Module 6-Agency Problems

3. Agency Problem
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An agency in general, is the relationship between two parties, where one is a principal and
the other is an agent who represents the principal in transaction with a third party. Agency
relationship occur when the principal hire the agent to perform a service on the principal
behalf. In common, principal will delegate decision making authority to the agent.

      Agency Theory is concerned with resolving problems that may exist in agency
relationship; that is, between principals (such as shareholders) and agent of the principals
(such as company executive). The two common problems that agency theory addresses are:

1) the problem that arise when the goals of the principal and the agent are in conflict.

2) the problem that arise when the principal and agent have different attitudes towards
risk.

     Because of different risk tolerances, both principal and agent may each be refused to
take different action.

      Agency problems may arise because of inefficiency and incomplete information. A

simple agency model suggest that, as a result of information asymmetries and self-interest
principals lack reasons to trust their agent and will seek to resolve these concerns by
putting in place mechanism to align the interests of agents with principals as well as to
reduce the scope of information asymmetries.
MOTIVES OF AGENTS AND INFORMATION ASYMMETRIES
         At times, agent and principal are prone to have different motives. They may be influenced
by factors such as financial rewards, labour market opportunities, and relationships with other
parties that are not directly relevant to principals. Agents may also be more risk averse than
principals. As a result to these differing interests, agents may have an incentive to bias
information flows.

Principal’s Problems

        Since principal has delegated the authority and responsibilities to agent, principal depends
on agent’s effort, and possibly other factors to determine his/her profit. Earning maximum profit
would be the main interest of the principal. However, the agent also would like to maximises
his/her utility. 

       Doing work is a disutility, so agent needs compensation to be induced to work. Besides that,

agent may require a minimum level of utility before agreeing to work. This contradict with
principal’s objective, which is to maximize his profit.

Agent’s Problems
     Agents are somewhat the same like principal. They would also like to maximize their utility.
When such intention arises, it will compromise the principal’s interest. 

      For example, in dealing with a high-risk business contract the has possibility high return,
managers might as well avoid such contract because they are afraid of the negative impact on
them (no bonuses, being laid off, etc.) should the contract fails. However, the managers action is
not in the best interest of the principal. Agent’s objective is not aligned with principals.
COSTS OF SHAREHOLDER-MANAGEMENT CONFLICT
      Problems arise when the goals of principals are not completely shared by their agents.
For example, employees may exert insufficient effort, or managers may waste
organizational resources. 

     The costs that arise when agents fail to act in the interest of principals are called agency
costs. The table below explains further:
MECHANISMS FOR DEALING WITH SHAREHOLDER-MANAGER CONFLICTS
       There are two opposing positions for dealing with shareholder-manager agency conflicts. At
one extreme, the firm's managers are compensated entirely on the basis of stock price changes. 

      In this case, agency costs will be low because managers have great incentives to maximize
shareholder wealth. It would be extremely difficult, however, to hire talented managers under
these contractual terms because the firm's earnings would be affected by economic events that
are not under managerial control.

      At the other extreme, stockholders could monitor every managerial action, but this would be
extremely costly and inefficient. The optimal solution lies between the two extremes, where
executive compensation is tied to performance, but some monitoring is also undertaken.

       In addition to monitoring, the following mechanisms encourage managers to act in

shareholders' interests:

1) performance-based incentive plans

2) direct intervention by shareholders

3) the threat of firing

4) the threat of takeover

     Most publicly traded firms now employ performance shares, which are shares of stock given
to executives on the basis of performances as defined by financial measures such as earnings per
share, return on assets, return on equity, and stock price changes. 

 If corporate performance is above the performance targets, the firm's managers earn more
shares. If performance is below the target, however, they receive less than 100 percent of the
shares. Incentive-based compensation plans, such as performance shares, are designed to satisfy
two objectives. First, they offer executives incentives to take actions that will enhance
shareholder wealth.

      Second, these plans help companies attract and retain managers who have the confidence to
risk their financial future on their own abilities—which should lead to better performance.

     Reward systems and incentive plans may align the interests of shareholders and managers.
The challenge from a managerial control system perspective is to do this in a way that
encourages better individual and organizational performance than if incentives did not exist.
When entities are small, principals minimize energy costs by personally overseeing agent
behavior and performance. However, as organizations grow larger, agent behavior is more
difficult to observe, and agency costs tend to increase. 
     To reduce agency costs, entities establish accounting systems to monitor and influence agent
behavior. For example, public companies publish audited financial statements, and employees
are often paid bonuses for achieving profit goals.

Thus, accounting information is used not only to measure and monitor an organization’s
activities, but also to measure, monitor and motivate the performance of agents. This would form
part of the management control system of the entity.

      It is impossible to completely eliminate agency costs because agent behavior and decision
making cannot be perfectly observed or measured. Poor results might be caused by poor agent
performance or by circumstances outside the agent’s control. Similarly, favorable results cannot
be attributed to the agent’s performance alone.

       For example, the sales generated by a salesperson are partly a function of the effort and
skills of the salesperson and partly a function of the price and quality of the product, economic
conditions, competition, customer tastes and so on.

      One way to reduce agency costs is to give specific decision-making authority to agents and
then hold them responsible for the results of their decisions. Shareholders on the other hand give
managers authority to decide how company resources are used. 

      The shareholders hold the managers responsible for creating shareholder value. To reduce
agency costs, individual employees are held responsible for their decisions, and limits are place
on their decision-making authority.
 CONCLUSION
he principal-agent relationship form parts of our lives without we realized it. It is not only restricted
to business purpose only. It is just that the principal-agent relationship is reflected more in business
activity, where the shareholder (principal) delegate the responsibilities of managing the business to
managers (agents).

Although the agent is bound to work in the principal’s interest, we cannot deny that agent is also
people who seek for utility maximization. In the agent-principal relationship, it is very rare that agent
get tu maximize his utility while at the same time, maximize the principal’s wealth. In most cases,
only one party get to benefit at a time. Therefore, conflicts arise as both party seek benefits for
themselves.

Due to these conflicts, principal has to incur costs so as to ensure that the agent act in their best
interest and prevent further loss. These costs are called the agency cost. Besides that, some measures
can also be undertaken by principal to aligned the agent’s objective with his.

In reality, despite the agency costs and measures taken by managers, the conflict between agent and
principal cannot be resolved completely. It can only be reduced to a tolerable level.