Agency Theory

Agency Theory emerged as a response to managerial theory (Jensen & Meckling, 1976). The core idea is the relationship between stockholders (owners, principals) and managers (agents). This is often described as the principal-agent relationship. This theory assumes that managers (agents) may pursue goals that are not always aligned with those of their principles (stockholders). As a result, there is a loss in efficiency. In order to avoid misalignment of principal-agent interests, governance mechanisms have evolved to limit managerial discretions. These include:

  • Performance based compensation (stock options)
  • The board of directors (a monitoring mechanism)
  • Corporate debt
  • Market for corporate control (takeover constraint)

The costs to deal with the principal-agent problem are called agency costs.

Collectively, agency theory believes that incentive alignment, monitoring, and enforcement mechanisms are generally sufficient to limit managerial discretion. This has a couple of implications:
  • The scope for pursuing inefficient corporate strategies is limited. Management teams that do so will be replaced by teams that have the nest interests of owners in mind
  • Organizational forms (franchising, vertical integration) may be a response to agency costs.
Some key articles include:
  • Jensen & Meckling (1976)
  • Fama (1980)
  • Demsetz (1983)
  • Fama & Jensen (1986)
  • Jensen (1986)
  • Eisenhardt (1989)
(Adapted from course notes)
(Flashcards and other resources here)

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