Agency problems—also known as principal-agent problems or asymmetric information-driven conflicts of interest—are inherent in many corporate structures. This conflict arises when separate parties in a business relationship, such as a corporation's managers and shareholders, or principals and agents, have disparate interests.
Principals hire agents to represent the principals' interests. Agents, working as employees, are assumed and obligated to serve the principal's best interests. Problems occur when the agent begins serving different interests, such as the agent's own interests. Thus, conflict occurs between the interests of principals and agents when each party has different motivations, or incentives exist that place the two parties at odds with each other.
Corporations employ several dynamic techniques to circumvent static issues resulting from agency problems, including monitoring, contractual incentives, soliciting the aid of third parties, or relying on other price system mechanisms. The study of agency problems is ongoing in both corporate and academic circles. Increasingly, contract design limits are recognized and corporations are turning to different incentive mechanisms.
- An agency problem is a conflict of interest inherent in any relationship where one party is expected to act in another's best interests.
- In corporate finance, the agency problem usually refers to a conflict of interest between a company's management and the company's stockholders.
- The manager, acting as the agent for the shareholders, or principals, is supposed to make decisions that will maximize shareholder wealth even though it is in the manager’s best interest to maximize his own wealth.
- Agency problems can be mitigated with the right incentives and contract design.
If agents are acting in accordance with their own interests, changing incentives to redirect these interests may be beneficial for principals. For example, establishing incentives for achieving sales quotas may result in more salespeople reaching daily sales goals. If the only incentive available to salespeople is hourly pay, employees may have an incentive for discouraging sales.
Creating incentives that encourage hard work on projects benefiting the company generally encourages more employees to act in the business's best interest. By aligning agent and principal goals, agency theory attempts to bridge the divide between employees and employers created by the principal-agent problem.
Standard Principal-Agent Models
Financial theorists, corporate analysts, and economists often use principal-agent models to study and offer solutions for problems that result from conflicts of interest in business arrangements. These models are constructed to spot and minimize costs.
An agency relationship exists whenever one party's actions affect his own welfare and the welfare of another party in a contractual relationship. Most agency experts attempt to design contracts that can align the incentives of each party in a more efficient manner. Traditionally, such contracts result in unintended consequences, such as moral hazard or adverse selection.
Principal-agent models form the basis of agency theory. Agency theory states that labor and knowledge are imperfectly distributed (asymmetrical) and that additional measures are necessary to correct these distributive inefficiencies.
Agency problems arise from conditions of asymmetric information, where one party knows more about something than the other.
Agency theorists have always assumed a large role for explicit incentive mechanisms, such as written contracts and monitoring, to mitigate agency problems. History demonstrates that these solutions are incomplete based on moral hazard and adverse selection.
Principal-agent problems contain elements of game theory, the theory of the firm, and legal theory. For example, game theory demonstrates limits for otherwise rational self-enforcement mechanisms. Economist Ronald Coase argued as early as 1937 that market price mechanisms are suppressed by transaction costs inherent in a hierarchical corporate structure.
Through the years, several different corporate-specific mechanisms have been identified as possible solutions through agency theory. For example, in 2013, Apple began requiring senior executive employees and board of directors members to own stock in the company. This move was intended to align executive interests with those of shareholders.
Management, in theory, no longer benefits from actions that harm shareholders as the significant investment owned by executives forces them to view their own interests as being identical to investor interests. Executives, hired by shareholders to represent the best interests of the company and therefore the best interests of investors, must pay attention to issues impacting the company's health and long-term growth. Apple believes this effort to address the principal-agent problem can improve profitability for investors and keep the company competitive for the future.
Market for Corporate Control
The most frequent example of market discipline for corporate managers is the hostile takeover. Bad managers damage shareholders by failing to realize a corporation's potential value, providing an incentive for better management to take over and improve operations.
System of Reputations
A powerful force in every voluntary market, the reputation mechanism provides an incentive for coordinating the actions of parties with limited information and trust. There are dozens of examples of reputation-based associations, the broadest of which is classified as corporate culture.
Other examples include the Better Business Bureau, Underwriters Laboratories, consumer unions, watch groups, and other consumer agencies that reinforce reputation constraints.
The estimated cost of the Enron bankruptcy in 2001, the largest corporate collapse in American history at the time, which was attributed to agency problems.
The Bottom Line
Ultimately, individual corporate management is disciplined by other competitive managers. All management competes for shareholder equity, and shareholders who feel the loss of mismanagement have an incentive to switch ownership toward better management.
Agency theory has only recently come to recognize the role of dynamic capital and money markets in solving agency problems. Inefficiencies in corporate operations create a form of arbitrage opportunity for entrepreneurs, through reputation-creating organizations or takeovers, to move capital toward better management.