Question 1

Agency theory is concerned with resolving problems that can exist in agency
relationships; that is, between principals (such as shareholders) and agents of the
principals (for example, company executives). The two problems that agency theory
addresses are:
1.) the problems that arise when the desires or goals of the principal and agent are in
conflict, and the principal is unable to verify (because it difficult and/or expensive to
do so) what the agent is actually doing; and
2.) the problems that arise when the principal and agent have different attitudes
towards risk. Because of different risk tolerances, the principal and agent may each be
inclined to take different actions.
An agency, in general terms, is the relationship between two parties, where one is a
principal and the other is an agent who represents the principal in transactions with a
third party. Agency relationships occur when the principals hire the agent to perform a
service on the principals' behalf. Principals commonly delegate decision-making
authority to the agents. Agency problems can arise because of inefficiencies and
incomplete information. In finance, two important agency relationships are those
between stockholders and managers, and stockholders and creditors.

AT has been applied by researchers in many disciplines, including accounting,

economics, finance, marketing, political science, organizational behavior, and
sociology (Eisenhardt, 1989a). It addresses the agency relationship in which the
principal delegates work to the agent, who then performs the work. The AT unit of
analysis is the contract that governs the principal agent relationship (Jensen and
Meckling, 1976). AT suggests two types of contracts between principals and agents
(Eisenhardt, 1989a): Behavior-based contracts specify the way in which an agent
should behave. The agent is rewarded on the basis of information about his behavior.
Outcome-based contracts reward the agent on the basis of the realized outcomes. This
theory makes the following human, organizational, and informational assumptions
(Eisenhardt, 1989a): In the context of AT, people are self-interested, risk-averse and
have bounded rationality. The organization is characterized by partial goal conflicts
among participants and information asymmetry between principals and agents.
Efficiency is considered as the effectiveness criterion. Finally, information is
considered a purchasable commodity. The aim of AT is to solve two problems that can
occur in an agency relationship (Eisenhardt, 1989a). The first is a control problem

resulting from goal conflicts between the principal and the agent and the difficulties
involved in verifying what the agent is actually doing. The second problem is a risksharing one that occurs when principals and agents have different risk preferences.
Two branches of neoclassical economic theories of the firm, which we discuss in this
chapter, rest on the notion of the agency problem. According to Baiman (1990: 342)
an agency relationship exists when one or more individuals (called principals) hire
others (called agents) in order to delegate responsibilities to them. Examples for such
agency relationships include those between owners (principals) of a firm and the
managers (agents); owners of an estate (principals) and their stewards (agents); a
superior manager (principal) and his/her subordinates (agents); a client (principal) and
a service provider (agent), such as a physician, a lawyer or an accountant, who makes
decisions that affect the client. Thus, it is clear that such agency relationships can be
intra- organizational as well as inter-organizational. Organizational hierarchies, for
example, manifest intra-organizational agency relationships, while inter-firm
arrangements such as franchising, licensing, subcontracting and so on are also
examples of agency relationships.
Inter-organizational approaches in which the agency and client are viewed as forming
a business alliance and having a symbiotic relationship may also be useful for
considering the organizational integration necessary to achieve effective integrated
marketing communications. While these approaches do not deny conflict and cultural
differences among aligning businesses, they also recognize that non-economic,
relational factors often may be also important for better business performance than are
various contractual and monitoring activities which are the focus of agency theory. In
this regard, many theorists have found agency theory to be problematic and simplistic
in ignoring the complexity of organizations.
Agency relationships are governed by implicit or explicit contracts between agents
and principals. Such agency contracts spell out specific objectives, duties,
responsibilities and authorities delegated to the agent; compensation arrangements for
carrying out those delegated responsibilities; information and communication
arrangements; allocation of ownership rights; and so on. Various managerial
techniques and tools, such as management by objectives, budgeting and responsibility
accounting, as well as human resource management practices of job descriptions,
prescriptions and letters of appointment, form complementary methods of contractual
arrangements between agents (employees) and the principal (the firm). Such methods
of contractual arrangements not only define the agency relationships between the firm
and its employees but also construct the organization as a nexus of contracts (Fama
and Jensen, 1983a and b).

As already noted, the agency problem is the analytical root for economic theories on
the nature of the firm and relations therein. Agency theory or the theory of principal

and agent attempts to handle the agency problem in a rather normative or deductive
way by modelling agency relationships and solving them for optimal contractual
relationships between the agent and the principal. It should be noted that optimality
means here a solution that would maximize the net return for the principal, which is
the firm. Thus, agency theory fundamentally concerns devising contractual
relationships between the agents (employees) and the principal (the firm) that produce
the required level of effort and risk from the agents to maximize the firms profits.
According to neoclassical economic terminology, this profit-maximization contractual
relationship is an equilibrium, as it balances the conflicting needs of agent and
principal. The agency theory employs marginal analysis as its analytical device to
determine this equilibrium, and it holds the assumptions that both agent and principal
are rational, wealth-seeking and utility maximizers (Ezzamel and Hart, 1987: 262).
Thus, in essence, agency theory is a neoclassical economic theory aimed at devising
equilibrium contractual relationships between agent and principal to mitigate the loss
(to the principal) caused by the agency problem.
Agency theory suggests two fundamental behavioural reasons for the agency problem.
First is the goal incongruence between agent and principal. It is assumed that the
employee or agent, while economically rational, acts out of self-interest rather than
necessarily in the interests of his employer or principal (Ashton, 1991: 106). When
this self-interest is coupled with the risk and work aversion of the agent, goal
incongruence between agent and principal becomes the norm rather than the
exception. The second reason is information asymmetry, which is the agents
possession of private information about his/her level of efforts to which the principal
cannot gain access without incurring additional costs. In other words, information
asymmetry is the issue of how well the principal can observe the agents behaviour. In
typical situations, the principal has no information about the agents behaviour other
than some signals concerning the agents level of effort. For example, output by the
agent would constitute a signal concerning the agents level of effort. However, that
would never be a perfect piece of information on the agents level of effort, as output
is determined not only by that effort but by many other random variables beyond the
control of the agent.
Given the agents risk and work aversion and information asymmetry, the challenge of
the principal is to devise a contract that motivates the agent to exert a level of effort
that would maximize the firms (i.e., principals) profit. There are two contrasting
employment contracts that a principal can devise, though neither is likely to maximize
the principals payoff. A combination of these two is also possible, which is more
likely to maximize the principals payoff.
For example, suppose that you have an estate which you think would be better
managed by hiring a capable manager (an agent). It is easy to understand that you
have three basic contractual options under which you could hire the manager.

A wage contract, where you agree to pay a fixed monthly wage irrespective of effort
and performance by the manager. In this case, you (the principal) bear the total risk of
the business, and the agent has no incentive to exert greater effort or perform better. It
is you, the principal, who ultimately has to bear the losses due to managerial
inefficiency and/or any other factors.
A rent contract, where you rent out the estate for a fixed monthly payment and the
manager agrees to pay a fixed monthly rent irrespective of performance so that any
extra net income (or loss) generated from the estate goes to the manager. In that case,
it is the agent who bears the total business risk as your return is fixed. Although a rent
contract surely motivates the manager to perform better, his performance brings no
additional gains for you.
Your third option is a combination of the above two, where you and the manager
share the risk and return. So, you would pay a base salary plus an incentive payment
based upon the managers performance.