Agency Theory Essay

1331 words - 6 pages

b. Agency theory - Agency theory has often been used by economists to explain executive pay. Both executives and shareholders may have divergent interests and risk profiles under agency theory. For instance, executives view their interest in profits as a bonus in contrast to shareholders that consider their interest to be dividends and capital gains. With divergent interests, executives may prefer to avoid risking company assets or resources to protect their jobs. That is, a risk that fails can put executives out of a job while shareholders only lose part of their portfolio. Risk-adverse executives may prefer to pay themselves excessive salaries rather than take on risks that could ...view middle of the document...

A participation constraint acknowledges that the contract must satisfy the executive's minimum required utility. Compensation contract can satisfy these concerns by linking the executive's wealth to shareholder wealth through equity-based incentives such as restricted stock and stock options. When equity-based incentives are combined with performance bonuses tied to accounting measures, the executive's own wealth is implicitly tied to outcomes that produce shareholder value. Due to moral hazard, that is, the inability of principals to observe the actions or behavior of an agent, incentives linked to outcomes can counter this issue. An emphasis on incentives in the principal-agent model reflects an important trade-off inherent in the principal-agent model. Executives that are comfortable taking risks will be motivated by incentives. However, the risks in the principal-agent model are not identical. While principals can diversify their investment risk through portfolio management, agents often have a large portion of their wealth and employment tied up in the company. Thus, the level of an executive's wealth is likely to affect the appetite for risk. The wealthier an executive is, the more likely they are to take on greater risks. The principal-agent model recognizes that executives are motivated by financial and non-financial incentives that maximize their utility.

Shortcoming of agent theory - According to agency theory, principals are assumed to know what actions should be taken to increase value. In practice, however, principals hire self-interested agent-executives because they possess unique skills, knowledge, or other information to create value. Incentive tied to outcomes, rather than inputs, provide a degree of control over this aspect of the principal-agent relationship. The incentive designs should balance performance outcomes against the risk necessary to achieve them. For instance, incentive contracts should discourage agents from taking risks to achieve outcome that require risks beyond the principal's tolerance. An effective incentive contract should have a limited number of outcome based metrics that are easily understood and explained to principals and agents alike. If an incentive design is so complex that it fails to satisfies either of these elements, it may not be capable of effectively motivating agents or controlling their actions to create values for shareholder-principals.

Allocation problems - Agency theory is both normative and descriptive. It is normative because it provide ways to effectively structure incentive contracts. It is descriptive because it explains why things are the way they are. What agency theory does not address is allocation problems. That is, agency theory does not address how individual managers contribute to the company's overall performance or how effort is balanced between short term performance measures and investments necessary for long-term sustainability.

a. Systems thinking -...

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