When human interaction is viewed through the lens of the economist, it is presupposed that
all individuals act in accordance with their self-interest. Moreover, individuals are assumed to
be cognizant of the self-interest motivations of others and can form unbiased expectations
about how these motivations will guide their behavior. Conflicts of interest naturally arise.
These conflicts are apparent when two individuals form an agency relationship, i.e. one
individual (principal) engages another individual (agent) to perform some service on his/her
behalf. A fundamental feature of this contract is the delegation of some decision-making
authority to the agent. Agency theory is an economic framework employed to analyze these
contracting relationships. Jensen and Meckling (1976) present the first unified treatment of
agency theory.
Unless incentives are provided to do otherwise or unless they are constrained in some other
manner, agents will take actions that are in their self-interest. These actions are not
necessarily consistent with the principal’s interests. Accordingly, a principal will expend
resources in two ways to limit the agent’s diverging behavior: (1) structure the contract so as
to give the agent appropriate incentives to take actions that are consistent with the principal’s
interests and (2) monitor the agent’s behavior over the contract’s life. Conversely, agents may
also find it optimal to expend resources to guarantee they will not take actions detrimental to
the principal’s interests (i.e. bonding costs). These expenditures by principal and/or agent may
be pecuniary/non-pecuniary and are the costs of the agency relationship.
Given costly contracting, it is infeasible to structure a contract so that the interests of both the
principal and agent are perfectly aligned. Both parties incur monitoring costs and bonding
costs up to the point where the marginal benefits equal the marginal costs. Even so, there will
be some divergence between the agent’s actions and the principal’s interests. The reduction in
the principal’s welfare arising from this divergence is an additional cost of an agency
relationship (i.e. ”residual loss”). Therefore, Jensen and Meckling (1976) define agency costs
as the sum of: (1) the principal’s monitoring expenditures; (2) the agent’s bonding
expenditures; and (3) the residual loss.
Barnea et al. (1985) divide agency theory into two parts according to the type of contractual
relationship examined – the economic theory of agency and the financial theory of agency.
The economic theory of agency examines the relationship between a single principal who
provides capital and an agent (manager) whose efforts are required to produce some good or
service. The principal receives a claim on the firm’s end-of-period value. Agents are
compensated for their efforts by a dollar wage, a claim on the end-of-period firm value, or
some combination of the two.
Oct 31