Assessing The Validity Of The 'Agency Problem' And Its Effects On Enterprise Efficiency

1). Whereas a typical solution to the “agency problem” involves greater use of monitoring and performance management, many have argued that these promote a culture of short-termism and “managing the measure.” Assess the validity of this view using a combination of theory and examples.

Discussion

Callen and Fang (2013) opines that the agency problem is the age- old issues which persevered since the development of joint stock enterprise. It has been evident from historical studies that every companies possibly suffered in various forms from this agency issue. With change in time, this agency issue has taken various shapes and costs. From the basics of information economics, the agency theory has developed mainly along two lines that includes- principal agent and positivist. These two lines have general unit of analysis, which is the primary contract between agent and the principal individual. In fact, these two parties also share general assumptions about companies, information and other individuals. According to (), the positivist agency theory is mainly concerned with explaining governance mechanism which solves the agency issue. There are two proposition that capture governance mechanisms that are recognized in positivism stream. The first proposition is that the contracts made between the principal individual and agent are effectual in curbing opportunities of agent. In context to this, several researchers have argued that such contracts usually coalign agent’s preferences with that of principal as the rewards for these two parties is based on similar actions (Chen and Sougiannis 2012). Another proposition is that the information system curbs the opportunities of agents. The argument has also occurred in this case as information system generally inform the principal individuals about the actions of agents, it likely curbs opportunism of agents because agents might realize to deceive the principal individual. On the other hand, the principal agent theory is less accessible to the entity’s theory (DeMarzo, Fishman and Wang 2012). The focus of this theory is to determine optimal contract between the agent and principal agent. In addition to this, this theory assumes target conflict between the agent and principal where the agent is risk-averse than principal. Few economists have argued that risk averse agent do not have the ability to spread their employment while the principal agents have the capability to diversify their investments and hence is risk neutral.

Even though the principal agency issues occur when the principal mainly delegates action to the agent, the principal agent does not have all the information about the behaviour of other agent. Moreover, the principal agent interest also diverges from the agent interest, which means that the result is less desirable in comparison with principal expectation.  The principal agency problem might lead to market failure as the agent pursue their self- interest despite the principal as well as business run in inefficient manner (Bosse and Phillips 2016). Moreover, in several extreme cases, mutually beneficial action might not occur since the principal agent lacks information. Apart from this, the principal individual issue might cause adverse selection as poor selection is dependent on the asymmetric information. However, this is the situation in which the agent gets certain information before the contract has been written. There are certain requirements of the principal- agent issues which includes-

Several actors who have various kinds of objectives

Asymmetric information which means the agents have more information as compared to principal agent.

Cost of agency problem

The agency problem also causes an individual to take excessive risk as the final cost is carried by other agent. This highlights an example of morale hazard, which occurs when any individual enhances their exposure to risk if insured. Poblete and Spulber (2012) cites that moral hazard is caused due to agency problem as it occurs under asymmetric information in which risk taking individual to a specific transaction knows better than another party paying risk consequences. Moral hazard arises in agency problem because the agents have better information about their actions as compared to principal agent. The reason behind this is that the principal agent do not have the ability to monitor these agents.

Cost of agency problem

Agency cost-For limiting the agency conflicts, agency cost is usually incurred. Agency cost refers to the cost that arise from interest conflicts among the shareholders and managers. Owing to asymmetries of information, the principals might be unaware of the fulfilment of contract (DeMarzo, Fishman and Wang 2012). However, the principals might be reluctant in entering into the contract as they are unaware of not knowing this.

Monitoring cost- For trying to overcome principal agent issue, they have to spend fund on monitoring as well as giving incentives for the workers.

Inefficiency- The principal agent issue enables the agents to produce the sub-optimal work. However, the managers of the organization might be the profit satisfiers and thus leading to huge cost as well as less profit.

The agency problems largely hampers enterprise efficiency and also declines productivity of agency. Also it makes unpleasant place for work and leads to increase in workers turnover rate, which in turn lowers the efficiency level.  The enterprises integrates numerous dynamic techniques to static problems that results from agency issues, which involves- contractual incentives, performance monitoring, soliciting aid of the third parties. The modern enterprise deals with the agency issues by implementing certain practices and models that are explained below-

Incentivizing workers- If the agents act according to their self- interest, changing incentives for redirecting these interest might be beneficial for the principal agents. By creating incentives motivates hard work on the projects, thereby benefitting the company motivates more workers to act in business interest (Economicshelp.org. 2018). Moreover, aligning principal agent and other agent target, the agency theory generally attempts in bridging division between employers and workers that occurs due to principal agent issue.

Standard models of principal- agent-Economist uses this principal agent models and provides solution for issues which outcome from the conflicts of self- interest in business. These framework also helps in reducing agency cost. Moreover, this model also forms the basis of the agency theory, which states that knowledge as well as labor are asymmetrical distributed and hence measures are vital for correcting distributive inefficiencies.

Implementing agency theory- The agency theorists assumes huge role for explicating incentive mechanisms including written contracts, performance monitoring for mitigating agency issues. It has been demonstrated in previous studies that all these solutions are incomplete on the basis of moral hazard and averse selection. The agency problem mainly consists of game theory, which is the theory of legal work and enterprise (Economicshelp.org. 2018).  Over the last few years, various mechanisms relating to corporate have been recognized as the possible solutions through the agency theory.       

Implementing agency theory

 If the agency issue can be mediated successfully, then both the principal agent and other agent might choose in arbitrating the dispute. However, in this situation both these parties agree to listen their sides of disagreement and then abide by the rendered decision.      

One solution relating to the issue of agency cost can be found in effectiveness of the managerial monitoring and utilization of managerial incentives (Nagy 2013). The solution of incentives is to link shareholders wealth to executive’s wealth. However, the two group’s interest are aligned in such a way. Moreover, the agency problem can also be solved by setting up mechanisms for monitoring manager’s behaviour.

It has been argued by several economist that this agency problem helps to promote culture of short termism and management of measure. Short termism relates to the main focus on the short term outcome at expense of long- term interest or objectives (Thanassoulis 2013). Some researchers have found out that short- termism outcomes in insufficient attention that is being paid to strategy and long- term value creation of the institution. Moreover, short- termism is generally dangerous in advanced economy as this has led to deplorable impact involving- global financial crisis and Lehman Brothers case. Van Puyvelde et al. (2012) argues that the managers of the enterprise might make decision by sacrificing long- term interest of shareholders and thus connects short- termism to  principal agent problem to the managers and stakeholders.

Conclusion:

From the above discussion, it can be concluded that the agency theory gives a unique and realistic perspective on the agency problems of cooperative effort. The methods that are used for resolving this agency problems leads to creation of short- termism culture which the scholars call as “managing the problem”. However, creation of short- termism culture causes several problems within the companies by inviting corruption in the business world.

The essay provides an overview on the typical solution to the agency problem that involves larger use of monitoring and performance management which several people have argued that these promote culture of short- termism and managing the measure. Agency theory involves the agency problem which arises when the cooperating parties generally have various targets as well as labor division (Ballwieser et al. 2012). It is mainly directed at agency relationship where the main party generally delegates work to another party who are also considered as agent. These agents thereby performs the work for the principal agent. This theory attempts in describing the relationship using metaphor of the contract. Agency theory is mainly concerned with resolving two issues, which might arise in the agency relationship. These two issues include – agency problem and risk sharing problem. Agency problem occurs when targets of principal party conflicts with that of the agent. On the other hand, risk sharing issues occur when both the principal party and agent have various attitudes towards risk, which means that both these parties might prefer various actions owing to different preference of risk. This essay also discusses about the agent problem issue in the context of economic survival.

References:

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Bosse, D.A. and Phillips, R.A., 2016. Agency theory and bounded self-interest. Academy of Management Review, 41(2), pp.276-297.

Callen, J.L. and Fang, X., 2013. Institutional investor stability and crash risk: Monitoring versus short-termism?. Journal of Banking & Finance, 37(8), pp.3047-3063.

Chen, C.X., Lu, H. and Sougiannis, T., 2012. The agency problem, corporate governance, and the asymmetrical behavior of selling, general, and administrative costs. Contemporary Accounting Research, 29(1), pp.252-282.

DeMarzo, P.M., Fishman, M.J., He, Z. and Wang, N., 2012. Dynamic agency and the q theory of investment. The Journal of Finance, 67(6), pp.2295-2340.

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Heracleous, L. and Lan, L.L., 2012. Agency theory, institutional sensitivity, and inductive reasoning: Towards a legal perspective. Journal of Management Studies, 49(1), pp.223-239.

Nagy, D.M., 2013. Owning stock while making law: an agency problem and a fiduciary solution. Wake Forest L. Rev., 48, p.567.

Poblete, J. and Spulber, D., 2012. The form of incentive contracts: agency with moral hazard, risk neutrality, and limited liability. The RAND Journal of Economics, 43(2), pp.215-234.

Thanassoulis, J., 2013. Industry structure, executive pay, and short-termism. Management Science, 59(2), pp.402-419.

Van Puyvelde, S., Caers, R., Du Bois, C. and Jegers, M., 2012. The governance of nonprofit organizations: Integrating agency theory with stakeholder and stewardship theories. Nonprofit and voluntary sector quarterly, 41(3), pp.431-451.