22 December 2010

A short introduction to agency theory - Part 1

A short introduction to Agency Theory

Where ever you look in society, you can see people doing things for other people.  Rather than asking as a blind unthinking robot merely processing instructions, the doing person often has some degree freedom as to how they go about the task. 

Let’s call person doing things, “the agent” and the person who benefits “the principle”.  In the standard corporate setting, you have shareholders who pool together cash and delegate the authority to manage those funds as they best see fit.  We actually see this in all walks of life.

Perhaps the most fundamental example is that of mother and child.  The child is unable to do things for itself, and so the mother must act to feed, clothe and protect the child in a way that is selfless to the mother and importantly, always in the child’s best interest.  In this sense, the CHILD is the principle and the MOTHER is the agent of the child

This agent-principle relationship some times creates a lot of risks because there is no automatic assumption that the agent (the manager) will always act for the best interest of the principle.  Of course, under the law of equity, there is this concept called a “fiduciary duty”  in which the trustee (agent) is obliged to act for and on behalf of the beneficiary (principle).  In the religious would, there are similar concepts in both Christianity and Islam where you are morally obliged to behave in a way that looks after other people.   

But can we really rely on this?  What people SHOULD do it not what they WILL do.  Is not it naive to rely on people morals?

Agency theory does not assume nor does it depend on people’s good nature.  Being a positive theory, it assumes that people are rational, strategic, and self-interested.  Basically, we assume that people are greedy bastards.  Not evil, just greedy.  

We can make some further assumptions about managers and their ultimate masters. Like the debt holders, managers are risk adverse.  In the absence of any incentive program, managers nothing more special than regular employees.  They receive a regular pay cheque and do not benefit from any of the upsides of the firm’s performance.  We can also assume that laziness is a good thing in their view, just like it is for any other employees.  So to squeeze another extra dollar from the firm will often require significant effort and risk on the managers behalf. Yet why would a manager bother if it yeilds nothing for them personally? If the program fails, then they  might lose their job. This means that if there is no incentive for them to undertake risky but positive NPV programs when it’s their ass and reputation on the line. 

Shareholders on the other hand, are likely to be diversified and risk neutral. So they really don’t care if one project fails, because they will have other positive NPV programs (shares) that can take up the slack of one loss.  The most important thing for the shareholder is that the average return is as high as possible. Shareholders will therefore, rationally want managers to take that risky projects that managers might be reluctant to do so.  The only problem is, unlike regular employees that you can clearly instruct, the manager is also in control of the flow of information.  You are forced to rely on their version of the story, and that story will biased in a way that will - at all times – suit their own personal interests.

Basically the agents have access to all the cash and do not always have people checking on them asking questions.  Part of this problem is information asymmetry.  This means that the managers are “insiders” to the business and the shareholders (principles) are outsiders.  The owners are forced to rely on what they principles tell them. No rational person would ever tell a version of the truth that didn’t paint themselves in a good light.

Click here for part Part 2 

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