Tuesday, March 27, 2012

What is Agency Problem in businesses?

In the last blog, we looked at some of the issues that happen within the organization, but are not explained by the TCT. In today's blog we build on this drawback and begin our discussion on "Agency Theory". 

Agency Theory has its origin from the property rights literature and to a very small portion on the TCT. Just like TCT, Agency theory also assumes that humans have bounded rationality, are self interested and are prone to opportunism. Both theories emphasize on information asymmetry problems in contracting and on efficiency as the engine that drives the transaction governance. The two differ in that; Agency theory emphasizes the risk attitude of principals and agents.

When Agency theory originated, the emphasis was on the relation between managers and stockholders. It analyzed the corporate governance issues including - the role of directors, role of top management compensation. This has been extended to explain a numerous intra-organizational conflicts.

For the sake of clarity - an agency relationship occurs when one partner (the principal) in a transaction delegates authority to another (The agent) and the welfare of the principal is affected by what choices the agent makes. The most common example we see is the relationship of investors in a firm and the mangers of the firm. 

In the case explained above, the investor delegates the management authority to managers who may or may not have any equity ownership in the firm. The problems that could arise are:

  1. The interest of the two parties diverge
  2. Agent actions cannot be seamlessly and costlessly be monitored
  3. Information available to the principal is not the same as the information available to the agent

These three together form the agency problem

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