Agency Theory

Agency Problems
It has long been recognized that the separation of ownership and control in the modern
corporation results in potential conflicts between owners and managers. In particular, the
objectives of management may differ from those of the firm’s shareholders. In a large cor-
poration, stock may be so widely held that shareholders cannot even make known their
objectives, much less control or influence management. Thus this separation of ownership
from management creates a situation in which management may act in its own best interests
rather than those of the shareholders.
We may think of management as the agents of the owners. Shareholders, hoping that the
agents will act in the shareholders’ best interests, delegate decision-making authority to them.
Jensen and Meckling were the first to develop a comprehensive theory of the firm under
agency arrangements.1 They showed that the principals, in our case the shareholders, can
assure themselves that the agents (management) will make optimal decisions only if appro-
priate incentives are given and only if the agents are monitored. Incentives include stock
options, bonuses, and perquisites (“perks,” such as company automobiles and expensive
offices), and these must be directly related to how close management decisions come to
the interests of the shareholders. Monitoring is done by bonding the agent, systematically
reviewing management perquisites, auditing financial statements, and limiting management
decisions. These monitoring activities necessarily involve costs, an inevitable result of the
separation of ownership and control of a corporation. The less the ownership percentage
of the managers, the less the likelihood that they will behave in a manner consistent with
maximizing shareholder wealth and the greater the need for outside shareholders to monitor
their activities.
Some people suggest that the primary monitoring of managers comes not from the
owners but from the managerial labor market. They argue that efficient capital markets
provide signals about the value of a company’s securities, and thus about the performance
of its managers. Managers with good performance records should have an easier time finding
other employment (if they need to) than managers with poor performance records. Thus, if
the managerial labor market is competitive both within and outside the firm, it will tend to
discipline managers. In that situation, the signals given by changes in the total market value
of the firm’s securities become very important.