Wednesday, April 4, 2012

The role of market discipline in agency theory

In the last blog we looked at bonding and incentives as a mechanism to handle agency costs. In today's blog we look at the role markets play in determining the arrangements and outcomes that agency theory predicts.

Agency theory adopts a semi-strong form of capital market efficiency. We mentioned this to be semi-strong since the asset prices do not reflect all the information - irrespective of public or private. We also cannot call it weak since the info of prices doesn’t limit itself to historically available information. 

One of the implications of this semi strong assumption is as follows - if managers (agents) of the firm  take actions that are viewed adversely affecting the value of the firm’s assets, then the price of these (stock price) will drop. If the situation progresses this way, the firm's management could eventually lose control of the firm - the old high agency cost managers will be replaced by low-agency cost managers. This is akin to take over. If by the takeover, significant wealth gains are achieved - in many ways this could be associated with the reduction in the agency cost that is expected after the acquisition is complete.  

In many cases economics is slow to recognize conflicts within firms and between the firms and its numerous stakeholders, the influence of agency theory in organization economics could hardly be neglected.

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