Agency Theory & Jensen and Meckling's Theory

• Agency theory is an area of transaction cost economics.
• Jensen and Meckling's book, "Theory of the company: management; agency costs and ownership structure," is based on theoretical findings.
• Theoretical findings are based on property rights, agency, and finance, to develop a theory of the structure of ownership.
• While this theory is often used to study hierarchical behaviors, it can also be used to analyze any type of exchange situation.
• Economists of the nature of the company, such as Alchian, Demsetz, Jensen, and Meckling, view the company as a set of contracts between production factors.
• Companies consist of team whose members act to satisfy their own interests, aware that their future depends on the survival of their team in the process of competing with other teams.
• The agency relationship is established when a principal delegates certain rights to an agent who is contractually obligated to defend those interests.
• Agent is compensated in some form.
• Contracts often involve clauses describing the permissible behavior for agents.
• It can be beneficial for the principal to have the agent provide some guarantee against their possible opportunistic behavior, usually subscribed from the moment of joining
• Restrictions have a cost.
• Most company managers are not responsible for the economic consequences of the company with their own property, their management often includes excessive spending at the company's expense, non-compliance with established work, and business objectives that differ from maximizing profit.
• Other issues are redirecting incentives toward technology acquisition rather than profit distribution, long-term concentration seeking to perpetuate their positions, market expansion, and internal luxuries.
• Attempt to minimize the difference between the principal's actual level of well-being and the level the agent would reach if they acted optimally.
• The difference in this behavior is called residual loss.
• The difference is greater as the agent's behavior is more opportunistic and cannot be countered by the control mechanisms established by the principal.
• Operating these control mechanisms incurs a cost and will only be done until the expected marginal cost equals the expected marginal reduction in the principal's residual loss.
• Marginal cost, added to supervision or bond costs, equals agency costs.

Agency Costs

• Agency costs include supervision costs, also known as control costs by the principal, bond or guarantee costs, which correspond to the costs of ensuring the agent's loyalty, and costs associated with the principal's residual loss.
• High agency costs can lead to problems arising from the associated cost and the characteristics of the agents, as well as the need to measure them approximately rather than exhaustively to obtain benefits.

Problems with Agency

• In the agency relationship, as mentioned in previous sections, there are two types of agency problems: adverse selection and moral hazard.
• Adverse selection, or antiselection, arises from pre-contractual information asymmetries.
• It can occur when a business owner hires personnel with only a college degree, without any other indicators for measuring productivity.
• New applicants are randomly selected from a pool of applicants with college degrees and paid the average salary of all active college graduates.
• Business owners who use other indicators to measure productivity, such as training, age, work habits, work experience, and reputation, when hiring will avoid this problem.
• Those relying solely on college education as an indicator of work capacity are more likely to experience adverse selection.
• Antiselection is a pre-contractual opportunism issue that arises due to private information that an individual has before being hired.
• In this case, they would be willing to be hired even below the average salary.
• Moral hazard emerges when measuring an agent's activity in its entirety during contract execution becomes too costly, leading to measuring only some of its components.
• Moral Hazard can induce the agent to neglect certain aspects of their work and focus only on those measured by the principal, such as achieving good market quotas, without much concern for quality, high employee productivity, or evaluating the work environment within the company.
• External forces limit the opportunistic behavior of managers, such as competition in the capital market, which tends to equalize the expected net profit rate of investments in the long term.
• External forces impact the performance of a company in the capital markets.
• Abnormal price increase or decrease in a company's stock is a relatively reliable and inexpensive signal to provide shareholders with relevant information about the quality of business management.
• There is competition in the labor market for managers which tends to equalize the real and total salary of managers of the same level of qualification, including social charges and consumption paid by the company.
• Competition among management teams is demonstrated in business absorptions where managerial inefficiency is eliminated through the takeover mechanism.
• Takeover is a deterrent to erratic managerial behavior, as one can lose their position if a takeover occurs in the absorbed company.
• External forces also act on contractual mechanisms, which function as limiters of opportunistic behavior
• Jensen and Meckling mention various types of supervision and forms of control, such as audits by company boards of directors, formal control systems, budget restrictions, and incentive-based compensation systems, in which managers are paid partly with company stock, so that the manager's complete salary is fully linked to the company's income statement.
• These limiting forces seek to reduce or eliminate opportunism of the manager or executive body of companies managed by salaried individuals and attempt to reconcile behavior between principals and agents in such a way that there is a minimum of residual loss.