A:

Agency problems – also known as principal-agent problems or asymmetric information-driven conflicts of interest – are inherent in static corporate structures. This conflict arises when separate parties in a business relationship, such as a corporation's managers and shareholders, have disparate interests. In other words, corporate managers aren't really beholden to dispersed ownership.

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.

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 (asymmetry) and that additional measures are necessary to correct these distributive inefficiencies.

Agency Theory

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 hierarchical corporate structure.

Through the years, several different corporate-specific mechanisms have been identified as possible solutions through agency theory.

Market for Corporate Control

The most frequent example of market discipline on 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 most broad 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.

Economic Calculation and Competition

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.

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