigate agency problems is to implement an incentive structure that takes agent performance into account. If the principal succeeds in aligning the agent’s incentives with his own, the agency problem is solved.
It can align preferences in two ways:
Make the agent’s remuneration depend on his performance. Use non-monetary incentives, such as increasing personal motivation by playing on the employee’s ego.
Bureaucracy
This solution aims to reduce agency problems by clearly delimiting the set of actions that the agent can perform.
This can be used to limit the discount rates granted by salespeople, who seek to maximize turnover at the expense of company profit, in order to maximize their (merit) compensation.
The principal can complicate the procedure for granting reductions by centralizing this decision more and more as the rate is high.
Conclusion
In conclusion, agency theory remains an important theoretical framework for understanding agency relationships and for designing effective governance systems.
However, it should be used with caution and should not be seen as a one-size-fits-all solution to all governance and management issues.